What if the US economy does not land?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below. 

All data referenced in this article are sourced from Refinitiv Datastream unless otherwise stated, and are accurate at the time of publishing.

Key points

• Economists have long pondered whether the series of rate hikes seen in the last two years would crash the economy. While concerns about a “hard landing” dominated early 2023, forecasts now lean towards a “soft landing”. But what if these latest ones are being overly cautious – and further optimism is warranted? 
• Indeed, recent economic data has been better than expected, particularly in the US and eurozone. There have also been tentative signs that the global manufacturing cycle may be bottoming out, which, if confirmed, would be positive for risk assets
• With global equity markets back to all-time highs, investors appear to be discounting an even more optimistic macro-outlook, where the economy does not “land” and growth remains resilient. To be clear, this is not our base case scenario, but in this article, we consider the upside risk to our cautious macro forecasts
• Encouragingly, and despite the 20% rebound in global equities since October, attractive opportunities remain for those investors who wish to position their portfolios for a continuation of this “goldilocks” scenario. For instance, we highlight small-cap equities and certain cyclical sectors such as autos, basic resources and banks

Global equities have continued to march higher in recent weeks, reaching new all-time highs. This has led to a growing disconnect between the current state of the economy and equity prices. While the probability of a “soft landing” for the economy has certainly improved, financial markets seem to be discounting an even more optimistic outcome. This article explores the upside risk to our macro forecasts. 

Global growth likely to moderate further, in our view…

Global growth seems likely to moderate over the coming months, in part due to the lagged impact of the aggressive monetary policy tightening of the past couple of years. While some developed economies, like the eurozone, may flirt with a technical recession (being two consecutive quarters of slowing growth) in coming months, the risk of a significant contraction appears limited, in our view. 

The UK and Japan did finish the year in a technical recession, but the declines seen in the last two quarters were relatively contained (-0.1% and -0.3% annualised quarter-on-quarter growth for the UK; and -3.3% and -0.4% for Japan). 

…despite more encouraging macroeconomic releases recently

As central bankers consider when to start cutting rates, recent macroeconomic data have surprised positively, particularly in the US and the eurozone, where labour markets and business surveys have been more resilient than expected. Indeed, US gross domestic product growth forecasts have been revised up to 1.6% for 2024 at the time of writing, compared with 0.6% back in August, according to Bloomberg.

Similarly, there are tentative signs that the global manufacturing cycle may be bottoming out. The JP Morgan global purchasing managers index for manufacturing was back to 50 in January, the limit between expansion and contraction, after spending fifteen months in contraction territory. While too early to extrapolate, this development is important to note. If sustained, an improvement in the global manufacturing cycle would be positive for risk assets.

What if our economic expectations are too conversative?

This article explores the upside risk to our base case of decelerating global growth this year: 

• What if our projections are too conservative and the US economy keeps growing at a healthy clip (or does not land)? 
• What if the US Federal Reserve manages to bring inflation down to their 2% target, without triggering a recession or a significant deterioration in the labour market? 
• And more importantly, for investors wishing to position portfolios for re-accelerating global growth, where do the opportunities lie?

With global equity markets back to their all-time highs, we feel that share prices already reflect a fairly optimistic economic outlook, as highlighted in ‘Playing defence through quality and pricing power’. More specifically, global equities appear to be discounting a “no-landing” scenario, where economic activity re-accelerates from current levels and corporate profits rebound sharply. 

Areas of the market best positioned to benefit in a ‘no-landing’ scenario

Encouragingly, certain areas of the market have lagged in the recent rally, trade on more reasonable valuation multiples and offer upside potential if a “goldilocks” scenario materialises, notably small-cap equities and certain cyclical sectors.

The main winners from an improving manufacturing cycle, if history is a guide, should include chemical companies, autos and parts manufacturers, financial services, basic resources and banks. These sectors have tended to outperform the broader market globally in periods of improving economic momentum. By contrast, telecommunication services, consumer staples, utilities and healthcare sectors have usually underperformed the most (see chart).

Global sector returns’ sensitivity to changes in the manufacturing cycle

Correlation of global sectors' relative 12-month performance versus the ISM manufacturing index over the past 10 years

Which of those areas still look reasonably priced

Taking valuations into account, three sectors stand out as being both positively correlated with the business cycle and cheap globally: autos, basic resources and banks. Those sectors trade at a significant price-to-earnings (PE) discount to their 10-year average (23%, 18%, and 27% respectively).

Similarly, small-cap equities appear well positioned to benefit from (i) a pick-up in the manufacturing cycle, (ii) a decline in rates, and (iii) an easing in credit conditions, supported by (iv) cheap valuations and depressed sentiment.

Small caps have significantly underperformed large caps in the past three years, as (i) business activity has weakened, (ii) yields have surged, and (iii) credit conditions have tightened. Small caps have lagged by 19% globally over the period, and by 25% in both the US and Europe.

• Because of their sector composition, small caps are generally more sensitive to the economic cycle, compared with large caps. Based on MSCI All Country World indices, small caps are heavily overweight cyclical sectors like industrials, and to a lesser extent, materials and consumer discretionary. By contrast, small caps are heavily underweight technology, and to a smaller extent, defensive sectors such as communication services, healthcare and consumer staples (see chart).

Small caps are a geared play on the business cycle, relative to large caps

Relative sector weights of MSCI All Country World Small Caps versus Large Caps indices flag the former’s overweight exposure to cyclical sectors and underweight exposure to defensive sectors  

• Small caps’ earnings tend to be more sensitive to changes in the cost of debt, as they are often more highly leveraged and hold a larger proportion of debt linked to variable rates than their large-cap peers. As central banks in the US, eurozone and the UK contemplate cutting rates, this concern should dissipate.

And finally, small caps are also more exposed to changes in lending standards, given their heavier reliance on the banking system for their financing needs, while larger firms can tap capital markets. Encouragingly, in the past few months, we have seen an easing in lending conditions on both sides of the Atlantic.

Global small caps’ underperformance against large-cap companies over the past three years has left them trading close to their historical lows, based on relative PE multiples. More specifically, small caps currently trade at a 3% PE premium relative to large caps, significantly below the 38% premium enjoyed over the past 10 years (see chart).

Small caps trade at historical lows relative to large caps

Relative price-to-earnings ratio of global small caps versus large caps

What this means for investors

While global equity markets, at the broad index level, already seem to be pricing in a significant improvement in economic activity, attractive opportunities remain for investors who wish to position their portfolios for a continuation of this “goldilocks” scenario. 

Small-cap equities appear well positioned to outperform in such an environment, as do autos, basic resources and banks globally. Those pockets of the market are geared to a pick-up in business activity and are supported by relatively cheap valuations.

Having said that, and not wishing to draw hasty conclusions from recent positive economic data surprises, the most likely scenario at this point seems to be that global growth will decelerate over the coming months and remain below trend for some time.  

Given stretched valuations and extended positioning, such an outcome seems to favour a more defensive portfolio positioning, as outlined in ‘Time for more defensive equity positioning’.

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