Why US risk assets may perform better in this slowdown than those of the past

Kondi Nkosi

A relatively better inflation picture not only reduces the risk of recession but also increases the potential for interest rate cuts.

Nearly a year ago, the US economy experienced a textbook recession with two consecutive quarters of negative real GDP. But the rapid rise in inflation suggested an economy facing stagflation rather than recession. On the other hand, the strong US labor market indicated an economy in expansion, which was consistent with the Schroders Output Gap model.

We had expected some semblance of a normal cycle to return this year. Not only would GDP growth be contracting, but the pick-up in the unemployment rate would lead to the output gap shrinking, then turning negative. Inflation would have also eased from lofty levels. In short, the US economic cycle would be in the recession phase.

Since then, inflation has fallen but the US economy has proven to more resilient than expected. In particular, the labour market remains relatively robust with the unemployment rate close to multi-decade lows. That said, the unemployment rate has risen, and the Schroders Output Gap model has moved on to the slowdown phase. Like the market, we now expect the US economy to experience a slowdown but not an outright recession.

Schroders Output Gap model and the phases of the economic cycle
The Schroders Output Gap model measures the amount of spare capacity in the economy by comparing the economy’s actual output with its potential output (the maximum level of output an economy can produce without generating inflation).

A positive output gap suggests the economy is running out of spare capacity. As economic activity eases the positive gap begins to shrink, and the economy enters the slowdown phase. Based on our model, the US economic cycle is in the slowdown phase and is likely to stay there over the next 12 months (chart 1).

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