US Economy remains resilient while underlying inflation falls

Quarterly Market Overview Q3 2023 | United States

Investors in US equity markets continued to second-guess how the US Federal Reserve (Fed) might respond to economic data in its commitment to use interest rates to tame inflation. Economic growth picked up marginally to an annualised 2.1% (downgraded from an initial reading of 2.4%) in the second quarter of 2023 from 2% in the first quarter. This allayed some anxiety about monetary policy direction and helped the market rebound towards the end of August. Inflation meanwhile appeared to be coming under control, with the annual rise in consumer prices in June easing to 3% from 4% in May – the lowest level in over two years. Thereafter, headline inflation picked up, increasing by 3.2% in July and 3.7% in August. Less favourable base effects and reduced falls in energy costs were behind the rise in August. However, core inflation continued to fall, reaching 4.3% in August which marked the fifth successive decrease from March’s 5.6% level. The downward trajectory of core inflation increased investor expectations that the Fed could ease the pace of interest rate rises. 

The Fed hiked interest rates by 0.25% to a range of 5.25%-5.5% in July, although Fed Chair Jerome Powell refused to say when they would go up again. The minutes from the Federal Open Market Committee’s July meeting showed that most policymakers had supported the increase. However, by September, public comments from Fed policymakers seemed to point in both directions; some supported further interest rate rises, while others thought this was no longer necessary. Interest rates were left unchanged in September which maintained the Fed’s ‘higher for longer’ narrative. 

While investors kept a close eye on Fed comments, the Fed focused on key drivers of inflation such as unemployment and consumer spending. In the labour market, the threat of wage-driven inflation continued, with still-elevated job vacancies and lower numbers of people claiming unemployment benefits. Alongside the start of strikes in the automotive sector, these all indicated persistently tight labour market conditions. 

Regarding consumer spending, retail sales were fairly sluggish but headed upwards. Modest but higher-than-forecast rises in retail sales reported by the US Census Bureau in July and August added pressure on the Fed to keep hiking interest rates. On the political front, attention towards the end of the period was on the looming possibility of a government shutdown on 1 October, if Republicans and Democrats fail to reach agreement on spending levels. It would mean many government departments might have to close temporarily.

Our view

We have a neutral outlook for US equities. Corporate results in aggregate continued to reflect a still-resilient US consumer, with mentions of ‘recession’ in US company management post-result call transcripts falling for four calendar quarters in a row, and close to 10-year averages. While analysts’ earnings growth expectations for calendar year 2023 remain muted, there is a significant assumed up-tick with over ten percent year-on-year growth estimated in 2024. Markets have responded by lifting valuation multiples this year, unwinding some of last year’s multiple compression. Additionally, we recently introduced smaller-capitalised sized US company exposures. Here we are seeking to take advantage of a relative valuation derating versus larger capitalised companies post pandemic, as well as capture domestic sensitivity to a more resilient US economic picture. The US has an important role in providing growth investment-style exposures within the context of our current equity barbell balanced approach to asset allocation. Our US equity weights also support our longer-term investment themes of technology, healthcare, and sustainability which the US has exposure to at an aggregate equity index level.