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The US economy could get worse before it gets better — here’s what you need to know

The US economy is struggling — and EY predicts that the pain is not yet over.

The US economy is struggling — and EY predicts that the pain is not yet over. Image: REUTERS/Andrew Kelly

Gregory Daco
Chief Economist, EY-Parthenon
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United States

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  • EY predicts real GDP growth of around 0.9% in 2023 and around 1.2% in 2024.
  • Tightening credit conditions for businesses and consumers amid persistently elevated rates, prices and wages will constrain private sector activity.
  • The unique economic conditions post-pandemic mean that any economic slowdown will be very different from prior recessions.

The US economy is likely to get worse before it gets better, according to forecasting by EY.

The combination of persistently elevated prices, high interest rates and now tightening credit conditions will weigh on business investment, consumer spending and the transactions markets in the coming months. Even though we do not see evidence of broad-based economic imbalances, recessions are often nonlinear psychological events.

EY continues to expect a midyear recession, with the Fed proceeding with one more 25 basis point (bps) rate hike in May and likely proceeding with a “recalibration” rate cut (or cuts) before year-end.

Housing struggles

All interest rate-sensitive sectors have experienced a notable pull back, with housing suffering the brunt of the correction. With home sales plunging 30% over the past year and construction activity following the downfall with a lag, the housing sector is likely to remain under significant pressure in the coming months. And while the recent decline in interest rates and easing home prices (especially in some of the hottest regional markets) could provide some support to potential home-buying activity, we should recall that housing affordability remains near its all-time low.

Fortunately, the historically rapid housing correction occurred at a time when household leverage was near a 20-year low. As such, the current correction is not a repeat of 2008, when excess leverage and elevated credit risks combined into a broader financial crisis. With 80% of homeowners having locked in mortgage rates below 4%, the biggest concern for housing going forward is less of a credit risk than a lack of housing mobility and an elevated barrier to entry.

Business investment is contracting

Business investment activity is softening, with new orders, employment and backlogs all contracting. Business sentiment appears to be shifting with demand continually slowing and no clear evidence of positive spillovers from China’s reopening. Durable goods orders and shipment trends are also deteriorating rapidly, indicating slower equipment investment momentum in the first quarter of this year than at the end of 2022. With spending on structures under pressure from a higher cost of capital, it is increasingly likely that we’ll see a business investment contraction in Q2 and potentially Q3.

Inventory management has become a central concern for business executives. After spending the majority of 2021 and 2022 rebuilding inventories at break-neck speed, this year will likely be a year of inventory recalibration. We may very well see an amplification of the capex business cycle to the downside as business leaders look to rightsize stocks considering slower future demand.

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Consumer spending cools

The backbone of the US economy remains the consumer, but even there we’re observing a significant cooling of spending at the end of Q1. After a strong start to the year, real consumer spending growth is on track to grow around 4% annualised on average in Q1. The strong performance will be subject to misleading interpretations of underlying consumer strength. However, a situation where personal income remains well below its pre-COVID-19 trend and significantly lower than consumer spending is not sustainable. Consumers may have been able to manage elevated prices thanks to their savings and increased use of credit, but that simply cannot replace organic income growth in the medium term.

That is not to say that the rebound in real personal income over the last eight months is not a positive development — it is. But it won’t be enough to offset the growing headwinds facing the consumers, especially lower- to median-income families who have come under increasing pressure from persistent inflation, slower income growth, reduced access to credit and depleted savings.

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The ability of families in the top two deciles to continue fueling growth is diminishing. Two key factors are likely to weigh on their spending capacity. First, services costs have continued to rise rapidly, and while inflation is moderating, higher price levels are undoubtedly going to curb consumers’ enthusiasm. Second, credit conditions are tightening, and the recent banking sector stress will only further exacerbate the impact, leading to slower spending on big-ticket items and services. EY anticipates real consumer spending will likely contract around 1% (annualised) in both Q2 and Q3.

A unique labour market

Post-pandemic labour conditions are unique. Labour market tightness will remain a feature of this business cycle given business executives’ reluctance to let go of valuable and prized talent pools, but we continue to anticipate reduced hiring, strategic resizing decisions and wage growth compression. The latest Job Openings and Labor Turnover (JOLTS) report — while it must be read with caution given the low response rates — showed a downward trend in job openings and hirings. Similarly, quit rates have declined, especially in white-collar occupations.

Hiring efforts appear to have been scaled back notably across numerous sectors, and that is what the March jobs report showed. Slower job growth in the goods sector, easing hours worked, moderating sequential wage growth momentum and rising labor force participation indicate a welcome easing of labour market tightness. However, while this points to a soft landing of the US economy, the landing strip ahead is narrow and short. Sentiment is shifting and the labour market slowdown is accelerating.

Credit tightening persists

While it’s impossible to determine with any degree of precision how the banking sector situation will evolve, EY anticipates a tightening of credit conditions in the coming months. The fragmentation of the US banking system, with thousands of small banks providing financial intermediation for consumers, small and medium-sized businesses and real estate, means that tighter credit conditions will likely slow the economy through various channels.

Small domestically chartered commercial banks (outside of the top 25 banks by asset size) contribute to between a third and half of the banking sector’s consumer loans, commercial and industrial loans and residential loans in the US. They contribute about 80% of all commercial real estate bank loans. With a net 50% of banks tightening credit standards on commercial and industrial loans and 25%–40% tightening standards for auto loans, credit cards and mortgage loans prior to the banking sector stress episode, the tightening will only get worse.

What it all means for the US economy

EY anticipates tightening credit conditions will represent a drag on the US economy worth around 0.5% of GDP over the next 18 months. As a result, we now anticipate real GDP growth will be closer to 0.9% in 2023 and around 1.2% in 2024.

With the Fed adopting a dual-track approach distinguishing monetary policy tools from macro-prudential tools, EY anticipates a final 25bps rate hike in May. This would bring the terminal fed funds rate range to 5.00%–5.25% in line with the Federal Open Market Committee (FOMC) statement that “some additional policy firming may be appropriate.”

While the Fed will maintain its posture of “not thinking about thinking” about rate cuts in the coming months, we don’t discount the possibility of a pivot around the late-summer Jackson Hole meeting. By that time, we anticipate the economy will be in a recession with slower private sector activity, job losses and potential adverse financial market ramifications. EY maintains its view that rate cuts are a strong possibility before the end of the year. These will likely initially come as a recalibration exercise, but once there is ampler evidence of inflation having sustainably declined toward the Fed’s target, rate cuts may become larger and more rapid.

The views expressed by the author are his own and not necessarily those of Ernst & Young LLP or other members of the global EY organization.

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