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A gloomy economic outlook is par for the course for fixed income investors, but admittedly we have turned more bearish than most on the US in recent months. This is largely due to structural changes we believe the US economy is undergoing, which could have lasting implications for bond markets. There is a silver lining though: bad news for an economy is often good news for high quality “risk-free” government bonds. Investors anticipate a slowdown in US growth in 2023, and we expect this could last far beyond what the market might think. With long-end US Treasury yields close to 4% at the time of writing, Rick Patel, Portfolio Manager for US Investment Grade fixed income, believes the market is not discounting the structural changes to growth in the US, and that current yield levels present an attractive buying opportunity. Beneath our bearish exterior about the US economy, we are cautiously optimistic on the outlook for longer dated US government bonds. Of course, we caveat this by saying that timing remains a key challenge when it comes to investing in today’s market context.
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Higher inflation and the radical shift in central bank rhetoric have dominated the bond market narrative for the past year, not least because of the sobering impact both dynamics have had on fixed income returns. In the US, the Fed’s 2022 response to price inflation was so aggressive that the US economy is now entering one of the most well-flagged, widely documented recessions in history. While question marks remain about the speed at which inflation will fall, there are indications that we are past the peak in terms of headline numbers. As such, we expect the market’s focus for the remainder of 2023 will shift towards the outlook for growth in the US, which points to a worrying trend but one which has been largely overlooked in the current inflationary context. This piece outlines our views on long-term growth prospects in the US, all of which suggest that the upside potential could be capped due to structural challenges the US economy faces.
We look at trends in four main constituents of US GDP growth: government spending, capital expenditure, net exports, and consumption, where we observe several deep structural factors that neither covid-19 nor the high inflation environment have done anything to reverse. In many ways, we believe the US could be re-entering an era of ‘secular stagnation’, whereby growth could remain modest over the long term, even if we assume lower interest rates, due to structurally lower private demand and other negative productivity trends.
1. Government spending - expect less fiscal support
Most developed market economies, including the US, are running with significant fiscal deficits post the covid-19 pandemic. As a result, we can expect to see less spending from governments going forward as the focus shifts to rebuilding public finances and shrinking balance sheets. The US government is likely to hit its debt ceiling limit in the third or fourth quarter of 2023 so will be reluctant to create new fiscal spending before that. It is quite likely that any spending it had budgeted from previous years will also start to wind down. Overall, we can assume that fiscal spending will have a negligible contribution to US GDP growth for the year ahead. The caveat to this assumption is the potential contribution from individual states in the US, via tax cuts and state-level subsidies to support consumers. But in the most optimistic of scenarios, it is certain that US fiscal spending is not going to be any higher than last year and thus the contribution to overall GDP growth will likely be less than 0.5% in 2023.
Figure 1: US debt and the debt ceiling
Source: Fidelity International, JPM Research, US Treasury, end-January 2023.
2. Capital expenditure - modest at best
We can gauge the potential contribution to US GDP growth from capital expenditure (capex) by looking at capex intentions or indications of industrial health such as ISM manufacturing data and inventory trends. Currently, around 80% of global PMIs are below 50, which gives a good indication that sentiment around industrial sectors is poor. The growth contribution from private inventories was strong in 2022, however with slowing demand we can expect to see this trend to reverse going forward, resulting in excess inventories building up in 2023 and potentially forced liquidations. Overall, with higher input costs expected to remain for some time, many companies will be focused on preserving their revenues rather than investing for growth. Capex and inventory investment are therefore unlikely to have a meaningful impact on US GDP overall. Similar to that from government spending, we estimate the contribution to GDP growth from capex will be less than 0.5% in 2023.
Figure 2: Firms’ capex intentions have slowed
Source: Fidelity International, Morgan Stanley Research, February 2023. Capex Plans Index is a manufacturing weighted composite index compiled from various monthly Federal Reserve Bank surveys of manufacturers.
Figure 3: The US enjoyed record high energy exports in 2022
Source: Fidelity International, US Energy Information Administration, Petroleum Supply Monthly, 2022.
3. Net exports - impacted by lower energy prices
Net exports for the US economy supported GDP growth in 2022, with a large portion of the contribution coming from exports of oil and gas. Russia’s invasion of Ukraine spurred greater demand for US crude, particularly in the first half of the year (figure 3), while the extreme upward pricing of commodities meant that the overall contribution of energy to US net exports was higher than average in 2022. This year, consistent with the fall in prices in the US and Europe, it hard to assume a similar level of GDP contribution from US crude exports. While we might expect to see some offsetting contributions from US trade activity with large trading partners (Canada, Mexico, Japan, Germany, etc.), we do not expect net exports to have a meaningful impact on overall growth levels in 2023.
4. US consumption - the last beacon of hope?
As the fourth and final engine of GDP growth, a lot lies on the expected contribution from the US consumer going forward. Personal consumption in the US represents close to 70% of GDP and so it plays a critical role in the overall growth potential of the US economy. While the backdrop has been conducive to strong growth momentum from the consumer in recent years, with considerable levels of fiscal support during the pandemic and very low interest rates, we expect this trend could start to reverse going forward. Already we are seeing signs that the US consumer is under increased pressure, particularly those dependent on high levels of borrowing, those in lower-income cohorts, and those working fewer hours or facing job layoffs (with workers in the retail, healthcare, and tech sectors likely to be most affected). Private savings are now back to pre-pandemic levels, the divergence between the top and bottom income cohorts in the US is widening, and borrowing rates continue to increase despite the very tight lending conditions (figure 5). Overall, without strong and consistent wage growth going forward, current spending levels by the US consumer are unsustainable in our view and the contribution to GDP is therefore likely to be capped to the upside.
Figure 4: Fall in average weekly hours worked in the US
Source: Fidelity International, BofA Global Research, Bureau of Labor Statistics, Bloomberg, January 2023.
Figure 5: Credit card usage is increasing
Source: Fidelity International, UBS Neo Research, Federal Reserve, January 2023.
Why all this matters for bond investors
Understanding the long-term factors that affect an economy is critical to being able to assess the fair value of long-term government bonds. This is particularly relevant for developed market economies such as the US. Our investment framework involves not only taking a view on what the Fed will do in short-to-medium term, but also understanding what the long-term potential growth rate of the US economy might look like in order to determine a fair value of US government bonds. When we combine each of the above factors and their potential contribution to GDP growth in 2023, our best-case scenario arrives at somewhere between 1.5% to 2%. A similar assessment in years beyond 2023 is also important to gauge an understanding of the medium-term potential growth rates for the US economy. As yields we are seeing on US treasury bonds are comfortably higher than expectations for these growth rates, there is support for our view that long-term government bonds in the US are attractive at current levels, although as ever with investing, timing of markets remains an ongoing challenge.
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