Aurelia Butler

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The US economy is facing new peril as a federal government shutdown draws near, strikes in the US Midwest rumble on and rising energy costs coupled with the expiry of pandemic-era fiscal support hit household budgets.The combination threatens to undermine consumers and businesses just as their resilience shows signs of cracking under the weight of higher interest rates, making a sharp slowdown in growth likely later this year, economists say.“There’s a real chance that the economy is way weaker in the fourth quarter than in the third quarter,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics. The “multitude of hits” would all arrive “against the background of the lagged effects of the Fed’s rate hikes”, he added.One unexpected headwind is the widening autoworkers strike in the Midwest against the top three domestic carmakers. The labour action shows little sign of resolution. Another danger stems from Washington, where a US government shutdown — likely as soon as this weekend — would put hundreds of thousands of federal workers on furlough, while also delaying the collection and publication of data needed by the Federal Reserve to fully assess the economy’s health.This would be followed at the start of October by the expiry of coronavirus pandemic-era relief for student loan repayments and childcare subsidies for providers — another hit to financially vulnerable households and to some consumers’ spending.The combination could bring annualised GDP growth down to 1.3 per cent in the fourth quarter, compared with 3.1 per cent in the third quarter, reckon economists at Goldman Sachs. The government shutdown on its own could shave up to 0.2 percentage points from quarterly annualised growth for each week it lasts, Goldman says, while the impact of the strikes could be 0.1 percentage points per week. The resumption of student loan repayments is forecast to deliver a 0.5 percentage point blow.The gloomier mood from economists comes despite the Fed’s more recent optimism about its outlook for the US economy.Analysts have also pointed to the recent surge in oil prices, which are nearing $100 a barrel after Russia and Saudi Arabia agreed to keep restricting supply.“At a time when incomes are being squeezed again by higher fuel costs, the ongoing increases in borrowing costs and student loans restarting, I am concerned that we will see consumer spending slow rapidly in the fourth quarter,” said James Knightley, chief international economist at ING. Unless there is a swift resolution to the auto strikes and the government shutdown, fourth-quarter GDP growth could “easily” turn negative, he cautioned.Despite the prospect of such shocks, most economists still think the US can skirt a recession, in large part because the labour market has held up much better than expected despite interest rates at their highest level in 22 years. According to economic forecasts compiled by Bloomberg, US GDP growth will fall from an annualised seasonally adjusted 3 per cent in the third quarter to just 0.5 per cent in the final three months, before bottoming out at 0.1 per cent in early 2024. The unemployment rate is expected to peak at just above 4 per cent.But economists are worried that the foundations beneath the surprisingly strong US consumer — a source of the economy’s unexpected resilience in recent months — have become more fragile, leaving the economy more vulnerable.Once bolstered by a hefty stock of excess savings, Americans are estimated to have fully run down those balances this quarter, according to the San Francisco Fed. Delinquencies are rising again for credit cards and auto loans. Small and medium-sized businesses are also feeling the pressure, a new quarterly survey by Morning Consult showed, with many reporting shrinking sales and little expectation for improvement.Another concern is what all these lurking dangers could mean for US inflation. Price pressures for most goods and services may be down from their earlier peaks, but on the whole they remain well above levels consistent with the Fed’s 2 per cent target. Blerina Uruçi, chief US economist at T Rowe Price, said she was worried about higher energy prices leading to higher costs elsewhere. The autoworkers’ strike could also push up vehicle prices, given already-stretched supply.“Small shocks to the economy can really bring inflation back up again,” she said. “And as a central banker, you’re going to be worried that if you keep getting these upside shocks, what is that going to do to inflation expectations?”But a lengthy government shutdown would severely impair clarity on inflation and the labour market. The Bureau of Labor Statistics, for example, would cease collecting, processing and publishing data until funding is restored.That would complicate an already difficult interest rate decision for the Fed at its end-of-October meeting. The central bank, which kept its policy rate at 5.25 to 5.5 per cent this month, is debating whether its monetary policy is sufficiently restrictive to get inflation firmly under control. But to make that determination, Fed chair Jay Powell has said officials would look at the “totality of the data”.The central bank already has “imperfect vision, even with both eyes functioning”, said David Wilcox, who led the research and statistics division at the Fed until 2018. Operating without BLS data would be akin to covering up one eye, he added.“Monetary policy is a fraught exercise prone to mistakes under the best of circumstances, but right now with the economy in a fragile situation, you really don’t want to make a tough job even more difficult.” More

This article is an on-site version of our Unhedged newsletter. Sign up here to get the newsletter sent straight to your inbox every weekdayGood morning. The National Bureau of Economic Research officially declared yesterday that US long-term interest rates have “gone bananas”. Actually this is not true, but it should be. The 10-year Treasury yield has ripped through 4.6 per cent. This is getting a little scary, but looking on the bright side, the curve is less inverted now? Email us: [email protected] and [email protected] small caps have not worked Back in July, we wrote about the case for small caps. It came down to two factors: valuations and growth. Multiples looked reasonable, especially compared with the expensive S&P 500. The Russell 2000’s price/book ratio was well below the historical average. And the soft landing story was starting to come together. As recession fears got priced out, the Russell would rally, we thought.Well, er, about that:The S&P has been falling since July, but the Russell has fallen further. On valuations, the Russell has gone from cheap to ultra-cheap. Its price/book multiple is in the bottom quintile of its range stretching back to 1995. Generically, small caps tend to be more volatile in both directions. But soft landing is still many people’s base case and small caps remain far cheaper than the S&P. What derailed the case for small caps?One thing is a downward revision to market growth expectations. Soft landing, we should remember, still implies a slowdown. Ryan Hammond of Goldman Sachs reckons that market pricing of GDP growth has fallen in the past several months from something like 3 per cent to 2 per cent, pointing to measures like defensives’ outperformance relative to cyclicals.Another is the ambiguous spot we’re at in the economic cycle. As a rule, early cycle is when you want to own the Russell. Small caps, with their heavy representation of unprofitable minnow companies, tend to sell off hard as the cycle matures or falls into recession, often followed by a mighty rally once growth picks up again. We showed you this chart back in July:But lately, it’s not been quite so clear if we’re in early cycle, late cycle or some ambiguous spot that defies the cycle framework. As such, it’s not clear small caps are due for an early-cycle rally anytime soon.Lastly, higher interest rates are biting for small caps. As we wrote elsewhere in the Financial Times, S&P 600 interest expense per share has hit a record. Small-cap indices are laden with thin-margin companies, and plenty of unprofitable ones, so it’s not a stretch to figure the probability of defaults must be rising:One point of speculation. The rise of private equity in the past few decades may have sapped some vitality from the small-cap universe. As capital has flooded into PE funds, it makes sense that they would have picked through the small-cap universe for companies with potential, leaving a weakened group behind. That would fit with a striking fact about the Russell: the share of unprofitable companies (on a 12-month forward basis) is one in three.Still, any asset class, however junky, makes sense at the right price. With small caps historically very cheap, perhaps the buy case has gotten stronger. If you’ve a view, let us know. (Ethan Wu)Rates and stocks: trying to kill a zombie with mathsOn Tuesday, I argued, not for the first time, against the zombie idea that rising interest rates are especially bad for growth stocks. To summarise: when inflation expectations and interest rates rise, it’s not just the discount rate on future profits that changes. Growth rates change too, for example. So the “rates up = growth underperforms” theory is at best a wild oversimplification and at worst just false.But analysts and pundits keep at it. As if to taunt me, Bloomberg published this in a market wrap this week:The threat of tight policy is undoing some of the market’s biggest gains this year in the high-flying tech stocks. These growth companies are prized for their long-term prospects but hold less appeal when future profits get discounted at higher rates.But rates rose like crazy right through the summer, and tech stocks did great! What was happening then? Argh!Yet another final attempt, then, to put an end to this intellectual virus. Let’s try it with numbers this time. Below is a very simple net present value analysis of two imaginary companies, one growth-y, one value-y. Sorry to those of you reading on mobile, who will have to squint:Both companies have the same profits as of year one, but one will grow at 5 per cent for the next 10 years, the other at 2.5 per cent (I know, growth/tech companies usually grow faster than 5 per cent, but I wanted a flat rate over 10 years so I shaded it down). I use the 30-year Treasury yield for the risk-free rate, specifically the one from December 2021, when stocks peaked. I borrowed the equity risk premium calculated by Aswath Damodaran of NYU, again from the end of 2021. To calculate the terminal value of each stock at the end of 10 years, I shaved a percentage point from both growth rates. Sorry for all this boring arithmetic, I will make an interesting point soon, I promise.As you can see from the net present values at lower left — the prices of the two stocks, as it were — a lowish discount rate and a highish profit growth rate combine to make the growth stock look very expensive, at 38 times this year’s earnings. Most of that value resides more than 10 years in the future, in the terminal rate. The value stock is less expensive, at 20 times earnings, and its value is weighted more towards the present. Now let’s suppose there was a big inflation shock and rates rose or, to put in another way, let’s use the 30-year Treasury rate and the ERP from today, not late 2021, while keeping everything else the same:The prices of both stocks get crushed by the higher discount rate, but the growth stock, because more of its value is out in the future, gets the worst of it. Its value falls by half, versus a third for the value stock. Now let’s make another assumption, to make the analysis more closely resemble the real world: the two companies have inflation-offsetting pricing power, but to different degrees. Let’s suppose the growth company has higher pricing power, and can increase its nominal prices enough to move its profit growth rate to 7.5 per cent a year, while the value company can push to 4 per cent a year. Let’s push the terminal growth rates up a bit, too. Now the picture is very different:Now the value stock falls by more than the growth stock. Of course a little fiddling with the inputs would get you a different result, but that is exactly the point. Once you add in just one more variable — pricing power — the “rates up growth underperforms” theory goes to pieces. And it is not arbitrary to assign more pricing power to the growth stocks. Part of what defines many growth stocks is that their businesses have high barriers to entry. Think of companies most people are talking about when they are talking about tech and rising rates: the magnificent seven. Apple and Microsoft are defined by pricing power; Meta and Google perhaps less so, but as advertising businesses go, they must have more leverage with clients than anyone else; if you want an AI chip stack, it’s Nvidia or no one right now; Amazon and Tesla have niches where they dominate, too. This is part of why we’ve argued in the past that Big Tech may prove surprisingly defensive in a downturn.None of this is to deny that the prices of growthy tech stocks sometimes seem to have an inverse relationship with Treasury yields. The problem is we don’t seem to have a good theory of why this happens when it does. I suspect the theory will have to pull from the arsenal of behavioural finance, with its emphasis on bias and overreaction, rather than adding more macroeconomic variables. More on that tomorrow. One good readPeople on X née Twitter are angry about this New Yorker story about the Bankman-Fried family, saying it lets Sam’s academic haute bourgeois parents off the hook too easily, given their own links to FTX. But let me stick up for the writer, Sheelah Kolhatkar: maybe she trusted her readers to do the putting-on-the-hook themselves?FT Unhedged podcastCan’t get enough of Unhedged? Listen to our new podcast, hosted by Ethan Wu and Katie Martin, for a 15-minute dive into the latest markets news and financial headlines, twice a week. Catch up on past editions of the newsletter here.Recommended newsletters for youSwamp Notes — Expert insight on the intersection of money and power in US politics. Sign up hereThe Lex Newsletter — Lex is the FT’s incisive daily column on investment. Sign up for our newsletter on local and global trends from expert writers in four great financial centres. Sign up here More