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Over 2023, the US economy has defied expectations of a recession and current consensus forecasts are for another robust GDP outcome for the September quarter in the world’s largest economy. In this week’s Brief, we look at the strength of the US economy and its impact on US equity markets beginning with where the strength in the US economy has been and why? On any measure, the resilience in the US economy over 2023 has been remarkable and surprising. Looking back at forecasts of US GDP growth at the start of the year, the consensus view was that 2023 would see the economy grow at an average annual rate of just 0.3% with a recession a certainty.
Fast forward to the latest consensus forecasts compiled in the first week of August and expectations are that the US economy will grow at an above trend rate of 2% over 2023. So, what segments of the economy have surprised forecasters over the course of the year? Well, it turns out that surprises have come in just about every sector you could care to mention. Consumer spending, business investment, industrial production, auto production, the housing market, the labour market, and international trade have all been stronger than were predicted.
But can this virtuous circle continue indefinitely? One of the adverse responses we have seen to the resilience in economic growth is higher interest rates, especially since their low point around early April. Since that point, yields on US 10-year Treasuries have backed up almost a full percentage point, coinciding with the start of upgrades in the outlook for the US economy. Will the rise in interest rates be the catalyst for slowing US growth, or is monetary policy now ineffective in this post-Covid world? After all, the Fed have now been raising rates for over a year.
Our view is that monetary policy remains an effective, if not blunt, tool in slowing demand and economic growth. However, we must place the Fed’s tightening cycle within context. Although the US consumer has been the primary driver of US growth, it must also be conceded that the global recovery in the manufacturing sector over 2022 and into the first half of 2023, as Covid-driven disruptions to global supply chains dissipated, also played a role in driving growth. However, the evidence is emerging that the surge in global trade is coming to an end and will become a headwind to the US economy.
Perhaps more importantly, the US household has run down its savings to a level that to meet their debt obligations they must curtail spending. Combine that with the tightening of lending standards we are seeing in the wake of the banking crisis, and you now have a household sector under far greater pressure to restrain spending than you have seen in the last two years. In line with the outperformance of the US economy, US equity markets have also enjoyed outstanding performance this year, with the S&P 500 up by around 15% year-to-date. And the strong performance of US equities has come despite a 35 basis point rise in US 10-year Treasury yields since the start of the year.
But chinks in the seemingly bullet-proof equity armour are now appearing. Over August, reflecting the ever-stronger sentiment over the US economy, US 10-year real bond yields finally broke out of their trading range of between 1.2% and 1.6% (established over 2023) to hit momentarily 2.0%; a level last seen in pre-GFC years. Although yields have moderated a little since that high point, they remain at an elevated level of around 1.9%. This break out in real yields has coincided with a sharp retracement in equity prices, which are down almost 5% since their July 31st high point.
So, are equities now caught in a pincer movement? If economic growth slows over the second half of 2023, as we expect, will corporate earnings expectations hold up? In our view, current 12-month forward earnings expectations of around 8% seem elevated in an economy slowing to below trend growth and we would expect a re-rating of the earnings outlook to be a catalyst for a further sell off in equities. However, if we are wrong about the growth outlook and the US economy continues to outperform expectations, then we would expect US real interest rates to resume their climb, lifting the discount rate on equities and be a catalyst for a further sell off in equities, just as we have witnessed over the last two weeks.
What about tech stocks? Are we missing the big picture that the real driver of equity strength is the realisation of the potential of new technologies, in particular AI, have in lifting tech company equity valuations to new (higher) levels? It is the case that tech stocks have strongly outperformed over 2023, with the tech heavy NASDAQ up by around 28% over the year, almost double that of the broader S&P 500. Within tech stocks, AI names such as NVIDIA, are up over 200%.
However, these stocks have a lot of earnings expectations to live up to if they are to justify current pricing. For example, NVIDIA has been trading at an average Price/Earnings multiple 45x over the last 2 years; more than double the average S&P 500 average over the same time period; a level for the S&P 500 which we would consider excessive. The history of equity markets is riddled with unrequited expectations related to new technology. An earlier generation may remember the bursting of the tech bubble of 2000 and the enthusiasm for internet stocks that preceded the bust.
At the time (1999), a popular book justifying elevated tech-stock valuations unfortunately titled “Dow 36,000: the new strategy for profiting from the coming rise in the stock market” was released, predicting that the Dow Jones would hit 36,000 (from a level of around 12,000) by 2002. Almost 25 years since that book was written, the Dow Jones is still trading under 36,000 at around 34,000.