by Paul Hoffmeister, Chief Economist
The global economy and financial markets are experiencing an unusual set of contradictions. As many of the world’s major central banks have pursued aggressive interest rate increases to stem the post-Covid inflation, major macro indicators appear to be screaming that an economic downturn is in sight. The sovereign yield curves for the United States, Canada, United Kingdom, France and Germany are each inverted. In the United States, the Index of Leading Economic Indicators has declined for 22 consecutive months between March 2022 and January 2024. And money supply measured by M2, considered by some to be the “lifeblood of the economy”, has recently contracted more than at any time since the Great Depression.
And yet, major stock indices from the United States to Canada, Europe and Japan are trading near all-time highs. U.S. real GDP grew 2.5% in 2023, and the unemployment rate is less than 4%.
Dark clouds appear on the horizon, but many aspects of the economy and financial markets today appear highly resilient. So, what’s behind these contradictions? And should we ignore the macro indicators and trust seemingly forward-looking market signals?
In our view, massive spending by the U.S. government and consumers is supporting the economy so far. Furthermore, we’re seeing an AI boom that has ignited mega-cap tech stocks, which has in turn helped to boost headline stock indices.
With regard to the economy, U.S. government spending has been offsetting a lot of the slowdown that the Federal Reserve has been trying to engineer through their interest rate shock campaign. In fiscal year 2023, U.S. federal government net outlays were more than $6.1 trillion. This is nearly as much as the $6.5 and $6.8 trillion in outlays during the peak pandemic years of 2020 and 2021; and it’s much more than 2019 (pre-Covid) outlays of $4.4 trillion.
Just as Covid emergency spending helped to keep the economy afloat amidst widespread lockdowns between 2020 and 2022, the continued elevated spending by the federal government is helping the economy to withstand the headwinds of higher interest rates during the last two years.
Consumers aren’t holding back their spending either. The personal savings rate in the United States was a relatively low 3.7% as of December 2023. Between 2015 and 2020, the personal savings rate generally ranged between 5% and 8%. Today’s historically low savings rate indicates that consumers are stretching themselves financially to stay afloat. At the margin, this is helping to support economic activity.
While we’re seeing monetary and fiscal policies act against each other and consumers reaching deeper into their pockets to make ends meet, big tech has been seemingly in its own world during the last year thanks to the AI boom.
As chatbots went viral last year, major tech companies such as Microsoft, Alphabet and Amazon invested heavily into companies such as OpenAI and Anthropic. In many respects, these investments steered AI-related business, which requires massive amounts of cloud computing power, to these cloud service providers, locking in significant, new revenue streams. Of course, these cloud services companies -- as well as others looking to leverage AI -- rushed to buy the advanced computing chips produced by the likes of companies such as Nvidia.
This nascent technology and related business led to massive rallies in 2023 for the AI-related stocks. For example, stock prices for Microsoft, Alphabet and Amazon were up more than 50% for the year, while Nvidia’s share price appreciated nearly 250%, seemingly becoming a household name.
Zooming out and looking at the global economy from a high level provides more context of today’s economic environment. There is indeed a global slowdown underway, which arguably validates the major macro indicators. China’s economy is in distress (with ground zero being its property sector); Japan, Germany and the UK have fallen into recession; and Canada is close to it, having grown 1% in Q4 after contracting -0.5% in Q3. Indeed, the global interest rate shock appears to be having its intended effect.
While the U.S. economy seems to be an exception so far, its growth environment is not necessarily robust. According to Zerohedge, earnings in the last quarter grew a better than expected 8% year-over-year; but without the Magnificent 7, earnings declined -1.6%. Similarly, while the S&P 500 returned nearly 24% in 2023, were it not for the big returns in the “Magnificent 7”, the S&P would have returned nearly 12%. Indeed, we seem to have a bifurcated economy today, where a small handful of megacap tech stocks are currently prospering but most companies are experiencing a slowdown.
The big question today is, will the United States be able to buck the trend of what seems to be a synchronized global economic slowdown?
A soft-landing in the United States is possible; Alan Greenspan achieved it in 1995. Stocks seem to be pricing for this optimistic scenario.
With the S&P 500 trading near 5100 and expected to earn $241 this year (forecast by Goldman Sachs), its P/E ratio is 21.2. This means that stocks are currently paying an earnings yield of 4.7%. Meanwhile, the 10-year Treasury yield is approximately 4.1%. As such, at 60 basis points, there is very little equity risk premium in the marketplace today. Historically, this risk premium fluctuates, and during the last 15 years, it has averaged almost 3%. Arguably, there isn’t a lot of risk or “cushion” priced into stock prices today. It further suggests that investors are expecting economic growth to persist and earnings growth to accelerate in the coming years.
In our view, however, the economic policy status quo isn’t conducive for a soft-landing and enabling the U.S. to downshift and avoid recession. With interest rates as high as they’ve been in decades, the higher cost of capital is taxing most of the world, which is starting to become apparent.
Could AI boost productivity and growth to such a degree to keep the economy afloat? Sure, but we’re skeptical. Even the emergence of the internet didn’t prevent the recession that started in late 2000.
For a soft-landing scenario, it would likely require some combination of aggressive interest rate cuts from the Fed and proportional cuts from other major central banks, a continuation of today’s historic federal spending, and pro-growth tax cuts to reignite animal spirits throughout the economy.
Unfortunately, Fed officials appear reluctant to cut rates too soon, particularly given recent inflation data that has come in higher-than-expected. Furthermore, ballooning deficits and ever higher interest payments on the national debt are starting to catch the attention of legislators in Washington; and tax cuts are nowhere on the horizon.
Absent major policy shifts, it appears that the wheels of the global economy are grinding slower and slower. But to a certain extent, massive spending and today’s AI boom appear to be offsetting this grind lower, and market prices seem to be optimistic that they’ll succeed.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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