US economy likely to witness a hard landing in 2024?

29 Feb 2024 , 03:31 PM

As voices raising concerns around slower growth (some even projecting a recession) of the US economy in 2024 grow stronger, it is time to understand what this could mean for global growth at large and for Indian investors, in particular. 

To start with, the World Economic Outlook report by the International Monetary Fund, released in January 2024 pegs US GDP growth at 2.1% in 2024, down from 2.5% in 2023 (estimated). The IMF, however, expects world economic growth to stay put at 3.1% in 2024 (same as estimated for 2023). Jim Walker, Chief Economist, Aletheia Capital, believes global economic growth in 2024 could be weaker compared to 2023. His firm’s projections peg growth in US economy at 1.6%, down from the 2.5% growth estimated in 2023. Similarly, Japan’s growth forecast stands at 0.9%, down from 2.0% in 2023. The Eurozone is projected to grow by 0.7%. Overall, the global average growth forecast is estimated to be 2.4%, lower than 2.6% recorded in 2023. It is important to note here that the growth rates of major economies US, Japan, and the Eurozone are all below the anticipated global average. This suggests that for global growth to be sustained, it will heavily rely on the performance of emerging markets (EMs) like India. Emerging markets often have the potential for higher growth rates compared to advanced economies due to the presence of structural drivers such as favorable demographic trends, technological advancements, and infrastructure development. 

Coming back to the US economy, a deep dive into the projected growth rates reveals some concerns. While the economy is indeed expanding, much of this growth is fueled by government expenditure rather than sustainable private sector activity. This reliance on government spending has contributed to a significant debt-to-GDP ratio, currently standing at 120%, which is a cause for alarm. Despite the US being in a period of economic prosperity, its fiscal deficit remains high, leaving little room for implementing countercyclical measures in the event of an economic downturn. This means that significant adjustments (rise in fiscal deficit and/or debt levels) are needed to achieve sustained growth in the US economy over longer periods of time. However, such measures come with their own risks and challenges, including potential inflationary pressures and concerns about fiscal stability. The events unfolding in the Middle East, West Asia and the Red Sea route hold the key to inflation trajectory over the next few months and bring in an element of uncertainty.

At present, there is no significant pressure on the Federal Reserve to lower interest rates, given the apparent strength of the economy (an opinion echoed by US Federal Reserve Board member Christopher Waller and Lisa cook in their recent speeches). Typically, interest rate cuts are employed as a monetary policy tool to stimulate economic activity during periods of slowdown or recession. Central banks around the world also keep a firm eye on inflation levels before announcing any rate cuts as such cuts could make inflation soar higher. Therefore, for any rate cuts to occur, one would essentially need to hope for an economic downturn along with reasonable comfort on inflation levels. This underscores the delicate balance between economic growth, fiscal responsibility, and the role of monetary policy in maintaining stability within the US economy.

David Rosenberg, a top economist and President of Rosenberg Research, suggests that there is an 85% probability of the US economy entering a recession in 2024. He maintains the view that although the recession has been postponed, it remains highly likely. Rosenberg’s economic model, signaling an 85% chance of a US recession, marks its highest reading since the 2008 Financial Crisis. Notably, the model has demonstrated its superiority over the yield curve indicator. In 2023, while the former indicated a mere 12% chance of a recession, the latter suggested 50%. Since 1999, Rosenberg’s model has consistently provided timely warnings of recessions without generating any false signals[1].

In the December quarter of 2023, both UK and Japan faced a technical recession, underscoring the likelihood of more widespread economic difficulties.  A technical recession refers to two consecutive quarters of negative growth in real GDP. Reports suggest that 18 other nations, including Canada, South Africa, and New Zealand, are similarly teetering on the edge of recession. Noteworthy is Germany’s contraction of 0.3% during the same period, given its status as the Eurozone’s largest economy, potentially jeopardizing the region’s overall growth. Furthermore, the Eurozone as a whole experienced stagnation, reporting zero percent growth in Q4[2].

Although India remains a bright spot given its relatively robust GDP performance, it can hardly escape the impact of globalization. The Indian economy faces vulnerability to external pressures, especially due to its heavy dependence on service exports, which serve as a vital revenue stream for the IT sector. Additionally, the upward trend in global prices may lead to heightened import costs for India, adding some strain on its economic stability and corporate profitability.

Where should one invest during such a difficult time?

Given the current economic scenario, it will be prudent for investors to understand the current phase of a business’ cycle. For instance, if one’s analysis suggests that economic growth is decelerating or contracting, yet equity valuations do not fully account for the potential impact on corporate profits and cash flows, one may opt to bolster their portfolio cash position by divesting weaker stocks, which are particularly vulnerable to downturns. A strategy of sector rotation can also be employed, implementing profit booking in high-risk positions from more aggressive sectors and reinvesting into relatively safer, low-beta stocks. These belong to sectors hitherto considered as defensive bets, namely, consumer staples and utilities. One can also consider investing in stocks of public sector companies which typically offer attractive dividend yields. The figure below tells us how the financial cycle often precedes the business cycle. 

Stocks typically lead the economy by an average of six to nine months. For instance, the stock market often hits bottom and begins to rise while the economy is still in a full recessionary phase. Similarly, stocks tend to peak and commence a downward trend into the next bear market while the economy is still in a robust expansion phase. If the analysis indicates that the market has reached a bottom and is poised for an upward trend in anticipation of economic expansion, conventional wisdom suggests reducing exposure to defensive sectors and reallocating funds to aggressive or cyclical sectors. Examples include automobile and durable goods manufacturers, as well as technology stocks, as businesses and consumers tend to postpone significant purchases during economic downturns but catch up on these expenditures when conditions improve. Conversely, if the economy is already in an expansion phase and the stock market is well into a bull market, increasing allocations to industrial, basic material, and energy stocks is advisable. This is because inflation typically accelerates later in the business cycle, and rising commodity prices typically bolster the profits of these companies.[3]

As a number of countries are experiencing contraction and some are already in a technical recession as discussed earlier, it would be wise to allocate more towards defensive sectors like Utilities and Pharma. India’s power demand growth is real and frantic measures are necessary to ensure energy security. Call by power ministry to add 80GW/500GW thermal/Renewable Energy (RE) capacity and accommodative stance by CERC in its draft tariff regulations are good reflections. Analysts at IIFL Securities note that India’s per capita power consumption is at an inflection point and can mirror the trends in China. However, this could happen if India is able to address the sticky issues plaguing the sector, including inefficient operations of SEBs, fuel shortages, and transmission bottlenecks. Recent comments from the Power ministry suggest that the government is actively looking at stepping up coal based capacity additions to meet the rising demand. This is in addition to the >350GW RE capacity addition that the government has envisaged by 2032. In this regard, the entire industry presents a substantial opportunity for growth in the coming 8-10 years. Capital expenditure in the power sector, especially in generation, has a cascading impact on the economy and is poised to initiate a long-term investment cycle spanning a decade. It is worth noting that the power sector’s representation in the overall market is currently close to multi-year lows, indicating significant potential for enhancement with anticipated investments aimed at addressing increasing demand. Moreover, sector valuations are now no longer considered distressed. However, relative to their historic peak, valuations are not expensive. Moreover, the pool of investible stocks has also shrunk considerably, for which the quality names in the sector seem to be either trading at fair multiples or slightly above basis near-term earnings.  Utility stocks seem to price in earnings growth until FY25/26, at a time when growth visibility extends for the next decade and the pool of investible stocks has shrunk considerably (See figure below). Analysts at IIFL Securities like NTPC, and Torrent Power the most, as revenue models are sustainable, scalable, backed by impeccable track record. Tata Power also stands out with its diversification strategy. They also like other stocks including CESC, NHPC and Power Grid, but await better entry points in these.

The forecast for the pharmaceutical sector as a whole in 2024 remains optimistic. There has been a reduction in the severity of price erosion in the US generic market, resulting in a slight improvement in the business performance, margins, and earnings of major export-oriented pharmaceutical companies in 2023. Additionally, the domestic pharmaceutical market in India continues to experience consistent growth of 9-10% annually. Many mid-cap companies are surpassing the growth rate of the domestic pharmaceutical market by 300-400 basis points per annum, thereby enhancing business diversity, profitability, and return indicators. India healthcare delivery market is expected to sustain its 13-14% CAGR over the next four to five years, driven by increasing prevalence of chronic diseases, rising affordability levels, medical tourism and government’s push on primary healthcare in rural markets. According to some news reports, the government is reportedly developing a new PLI scheme targeted at the pharmaceutical sector. The aim is to enhance the manufacturing of essential chemicals crucial for API production and decrease reliance on China for these supplies^[4]. IIFL’s top-picks in the pharma sector are Sun Pharma, Mankind, JB Pharma and Aurobindo while the top picks in the hospitals sector are Apollo and KIMS. Analysts at IIFL Securities recommend to add Max and Rainbow on corrections.

Thus, with some start reallocation of capital in favor of the power and pharmaceuticals sectors can help investors navigate the increasingly cloudy macro environment with relative ease.

 

---

[1] The US now has an 85% chance of recession in 2024.

[2] 18 other countries apart from UK and Japan at risk of a recession

[3]  Applied Equity Analysis and Portfolio Management by Robert A. Weigand

[4] Government mulling new PLI scheme for pharma sector