US: misplaced concerns about a growth scare

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● Overblown fears: We do not believe that the recent downside surprise in macroeconomic data and Department of Government Efficiency (DOGE)-driven job cuts justify concerns about economic growth in the US. We expect the economy to grow above trend in 2025, with the labour market remaining healthy despite slower employment growth.

● A market overreaction? Since last Thursday, the US equity market (S&P 500) has dropped nearly 3%, the 10-year Treasury yield fell by 20bp, and futures/swaps markets raised their 2025 rate-cut expectations from one to two. This reaction stems mainly from the recent downside miss in macroeconomic data, beginning with Friday’s sentiment surveys. Specifically, the S&P Global PMIs revealed that the service sector slid into contraction, while the University of Michigan (UMich) consumer survey highlighted growing pessimism and the highest long-term inflation expectations since 1995. Adding to the concerns, the Chicago Fed’s national activity index pointed to below-trend growth in January, and Tuesday’s Conference Board survey echoed the negative findings from the UMich survey. Talks of rising federal layoffs and related spending pullbacks further fuelled the narrative of a significant US economic slowdown.

● Fade the sentiment: It is surprising that fixed-income markets rallied while risk assets sold off due to a relatively small downside miss in “soft” data. First, consumer sentiment did decline due to fears of tariff-induced higher inflation, prompting consumers to increase spending now to avoid higher future prices (which implies higher growth in the near term). The post-pandemic economy has shown that poor consumer sentiment is not a reliable leading indicator for economic growth. Both the Conference Board and UMich consumer confidence metrics have returned to their late-2023 levels, and it is worth noting that the economy grew by 2.8% yoy last year – at double the rate of consensus expectations.

● No severe impact of federal layoffs: We expect DOGE-driven layoffs to total a maximum of 300k by year-end, which would reduce nonfarm payrolls by up to 30k per month. This should not significantly impact the US labour market, which added an average of 237k jobs over the past three months. The US labour force is 170m; therefore, even if 300k suddenly moved to unemployment, it would only increase the unemployment rate by 0.2ppt, from 4% to 4.2%—in line with the Fed’s long-run estimate of maximum employment. Deportations matter more for the labour market than DOGE-related layoffs. Labour supply is expected to fall rapidly due to restrictive immigration policies; therefore, a marginal increase in supply from federal layoffs will not create much slack. Businesses are already facing challenges in filling positions due to self-deportations, and border crossings have slowed significantly. Immigrants have driven nearly all of the growth in the US labour force since the pandemic. Over the past year, more than half of job gains were attributable to illegal immigrants, while only 49k out of 2m job gains were from federal employees (with c90% of government hiring in 2024 occurring at state and local levels – see Chart 2).

● No room to cut: We believe that the Fed will keep rates steady for the foreseeable future, as it loses confidence that inflation will return to 2% anytime soon (see our US: stubborn inflation report). Even if the US starts a fiscal consolidation and uncertainty regarding economic/trade policy fades – potentially lowering the 10-year yield through reduced-term premiums – elevated future inflation and higher-for-longer rates will set a floor for the 10-year yield. We expect the 10-year Treasury yield to approach 5% by year-end as inflation concerns increase.

● Strong consumption: An increase in real disposable income from strong pay growth, tax cuts, accommodative financial conditions (see Chart 1), and healthy balance sheets will support strong consumption growth. While a major reversal in the equity market may eventually weigh on consumer spending, this will not happen immediately, as the wealth effect (ie increased spending due to rising wealth) operates with lags.

Atakan Bakiskan

US Economist

+44 20 3207 7873

[email protected]

Disclosures

This material is intended as commentary on political, economic or market conditions for institutional investors or market professionals only and does not constitute a financial analysis or a research report as defined by applicable regulation. See the "Disclaimers" section of this report.

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