Schroder Investment: More and more evidence shows that the US economy is heading towards a soft landing.

According to Dolphin Research, George Brown, an investment economist at Schroders, stated that there is increasing evidence that the US economy is heading towards a soft landing. The labor market in the US seems to be gradually returning to normal from a relatively high level, and there are signs that the US manufacturing sector has bottomed out and is recovering. In addition, the US core consumer price index has significantly slowed down when excluding special anomalies such as housing and used car prices. However, investors need to pay attention to whether real income will rebound. When real income stops declining, the household savings rate may not rise significantly as expected by the market, and more income may be used for additional expenses. This may once again put pressure on the supply chain, leading to a resurgence of inflationary pressures and resulting in a "second-round effect."

Based on the experience of the past few years, although the wages of this generation of employees are growing at the fastest rate, they cannot offset the sharp rise in inflation, which has disrupted the stable and low-priced environment of the past decades. Nevertheless, real household spending has continued to grow during this period. The US did not implement employment protection or wage subsidy plans during the pandemic, resulting in approximately 22 million workers being laid off in the early stages of the pandemic. Subsequently, as social distancing measures gradually eased, businesses rehired employees, thereby promoting strong and stable consumption growth.

Therefore, analyzing actual household expenditure based on absolute benchmarks is more accurate. From this perspective, household consumption expenditure not only recovered to pre-pandemic levels within a short year but also surpassed the trend level of the past 10 years, even when real income fell to the most severe and longest-lasting level in the past 40 years.

Continuous decrease in savings...

So why has household expenditure changed so much? Schroders Investment believes that consumers have been using the excess savings accumulated during the pandemic to fill the income gap. The reasons for the excess savings include direct financial transfers, such as economic subsidies, and indirect assistance such as eviction bans and student loan repayment deferrals. In addition, social distancing measures and business closures in 2020 also restricted consumption channels, leading to an increase in savings.

Table 1: Excess savings help compensate for insufficient real income, but they are now almost depleted

According to Schroders' estimates, these factors have led to excess savings in US households reaching as high as $20 trillion, but currently, only about 8% of the excess savings remain. Therefore, it is expected that more and more households will save their income and put pressure on household consumption, student loan repayments, and other expenses later in 2023.

Real income finally recovers

But the most important thing is that real income is finally recovering. Due to the decline in inflation, the US Consumer Price Index (CPI) has fallen from a high of 9% to a level of 3% over the past year. Although the upward trend in energy prices is coming to an end, there is still limited room for further decline in inflation. Similarly, there is currently no information indicating that inflation will significantly decline in the short term.

Historically, leading economic indicators have shown a slowdown in wage growth, but it has remained at an optimistic level. Additionally, there doesn't appear to be a large-scale layoff situation at the moment. Therefore, American consumers can still benefit from real income growth in 2024, even if there are unfavorable factors in the market, consumer spending can still be sustained.

Table 2: Declining inflation leads to a recovery in real income growth, which is expected to continue in the coming years

The pros and cons of real income growth for investors

Schroder Investment believes that on the one hand, there is increasing evidence that the US economy is heading for a soft landing. The situation in the US labor market seems to be gradually returning to normal from a higher level, and there are signs that US manufacturing has bottomed out and rebounded. Additionally, the US core consumer price index, excluding special anomalies such as housing and used car prices, has slowed significantly.

However, investors need to be aware of whether real income will recover. When real income stops declining, the household savings rate may not rise significantly as expected by the market, and there may be more income available for additional spending. This could once again put pressure on the supply chain, leading to a resurgence of inflationary pressures and resulting in a "second-round effect."

Schroder's latest forecast includes two possible risk scenarios. The first scenario suggests that a "soft landing" of the economy will help alleviate inflationary pressures, allowing the Federal Reserve to lower interest rates to even lower levels more quickly. The other scenario is a recovery in consumption, which would require the Federal Reserve to further raise interest rates, leading to a deep recession.

Table 3: Improvement in real income may lead to the emergence of two risk scenarios

Two factors to watch

Schroder Investment believes that the following two factors will impact the aforementioned potential scenarios: First, whether productivity can keep up with the pace. In 2020, low-skilled and consumer-facing workers were laid off, while employees with higher productivity were able to transition to remote work, resulting in a significant increase in productivity. Subsequently, as the labor market returns to normal, productivity will gradually decline and return to its original level.

The second factor is whether the labor force participation rate will recover. Currently, the labor force participation rate is still about 0.7 percentage points lower than the level in February 2020. The low participation rate is mainly due to older workers retiring early, so it is not possible to have enough workers re-enter the labor market. However, accepting new immigrants can help increase labor force participation, and currently, the number of immigrants has rebounded significantly, improving the situation.

Table 4: The soft landing of the economy will depend on two factors: productivity recovery to its original level and further increase in labor participation

What will be the future trend?

Looking ahead, Schroder Investment believes that if productivity recovers to its original level and the labor supply situation improves, the US economy is highly likely to achieve a soft landing. However, contrary to Schroder's predicted scenario, the US unemployment rate is still about 0.8 percentage points lower than the natural unemployment rate or the non-accelerating inflation rate of unemployment (NAIRU) valuation. Therefore, in the absence of a recession in the US economy, in order to restrain excess demand, economic growth must remain at a low level for a relatively long period of time.

Therefore, although the slowdown in inflation and employment growth means that the recent rate hike by the Federal Reserve may be the last one in the cycle, the policy shift of the Federal Reserve is not expected to occur in the foreseeable future. Ultimately, the Federal Reserve Committee may still be concerned about the risks of second-round effects.