Call Participants

ATTENDEES

BEN HERZON

KRISTEN HALLAM

KRISTEN HALLAM

You are listening to The Decisive Podcast: Insights and analysis to empower confident decision-making. Hello, I'm Kristen Hallam, Lead Content Strategist and your host for this episode of The Decisive Podcast.

We're going to talk about our U.S. macroeconomic outlook with Ben Herzon, Executive Director and Co-Head of U.S. Economics at S&P Global Market Intelligence. Ben, thanks for joining us. Why don't we start with a high-level overview of our forecast? Are we still expecting a soft landing for the U.S. economy?

BEN HERZON

It is our view that the U.S. economy is still on track for soft landing, but there are risks to this forecast, a couple of which we'll touch on. 2023, last year, the U.S. economy had solid momentum heading into this year, but we do believe that GDP growth in the U.S. will slow down this year.

After growing at about a 2% annual rate over the first half of last year, GDP growth picked up to 4% plus over the second half. Now this year, we do expect GDP growth to slow materially below that 4% rate. In fact, we showed GDP growth averaging 1.8% per quarter this year.

KRISTEN HALLAM

So what's contributing to the slowdown, Ben?

BEN HERZON

One factor is the ongoing effects of past Fed tightening, also tightening of bank lending standards on both loans to consumers and businesses. We do expect tailwinds that had been boosting growth in 2023 to diminish and go away, that will contribute to the slow down. The dollar has been strong of late. This will weigh on net exports in the forecast.

And we also expect that a cessation of what have been rapid gains in equity values will weigh on consumer spending through traditional wealth effects. And all these factors that contribute to a slowdown in GDP growth will set the unemployment rate on a gradually rising trend. Loosening labor market conditions and other factors will then set core consumer price inflation on a path to 2% along with the Fed to begin cutting rates later this year.

KRISTEN HALLAM

Thanks for that, Ben. Now can you drill down a bit deeper and tell us more about the factors that you believe will contribute to a slowdown?

BEN HERZON

First is the ongoing effects of past Fed tightening. So when the Fed began tightening in March of 2022, that set private borrowing costs on a rapidly rising trajectory. Private borrowing costs remain elevated, and we are seeing the effects in business fixed investment. Business fixed investment is slow, and we expect that deceleration to continue into the forecast.

Also related to the ongoing effects of past Fed tightening, when the Fed tightened, mortgage rates shot up. Mortgage rates were around 3% prior to the tightening. They shot up to a quarterly average of around 7%. Recently, they remain elevated. They've come down a bit from there. This sharp increase in mortgage rates really cut into housing starts. Housing starts fell sharply, and they are expected to remain at roughly current levels into our forecast.

Tightening bank lending standards: Here are results from the Senior Loan Officer Survey and what banks have been telling us is for the last couple of years, they have been tightening lending standards on both commercial and industrial as well as commercial real estate loans. We believe that this will also weigh on this business fixed investment.

So whether we're talking about businesses that have direct access to capital markets through the issuance of debt or whether we're talking about businesses who must go through bank intermediation to raise capital, for all of those businesses it's becoming even more expensive or more difficult to raise capital. And we do think that these factors will weigh on business fixed investment and contribute to the slowdown in GDP growth that we expect this year.

In that same survey, banks have been telling us for the last couple of years that they are becoming less willing to make consumer installment loans. In our modeling, this feeds into spending on durable goods and our growth of personal consumption expenditures on motor vehicles and parts and in our forecast, what you see is that this tightening of bank lending standards is contributing to a relatively flat profile for this type of consumer spending and forecast.

Diminished tailwinds: We do expect that tailwinds we had in industry growth last year are going away. And one example is real fixed investment in manufacturing structures. This is a sector that was benefiting from generous incentives in the Inflation Reduction Act and the CHIPS and Science Act. We believe that after surging over the last couple of years, this spending is reaching a peak. We're not saying that businesses are going to stop taking advantage of these incentives. We just think that they're going to be taking advantage of them to a lesser extent than they have in the past.

Real estate and local gross investment: This is a sector that was surging over the last couple of years, and this sector benefited from monies that were allocated in the Infrastructure Investment and Jobs Act. Now we believe that this spending will remain elevated in the forecast but will not be contributing to growth going forward.

And I will say that when we look at the monthly data from the construction report, in the case of manufacturing structures investment, the monthly data is showing a slowdown consistent with the peak that we forecast. The data on state and local construction spending has already plateaued. So both of those are falling into line with our forecasting.

The dollar has been strong of late. I think what's going on here is that domestic Treasury yields are above foreign sovereign yields to a degree that is unusual in a historical context. This is leading to the flows of capital into dollar-denominated assets, and that's creating an elevated demand for the dollar and keeping it strong. This contributes to a declining profile for real net exports in our forecasting since the declining profile is subtracted from growth.

Okay. Finally, a succession of rapid gains in equity values. Our projections for the profit share, both S&P operating earnings as a share of GDP and an analogous measure from the national accounts.

We do believe that profit shares currently are elevated and will drift down in the forecast and this will squeeze dividends, it will prevent what would otherwise be faster growth of dividends in our forecast, and that's going to weigh on equity values. After rapid increases, we do expect a period of flat declining values for the S&P 500.

The other series is the equity risk premium. And so in recent quarters, the equity risk premium has been at historically low values, suggesting that equity investors have been unusually sanguine about taking on risk. In our forecast, we expect the equity risk premium to rise back to levels that are more consistent with historical norms.

So dividends are being squeezed by falling profit shares. And even though Treasury yields are expected to fall, so the discount factor that discounts dividends to present value comprises a risk-free yield, Treasury yields and this equity risk premium. So even though Treasury yields are forecast to decline in our forecast as the Fed eases, which all else equal would boost equity values, the rising equity risk premium increases that discount factor and essentially offsets the impact of following Treasury yields.

And so this is why we expect equity values to be roughly flat in the forecast. There'll be some downs and ups. But when we go out a couple of years, what we think is that equity values will be not far from their current levels. So all of these factors contribute to the slowdown in GDP growth, contribute to an increase in the unemployment rate and loosening conditions in labor markets.

KRISTEN HALLAM

All right, that covers your growth forecast. What about the forecast for inflation?

BEN HERZON

Our forecast that core inflation will slow to 2% is based on other factors. It's not just the easing of labor market that's behind that forecast. There are other parts of the story. And to tell that story for you, the 12-month percent change in the Core PCE Price Index, and I've got that growth divided into contributions from three main sources. One is core goods inflation, residential rent inflation, and core services, excluding rent.

Now what you see is prior to pandemic, core PCE inflation was running south of 2% with about 2/3 of that inflation accounted for by core services, excluding rent, and about 1/3 of that inflation accounted for by residential rent. And we had COVID and then during the COVID recovery, supply chains became very tight and core goods inflation surged, which contributed to the rise in core inflation. Also, rent inflation began climbing in response to rapidly rising house prices.

And finally, core services ex. rent inflation rose in response to a tightening in labor market conditions. In recent months, core goods inflation is gone. So as supply chains ease, core goods inflation is back to where it was in pre-pandemic times so that the inflation that we're left with now is back to where it was before the pandemic, about 2/3 accounted for by core services ex rent and 1/3 accounted for by rent inflation. But inflation is still elevated, still around 3%.

So to get to 2% inflation, those two sources of inflation are going to need to diminish. So let me talk about those two sources of inflation. And the first is rent inflation. We do expect that rent inflation will slow in response to slowing market rates. And so what's going on here? Our forecast for PCE computed rent inflation, which is basically the same thing as CPI rent inflation.

Now the CPI for rent is based on a survey of observed leases. And when you take a sample of observed leases, you could be looking at market rents as they existed in the current month or you could be looking at market rents as they existed as long ago as a year ago or even longer depending on the terms of leases. So what this does, because the CPI for rent includes current and lagged market rents, this construct introduces inertia in the CPI for rents relative to market rents.

Market rent inflation peaked in 2022 and those rates of inflation have already returned to pre-pandemic rates. And just as you would expect, just by the way, CPI rents were instructive as current and lagged market rents, CPI rent inflation peaked after the peak in market rents and has already started to decelerate.

So, in our forecast, we assume that market rent inflation remains at roughly at current levels. In the best case, CPI rent inflation should continue to decelerate, eventually back to pre-pandemic rates over the next couple of years. That's the market rent inflation part.

Now the other part, core services, excluding rent, that rate of inflation is more closely tied to conditions in the labor market. The Core PCE Price Index ex-housing rate of inflation, charted along with the employment cost index for total compensation.

These two measures of inflation move very closely together. In our forecast, as the unemployment rate rises and labor markets ease, we do expect wage inflation to continue to decelerate and converge to pre-pandemic levels in the not-too-distant future.

And along with that, we expect core services, excluding rent inflation, to ease as well. So the bottom line is that the path to 2% inflation in our forecast relies on these three important points: one, that there is no material reemergence of supply chain stresses; two, that there's no re-acceleration of market rents; and three, that we do, in fact, see the easing in labor market conditions that we expect.

So big picture is core PCE inflation converges to 2% over the next couple of years, and Treasuries and private yields move lower, and this set of conditions allows the Fed to begin easing later this year.

KRISTEN HALLAM

Thank you for listening to The Decisive Podcast from S&P Global. Please subscribe and join us for next week's episode. Until then, stay curious and stay informed.