Market panics are a normal part of American business cycles. The recent scare, driven by a combination of slower hiring and the partial unwinding of the global carry trade, stands in contrast with resilient household spending, a fiscal tailwind and solid, if unspectacular, fixed business investment in the United States.
As the Fed cuts rates, pent-up demand for investment in equipment, software and intellectual property, as well as the refinancing of autos and housing, should all bolster the economy.
These catalysts underscore our forecast of 1.8% growth in the second half of the year, a 20% probability of a recession over the next 12 months and a slower pace of hiring, near 120,000 per month on average, in the final months of the year.
At the same time, we expect the Federal Reserve to begin cutting interest rates. Our model implies one 25-basis-point cut at each meeting starting in September until the central bank reaches the new post-pandemic neutral rate, which should reside somewhere between 3% and 3.5%.
As rates fall, pent-up demand for investment in deferred purchases of equipment, software and intellectual property, as well as the refinancing of autos and housing, should all bolster the economy. These factors could push growth back toward the long-term rate of around 2%.
In addition, our analytical framework for the post-pandemic economy, in which rates are higher for longer amid the reindustrialization of the American economy, remains firmly in place.
Despite the recent turbulence in equity and fixed-income markets, we do not see the conditions in which the current business cycle ends in the near term.
The business cycle
We think this business cycle has room to run.
Having navigated the pandemic and the twin shocks of war and inflation, the economy should continue to expand, stopping only when another geopolitical shock, or a policy error by the Fed or lawmakers, brings it down.
The last business cycle lasted more than 10 years, from 2009 until early 2020, and it was hampered by episodes of price collapse, government shutdowns and war.
The current cycle has been with us for only four years and has already weathered a health crisis, labor shortages, a logistics crisis, war and inflation.
From our point of view, this business cycle looks sturdy. The turmoil of the past month in financial markets can be charitably characterized as a mid-cycle correction. But the experience of the past 30 years shows there is a reason for optimism.
Read more of RSM’s insights on the global economy and the middle market.
To begin with, monetary and fiscal policies among the western democracies have matured. Central banks have abandoned the 1970s tinkering with interest rates in favor of forward guidance and the gradual changes that lead to financial market stability.
In fact, we would argue that central banks need to reduce their dependence on backward-looking data. Large revisions to the data will be part of the economic narrative for some time.
In addition, fiscal authorities have recognized the cost of austerity and accepted the need to quickly address market failures, leading to confidence in income stability.
Finally, financial markets and their overseers have matured. The U.S. bond market remains the cornerstone of global investment, and the dollar is the reserve currency and the facilitator of international trade.
As much as critics can argue about the timing of Federal Reserve policy choices, the normalization of interest rates in the U.S. and Europe has reintroduced risk into the securities market, forming the basis for prudent investment going forward.
We see a host of reasons for the U.S. economic expansion to continue at or above its long-run potential growth rate. It won’t last forever, but long enough to normalize interest rates and to transition from dependence on what has turned out to be an unreliable supply chain.
No. 1: Growth despite a tight monetary policy
In a normal business cycle, the Federal Reserve gradually raises interest rates as the economy expands and then drops them after the economy falls into recession. The current cycle, though, is anything but ordinary.
The pandemic wreaked havoc with rules of thumb of how the economy works. The aggressive fiscal and monetary responses to the shutdown of global supply chains and national economies have resulted in a most unusual business cycle that may not respond well to policies designed to work in past cycles.
Before the end of the last cycle, the Fed had already started dropping rates in response to the 2018-19 trade war. The 2020 pandemic mandated a total economic shutdown and a return to near-zero interest rates.
The pandemic wreaked havoc with rules of thumb of how the economy works.
Then, as the recovery took hold and the current business cycle began, the Fed and other central banks were forced to aggressively raise interest rates.
The result has been a slowdown in most of the world, with developed economies in Europe dealing with the higher cost of capital, the Russia-Ukraine War and competition from China.
In addition, emerging economies are facing lower demand because of the global slowdown, with the high cost of energy adding to the drop in disposable income.
But the U.S. has been an outlier. Yes, there has been a slowdown, but over the past four quarters, real GDP growth has averaged 3% on a year-over-year basis and the domestic economy may be on the verge of a post-pandemic productivity boom.
Inflation has dropped close enough to the Fed’s 2% target to expect a rate cut in September. The bond market is expected to react quickly, anticipating a reduced cost of credit for businesses and home buyers that will spark more than enough growth to keep everyone employed.
No. 2: This is not your parents’ labor market
The labor market has experienced profound structural changes in recent years that have upended long-held assumptions. As workers remain in short supply, higher wages for skilled and unskilled labor will maintain household wealth and spending and, in turn, economic growth.
Still, the labor market has cooled in recent months. Although the unemployment rate is still quite low by historical standards, it increased from 3.4% in January of last year to the current rate of 4.3%. Does this mean the economy is headed toward a recession?
Not necessarily. We view the cooling as a transition toward sustainable growth of the economy and of the labor market after the surge in spending and the hoarding of workers after the pandemic.
We think the events of the past four years have finalized the economy’s transition away from basic industries.
This period comes on the heels of the investments in productivity during the era of low interest rates.
There were also dramatic changes in the preferences of workers precipitated by the pandemic shutdown. These changes have increased productivity and altered the supply of labor, at least in this era.
In addition, we think the events of the past four years have finalized the economy’s transition away from basic industries.
Economic growth is now generated by the development of intellectual property, with the labor market adapting to the profound changes required by advanced production and the service sector.
Consider that at the end of the 1950s, only 37% of women were participating in the labor force. By 2000, the participation of women in the labor force peaked at 60% before drifting down to 57% this year.
Over the same period, the participation rate of men in the labor force has declined from 80% at the end of the1950s to 68% this year.
By another measure, there are now 138 million working-age women (16 years and older) in the labor force compared to 131 million working-age men. And with women now more educated than men, women are no longer limited to secondary roles.
As baby-boomer retirements continue over the next decade, the male-female participation ratios are likely to move closer together.
With immigration unlikely to keep up with retirements and with changes in worker preferences and skill requirements likely to keep a lid on the supply of labor, that is likely to maintain the higher levels of wages needed to attract workers into the labor force.
That, in turn, implies higher household income and higher spending that will keep the economy growing.
Finally, despite the rising need for highly skilled workers, the public’s attention remains focused on occupations in the goods-producing sector.
Although we expect increased domestic production as infrastructure spending continues, our economy is now staffed by five times as many people in service-sector occupations as there are in goods-producing jobs.
Buying American sounds good in principle but is almost impossible in practice. Washington will have to calibrate a path that reindustrializes the economy but does not descend into protectionism and price controls.
To keep inflation in check, American businesses and households will still need access to goods and services that are no longer profitable to produce domestically.
While it is important to help displaced workers transition to more productive sectors of the economy, policies that preserve low-skill production jobs in favor of the higher wages in skilled occupations is short-sighted.
The income level of college graduates is $93,000, more than twice that of the $42,000 income for those with some college or associate degrees, and 2.7 times the $35,000 income of high school graduates.
The unemployment rate for college graduates is 2.3% and 3.5% for those with some college or associate degrees. The unemployment rate for high school graduates is 4.6%, twice that of the college grads.
The labor force participation rate for college-educated people is 72.7%, 63% for those with some college or associate degrees, and 57% for high school graduates.
There will always be a difference in educational attainment, but to consign a segment of the population to low wages and low participation in the labor force is counterproductive.
No. 3: Infrastructure spending
The investment in U.S. infrastructure approved in 2021 will pay dividends in the long run, while providing household and business income in the short-term.
Funding of the Bipartisan Infrastructure Law is just the latest in the string of infrastructure investments that created the conditions for economic expansion, from the creation of land grant universities in the 19th century to the space race of the 1960s.
Today’s rebuilding and updating of the transportation system comes after a long period of neglect. The effect on the post-pandemic recovery can be seen by the acceleration of nonresidential construction spending, which has grown at an average rate of 12.8% per year since July 2021.
Compare that to the 5.7% rate from 2009 to 2019, when the recovery from the financial crisis was stymied by resistance to government spending.
Since the infrastructure investment was approved, private industry has committed to invest nearly $900 billion in:
- Semiconductors and electronics ($395 billion)
- EVs and batteries ($177 billion)
- Clean energy manufacturing and infrastructure ($81 billion)
- Biomanufacturing ($42 billion)
- Heavy industry ($44 billion)
- Clean power ($160 billion)
The improvement in the nation’s logistics will add to the increased productivity of the labor force and make the economy more competitive.
The investment in advanced industries will sustain economic growth in the short run and while adding to the economy’s long-term potential growth that would otherwise be expected to flatline at 1.8%
No. 4: The CHIPS Act
When economic growth stops because of a financial shock, a health crisis or a geopolitical event, it becomes the government’s responsibility to maintain household incomes.
And when the private sector cannot take on the risk of investing in the future, it becomes the government’s responsibility to provide the seed money for that growth.
When American industry faced a chronic shortage of semiconductors during the pandemic, the government stepped in. Now, the U.S. is on track to add more investment in construction for computer and electronics manufacturing than it had over the 20 years before the CHIPS Act was passed, according to an analysis of census data by the Petersen Institute.
Notably, in a nod to industrial policy among developed nations, the report continues that U.S. investment has already spurred investment by South Korea in what could become a subsidy race.
That dynamic suggests that the United States, Korea, Japan and the European Union should coordinate the global expansion of semiconductor production to avoid overcapacity and the need for further subsidies.
The cost of these endeavors should be weighed against the cost of not doing so. And once the cost of construction is done, the benefits will be avoidance of further disruptions to the supply chain and the return of an industry vital to our national security and global competitiveness.
No. 5: Oil is no longer an issue
The U.S. has become the world’s leading producer of crude oil. But that does not mean the U.S. can control the price of oil.
As of 2022, the U.S. produced nearly 15% of the world’s crude oil, slightly higher than the shares produced by Saudi Arabia and Russia. But because oil is easily substituted, the price of oil is determined on the global market.
The experience of the pandemic showed that a drop in the demand for oil has an impact on its price. The combined effect of the 2019 trade war and the 2020 pandemic was a 31% drop in the U.S. average price of gasoline from $3.20 to $2.20 per gallon. As demand picked up again, the difficulty in restarting wells resulted in a spike in gas prices and increased inflation.
We expect a shrinking demand for oil over time as the use of electric vehicles increases. The stock of EVs in China, the world’s largest market, has increased by 68% per year over the past two years. EVs in Europe, the next-largest market, increased by 44% per year.
Even as the stock of U.S. EV’s comprises only 12% of global electric vehicles, analysis by the International Energy Agency suggests that recent trends indicate robust growth as the market for electric cars matures.
And while this suggests that the demand for gasoline and diesel will gradually fade, the immediate time frame, particularly in the U.S., suggests the status quo will remain regarding the supply and demand for petroleum-based products.
No. 6: Transfer of wealth
The first of the baby boomers are already in their late-70s. The means that boomer-rebound generation is on the verge of inheriting the housing stock and the funds left in their parents’ IRAs and pension plans.
Aging boomers will slowly leave their residences, easing the housing crisis and putting a lot of cash in the hands of the next generation.
No. 7: Increased military spending
The Russia-Ukraine War, the need to protect the global supply chain and the conflict in the Gulf region suggest increased spending on the military.
Military spending goes to U.S. defense contractors and their employees, with a multiplier effect that benefits subcontractors and service providers throughout the economy. The initial spending acts as a transfer payment that will increase U.S. household incomes and consumer spending.
The takeaway
The American economy is not heading into a recession.
The economy has shown resilience despite high interest rates and elevated inflation.
The Fed is likely to embark on a series of rate cuts that will reduce the cost of credit, sparking consumer spending and commercial activity.
In cutting rates, the Fed will be joining the central banks among developed economies, easing financial conditions that will spur global growth in the coming quarters.
On the fiscal side, the impact of domestic infrastructure spending and industrial policies to improve the supply chain and to foster advanced industries will become apparent in the short-term, while increasing the long-term potential growth of the economy.
We see only a 20% probability of a recession, though Russia-Ukraine War and tensions in the Middle East will continue to pose a risk to the global supply chain.
