Will persistent economic resilience continue?

By Joseph Wu, CFA

Despite a steep rise in interest rates across many countries over the past year, global growth has maintained an upward trajectory. As the largest economy in the world, the U.S. continues to display resilience. Projections from the Federal Reserve Bank of Atlanta’s GDPNow model suggest U.S. real GDP could expand by over five percent in Q3. Should this forecast hold true, U.S. economic growth would more than double its Q2 rate, marking the fastest pace since Q4 2021. While we think this forecast will almost certainly be revised lower as the quarter progresses, the recent trend of economic data surprising on the upside paints a picture of an economy running stronger than expected. In our view, the following constructive factors that have been propelling the U.S. economy could help extend the growth runway in the near term:

• Disinflation is well underway. Since peaking at a 9.1 percent year-over-year (y/y) rate in June 2022, the U.S. Consumer Price Index (CPI) fell to 3.3 percent in July. Initially driven by lower energy and goods prices, the next source of disinflation is likely to come from housing-related categories. Real-time rent trackers have largely normalized to pre-pandemic levels, suggesting shelter inflation will ease substantially over the remainder of the year.
• U.S. households remain in good shape. Consumers still have deployable savings, and strong labour demand continues to augment income gains. Although the pace of hiring has slowed, the unemployment rate remains exceptionally low, job openings remain ample, and inflation-adjusted pay increases have turned positive.
• There are few signs of strain in corporate fundamentals. The Q2 reporting season has broadly featured above-average beat rates relative to consensus profit estimates, solid margins, and stable guidance. These trends indicate companies have been able to manage operating costs to defend margins without resorting to blanket layoffs.

Pay raises are outpacing inflation again after lagging for almost two years

U.S. real (inflation-adjusted) wage growth proxy

Line chart showing U.S. real (inflation-adjusted) wage growth, calculated as the Atlanta Fed Wage Growth Tracker Overall minus U.S. CPI. Based on this measure, U.S. real wage growth has improved to +2.5% in July, after dipping into negative territory between April 2021 and January 2023.

• Atlanta Fed Wage Growth Tracker Overall minus U.S. CPI

Source – RBC Wealth Management, Bloomberg; data through 7/31/23

Uncertainties

It is now easier to envision a “soft landing” for the U.S. economy, in which monetary policy tightening curbs inflation without inflicting major economic pain. But we think some uncertainties continue to stand out as potential sources of risk.

Lingering upside risks to inflation warrant monitoring, in our view. Price pressures have subsided meaningfully, but various measures of worker compensation growth still seem too high to be consistent with credible expectations of inflation returning to the Fed’s two percent target over the medium term. Core CPI (excluding food and energy) was 4.7 percent y/y in July, while the recent rebound in energy commodity prices serves as a reminder that central banks’ battle with inflation may not be over.

Given that Fed officials continue to reiterate their focus on inflation and a tight labour market, they will likely require more concrete evidence of softened labour demand before concluding that inflation is sustainably converging to their target and monetary policy does not need to tighten further.

We are also mindful of the delayed effects tied to monetary policy adjustments. Persistent economic strength has motivated some to take the view that the U.S. economy is immune to higher interest rates, but we believe the more likely explanation is the “long and variable” lag for monetary policy to be felt in the economy. According to RBC Global Asset Management, each rate hike can deliver a steady headwind to economic activity lasting about 2.5 years.

The possibility that monetary policy may have to remain restrictive for some time (higher rates for longer) or turn even more restrictive (more rate hikes), if Fed officials deem it necessary to counteract upside inflation risks, could inject additional uncertainty into the economic outlook. This uncertainty, coinciding with more onerous bank lending standards that are making it harder for households and businesses to get loans, could increase the vulnerability of the economy to higher borrowing costs, with spillover effects for corporate earnings.

Putting it all together

Global equities have generated solid returns this year, buoyed by continued robust data out of the U.S. which have allayed prevalent worries around a significant growth slowdown coming into 2023. Lower inflation with ongoing resilience in the labour market have emboldened markets to lean into a benign “soft landing” as the most probable outcome for the economy over the coming quarters.

This optimistic economic view has been reflected in the stock market through a rebound in valuation multiples and stabilization in consensus earnings estimates. In fixed income markets, compensation for taking credit risk has diminished – reflected in narrower credit spreads – though higher base interest rates have helped keep all-in yields at attractive levels.

Return potential in bonds now looks more competitive relative to equities

Valuations across major asset classes*

Bar chart showing the current forward earnings yield for the MSCI All-Country World Index and the S&P 500 and the yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index, compared to January 1, 2022, and the average since 2002. On a relative basis, the yield advantage that equities commanded over corporate bonds has sharply diminished over the past year.

• Jan 1, 2022
• Current
• Average since 2002

*Earnings yield is the inverse of the forward price-to-earnings ratio. Bond yield refers to yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index.

Source – RBC Wealth Management, Bloomberg; data through 8/18/23

On balance, we think a modestly defensive stance in portfolios with a focus on relative value remains sensible on the belief that the U.S. economy is likely in the later stages of the business cycle.

While history shows that the late-cycle period usually still delivers positive returns for stocks, we believe investors should prepare for potential bouts of volatility as perceptions about the outlook can shift rapidly. In this part of the cycle, we think equity portfolios can benefit from emphasizing companies with robust quality characteristics – lower debt levels, consistent pricing power, reliable cash flow generation, and sustainable dividends – as they tend to be better equipped to weather tougher economic conditions.

Given the rally in equity markets this year, relative value – proxied by the spread of bond yields over equity earnings yields – have moved in favour of bonds. Along these lines, we continue to see timely opportunities in fixed income markets for deploying capital, with government bonds a useful source of portfolio defensiveness and the potential for mid-to-high single-digit returns in corporate credit. Yields in many bond markets have risen to their highest levels in more than a decade. Historically, starting yields have translated closely into annualized returns over the medium term.