Soft Landing Is Still in Sight for U.S. Economy
Views You Can Use: Despite the Fed’s recent shift to easier monetary policy, we think a slowdown remains likely.
Key Takeaways
We expect growth to slow, even though the Fed has shifted to easing mode and the “no landing” scenario has gained market support.
Mounting pressures on consumers should continue to weave slowly through the economy, weighing on growth.
We believe higher-quality and more defensive securities may offer value to investors in a slowing or flat economy.
In the wake of the Federal Reserve’s (Fed’s) hefty half-point rate cut in September, many market observers jumped on the “no landing” bandwagon. Unlike the previously favored “soft landing” scenario, “no landing” suggests a more upbeat outlook. It assumes resilient growth, easing monetary policy, moderating inflation and a stable labor market.
Recent bond market movements have complicated this view. After dropping to year-to-date lows in mid-September, Treasury yields spiked through October on upbeat economic data and expectations for a growing federal deficit. For example, the 10-year Treasury yield jumped 64 basis points from September 16 through October 29.
It’s our view that this Goldilocks-type scenario remains unlikely. Following a modest slowdown in third-quarter GDP to 2.8%, from 3% in the second quarter, we expect the economy to slow further. High interest rates, persistent above-target inflation and weaker labor market data will likely weigh on the economy, particularly from the consumers’ point of view.
We believe this environment continues to underscore the role high-quality equity and fixed-income securities may play in investor portfolios.
Consumer Pressures Are Rising
In our view, the Fed’s extended period of restrictive policy will ultimately take a toll on consumers. As we’ve previously discussed, consumers have broadly depleted their excess savings. Therefore, maintaining recent robust spending patterns would likely require borrowing at today’s still-high interest rates:
The average 30-year fixed mortgage rate was 6.9% as of October 30, 2024, per Bankrate.com.
The overall average auto loan interest rate was 6.8% for new cars as of October 11, 2024, according to MarketWatch.
The median average credit card interest rate was 25% in October, according to Investopedia.com.
While Fed rate cuts typically influence consumer lending rates, the process takes time, and the correlation isn’t direct. Additionally, other factors, including supply and demand, credit scores and Treasury market moves, affect consumer loan rates.
Inflation Pressures Persist
Furthermore, longer-term inflation expectations, which have been on the rise, also affect longer-term interest rates, which typically drive mortgage and other consumer lending rates higher. We believe several factors, including slower but still positive economic growth, soaring federal debt and political uncertainty, may keep long-term inflation expectations elevated.
Meanwhile, some measures of current inflation, which remains above the Fed’s target, have moderated, and others have inched higher. The annual core Personal Consumption Expenditures price index, the Fed’s favorite gauge, increased in July and August and held steady at 2.7% in September. The monthly gain of 0.3% in September was the largest increase in five months.
The annual core Consumer Price Index (CPI) inched up in September to 3.3%, propelled by higher shelter and transportation services costs. Meanwhile, overall inflation, as measured by headline CPI. slowed for the sixth straight month in September to an annual pace of 2.4%. However, from a longer-term perspective, inflation’s cumulative effects have been stifling: Since January 2021, average consumer prices (headline CPI) are up 21%.
Labor Market Indicators Signal a Cooldown
We see additional consumer pressures mounting in the job market, where some recent data point to a potential slowdown. For example, U.S. employers announced nearly 73,000 job cuts in September, up 53% from the prior year.1 Year to date, the number of total job cuts is up 1% from the same period in 2023.
Elsewhere, the number of U.S. job openings fell by 418,000 from August to September, dropping to the lowest level since January 2021.2 The government also revised lower the number of job openings in August. Continuing jobless claims, a gauge of the number of people receiving unemployment benefits, spiked to a three-year high in October.
Slower U.S. Economic Growth Should Emerge in the Coming Months
We believe an economic shift is likely underway and eventually will stifle GDP. For these reasons, we put the odds of a slowdown (below-trend growth or recession) sharply higher than other possibilities.
Slowdown: We believe there’s an 80% probability of growth slowing to a below-trend pace (flat to slightly positive) for several quarters. We also believe a recession remains possible, though not as likely as anemic growth. We expect the Fed to continue cutting rates into mid-2025.
Overheated Economy: We believe there’s a slim chance of growth surprising to the upside with inflation hovering above target and financial conditions remaining tight. We place a 10% probability on this scenario unfolding over the next six months.
Goldilocks: In our view, a scenario in which inflation drops to 2% or lower, the Fed continues easing and growth persists at trend or above-trend levels seems like a longshot. We believe there’s a 10% chance of this economic outcome.
Source: American Century Investments. Opinion as of 11/6/2024. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice. The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund.
What Would a Slowdown Scenario Mean for Investors?
As the economy slows, U.S. Treasury yields will likely fall. We also expect credit spreads to widen. While inflation should moderate, we still expect core inflation to remain higher than the Fed’s 2% target in the short term due to:
Continued pressure on the services component of the CPI, mainly from wages and elevated shelter (rent and owner’s equivalent rent), transportation and medical costs.
The ongoing repositioning and rerouting of global supply chains, rising shipping costs and potential tariffs.
Global political tensions and record-high deficits.
Slowdown: Potential Investment Implications
Fixed Income
In a slowdown, consideration should be given to:
Managing reinvestment risk. We believe shifting exposure from cash equivalents to short-duration assets may help manage reinvestment risk. As the Fed cuts rates, yields on cash equivalents will also decline, so reinvesting in cash likely won’t deliver the same results. In addition to generally offering higher yields than cash equivalents, short-duration assets also tend to offer price appreciation potential in a declining rate environment.
Balancing duration exposure. Strategies with intermediate-duration exposure may potentially offer diversification and performance advantages as rates broadly decline and equity market volatility rises.
Staying high in credit quality. In addition to delivering diversification to investor portfolios, a modest allocation to high-quality investment-grade credit may now provide more attractive yields. However, we believe credit selection is critical to avoid weaker, economically sensitive issuers.
Maintaining inflation protection. Inflation strategies still appear attractive, given that inflation expectations remain higher than average in the short term.
Equities and Real Assets
In a slowdown, consideration should be given to:
Emphasizing quality stocks. Quality companies with higher profitability and healthy balance sheets may offer attractive potential. Investors tend to favor quality companies in more defensive sectors, such as utilities, health care and consumer staples. Additionally, we think dividend-paying stocks look attractive for the stability of income they generally provide.
Looking to sustainable growth. Companies with dependable, secular earnings growth have tended to outperform during economic slowdowns. Economically sensitive value sectors, such as financials, industrials and energy, have tended to lag alongside lowered growth expectations.
Treading carefully in the commodities market. As consumer and industrial demand wanes, commodities typically lose their luster. However, we believe gold may continue to shine amid falling interest rates and heightened economic and market uncertainty.
Maintaining selective exposure to real estate stocks. Certain real estate investment trusts (REITs) have tended to lag as poor economic conditions weigh on residential and commercial real estate markets.
What Would an Overheated Economy Mean for Investors?
If economic growth surprises to the upside, inflation would likely remain above the Fed’s target. A growth surprise scenario could also trigger additional Fed tightening.
Overheated Economy: Potential Investment Implications
Fixed Income
If an overheated economy emerges, consideration should be given to:
Focusing on credit-sensitive assets. Riskier fixed-income securities, including high-yield corporate bonds and bank loans, may offer attractive return potential when the economy is growing.
Maintaining inflation protection. We believe inflation-protection securities, particularly with short durations, are attractive as rates rise and inflation remains elevated.
Avoiding longer-duration assets. With the Fed in tightening mode, longer-duration securities should underperform as interest rates rise.
Equities and Real Assets
If an overheated economy emerges, consideration should be given to:
Focusing on traditional value sectors. The energy and basic materials sectors typically have benefited from higher commodity prices. Utilities generally have provided dependable cash flows and dividends despite higher inflation and interest rates.
Favoring cyclical stocks. Economically sensitive sectors, such as financials, communication services and industrials, have tended to benefit from strong economic activity.
Gauging commodities. Commodities historically have provided high average returns during periods of economic growth and elevated inflation. However, we believe astute management is required because geopolitics and supply chain issues may heavily influence performance.
Adding exposure to real estate. REITs may outperform their long-term averages as the economy remains robust.
What Would a Goldilocks Scenario Mean for Investors?
If inflation quickly drops to target or below-target levels and the Fed eases monetary policy, Treasury market volatility will likely subside. We would expect Treasury yields and mortgage rates to decline, credit spreads to tighten, and the economy to expand at trend or above-trend rates.
Goldilocks: Potential Investment Implications
Fixed Income
In a Goldilocks economy, consideration should be given to:
Evaluating higher-risk bonds. We believe credit-sensitive securities may offer outperformance potential, particularly high-yield bonds and bank loans, which historically have benefited during economic expansions.
Focusing on nimble duration management. Modest growth, lower inflation and a Fed pivot suggest that active duration management may be warranted as markets and rates adjust to the changing backdrop.
Reduce inflation exposure. As inflation subsides, we believe nominal Treasuries may offer better performance potential than Treasury inflation-protected securities (TIPS).
Equities and Real Assets
In a Goldilocks economy, consideration should be given to:
Looking to growth stocks. Pro-cyclical, growth-oriented sectors historically have outperformed in lower-rate, strong-demand environments. This has been particularly evident in the information technology and communication services sectors, where revenues rely on capital expenditures and advertising spending.
Assessing cyclical sectors, small-caps. Economically sensitive holdings, such as banks and consumer discretionary and industrial stocks, have tended to benefit from increased economic activity. Investors typically focus less on fundamentals, such as quality cash flows, in favor of market beta, at least initially. Small-cap stocks could also offer appeal.
Allocating to REITs. We expect REITs to outperform as the housing market recovers. Additionally, lower interest rates typically boost the attractiveness of REIT yields.
Limiting exposure to certain commodities. We believe industrial metals and other pro-cyclical commodities may outperform as economic activity and demand pick up. However, softer inflation correlates with lower prices for energy and food.
What a Slowing Economy May Mean for Portfolio Allocations
In our view, maintaining a broadly diversified portfolio is the appropriate antidote for a changing economic backdrop. However, certain investment characteristics deserve consideration in a slowing economy.
For example, given the uncertain growth outlook, we believe bond investors should consider tactical allocations to interest rate and credit sensitivity. Remaining nimble may be the best approach for credit-sensitive securities, offering opportunities to capture yield advantages across a range of economic scenarios. And because we expect inflation expectations to remain volatile, inflation-linked strategies may offer value.
Additionally, we believe focusing on quality in equities and real assets will be crucial over the next several months. In our view, companies that can pass on costs to consumers should be able to protect margins from wage and input cost inflation.
More broadly, emphasizing quality may also help investors navigate a weak or flat economy. In general, quality companies — those with healthy balance sheets, higher profitability and more stable cash flows — have tended to offer attractive performance potential in economic downturns.
“Job Cuts Flat in September 2024 from August; YTD Surpasses 2023,” The Challenger Report, Gray & Christmas, Inc., October 3, 2024.
“Job Openings and Labor Turnover Survey,” Economic News Release, U.S. Bureau of Labor Statistics, October 29, 2024.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.
In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
Diversification does not assure a profit nor does it protect against loss of principal.
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