Elusive Economic Slowdown Slowly Surfaces
Views You Can Use: Rising unemployment and falling manufacturing suggest investors may face a weaker economy and choppy markets.
Key Takeaways
In our view, the lagging effects of restrictive Fed policy are finally working their way into select economic data.
Amid a weaker labor market and persistent consumer pressures, we believe an economic slowdown will be the most likely scenario.
We believe higher-quality and more defensive securities may offer value to investors in a slowing or flat economy.
Recent employment, manufacturing and earnings data highlighted cracks in the long-resilient U.S. economy and triggered widespread financial market unrest. We believe these developments foreshadow a looming economic slowdown, which will likely coincide with Federal Reserve (Fed) rate cuts.
We believe this environment continues to underscore the role high-quality equity and fixed-income securities may play in investor portfolios.
Key Economic Data Succumb to Restrictive Fed Policy
In early August, three “bears” disrupted what many hoped would be a “Goldilocks” economy and market backdrop. These economic releases illustrated the lagging effects of restrictive Fed policy and the markets’ response. They also underscore the slowdown theme we’ve anticipated for several months:
Labor market: The nation’s unemployment rate rose for the fourth straight month in July, reaching 4.3%, its highest level since October 2021.1 U.S. employers planned to hire 3,676 employees in July, the smallest number this year and the lowest total for July since records began in 2009.2
Manufacturing: The ISM Manufacturing Purchasing Managers’ Index (PMI) dropped for the fourth consecutive month in July and remained in contraction territory since April.
Technology trade: Sentiment around artificial intelligence (AI) stocks, the primary drivers of year-to-date U.S. stock market performance, turned negative. AI product delays and decelerating earnings growth across the industry fueled the sentiment shift.
Against this backdrop, U.S. Treasury yields declined as investors staged a flight to quality. Additionally, deteriorating employment data helped lift expectations for several Fed rate cuts by year-end. In late August, the U.S. Bureau of Labor Statistics reported there were 818,000 fewer jobs for the year ended in March than originally reported.
Inflation Trends and Their Impact on Consumer Spending
While inflation has continued to moderate, it has yet to reach the Fed’s 2% target. And its cumulative effects have been stifling: From January 2021 through July 2024, consumer prices rose 20.2% on average.3 Over time, persistently elevated inflation has eroded consumers’ prior savings and wage gains.
Furthermore, the economy still hasn’t felt the full effects of Fed tightening, which has the short-term interest rate target sitting at a 22-year high. That process typically takes 24 months. We expect the full effects to unfold over the next few months, coinciding with our slowdown timetable.
U.S. Economic Growth Expected to Slow in the Coming Months
We believe an economic shift is likely underway and eventually will stifle gross domestic product (GDP). For these reasons, we put the odds of a slowdown (below-trend growth or recession) sharply higher than other possibilities.
Slowdown: We believe growth will slow to a below-trend pace (flat to slightly positive) for several quarters. We also believe a recession is a growing possibility, though not as likely as anemic growth. We expect the Fed to start cutting rates in September.
Overheated Economy: We believe there’s a slim chance of growth surprising to the upside with inflation rekindling.
Goldilocks: An economy in which inflation drops to 2% or lower, the Fed quickly eases, and growth continues at trend or above-trend levels is a longshot in our view.
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 (excludes food and energy prices) to remain higher than the Fed’s 2% target in the short term due to:
Continued pressure on the services component of the Consumer Price Index (CPI), mainly from rising wages and elevated shelter (rent and owner’s equivalent rent) costs.
The ongoing repositioning and rerouting of global supply chains and the onshoring of production.
Still-high energy and agricultural (food) prices caused by geopolitical tensions and deglobalization trends.
Slowdown: Potential Investment Implications
We believe a slowdown is likely.
Fixed Income
In a slowdown, investors should consider:
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. We believe inflation strategies still appear attractive, given that inflation expectations remain higher than average in the short term.
Equities and Real Assets
In a slowdown, investors should consider:
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 select dividend-paying stocks that provide consistent income streams are attractive.
Looking to sustainable growth. Companies with dependable, sustainable 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
We believe there’s a slim chance that economic growth will surge.
Fixed Income
If an overheated economy emerges, investors should consider:
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, investors should consider:
Focusing on traditional value sectors. The energy and basic materials sectors have typically benefited from higher commodity prices. Utilities have generally 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 have historically provided attractive 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
We believe a Goldilocks scenario is unlikely.
Fixed Income
In a Goldilocks economy, investors should consider:
Evaluating higher-risk bonds. We believe credit-sensitive securities may offer outperformance potential, particularly high-yield bonds and bank loans, which have historically 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, investors should consider:
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.
Authors
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U.S. Bureau of Labor Statistics, “The Employment Situation – July 2024,” Economic News Release, August 2, 2024.
Challenger, Gray and Christmas, “Challenger Report: Job Cuts Remain Low While Hiring Falls to Lowest YTD Since 20212,” August 1, 2024.
Consumer Price Index.
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.