Brighter prospects for the US economy in the road ahead

• US GDP came in at 5.2% in 3Q23, following the second quarter’s expansion of 2.1%. Gains in the third quarter were powered mainly by strong consumer spending and investment. 

• With an acceleration in fiscal spending and the robust balance sheets of both consumers and businesses, the likelihood of a broad-based US recession is diminishing. 

• Having already gone through a recession in the past year or so, we expect the tech sector to power the next leg of growth, benefiting from the tailwinds of AI and digitalisation. 

• Given the lofty valuations of the broader US equity market, we recommend investors to focus on areas such as big tech and semiconductors, which have the potential to deliver strong earnings growth and multiple expansion. 

• Investors should also keep an eye out for quality stocks, which should not only do well in a higher for longer interest rate environment but also in the long run. 

Even after enduring one of the most aggressive rate hiking campaigns by the Federal Reserve, the US economy continues to demonstrate its resilience, raising the hopes of a soft landing. Recent economic data has held up surprisingly well and the likelihood of a US recession is starting to diminish. 

According to estimates published by the Bureau of Economic Analysis, real GDP increased at an annual rate of 5.2% in 3Q23, following the second quarter’s expansion of 2.1%. The gains were largely driven by strong consumer spending (in both goods and services) as well as gross private domestic investment (Figure 1). 

Figure 1: Strong third quarter GDP growth was driven mainly by consumption and investment

Strong consumer & corporate health, acceleration in government spending to sustain the US economy  

Consumption, which accounts for more than two-thirds of GDP growth, has significant bearing on the health of the US economy. Fortunately for the US, consumer spending has managed to stay resilient – having risen 4% in 3Q23 following a gain of just 0.8% in the previous quarter. 

While there are many factors affecting consumption, in general consumers tend to spend more when they are feeling confident of their own finances, job prospects, and the economy. At present, the strength of the US consumer is largely underpinned by a tight labour market, which has resulted in above average wage growth in the post pandemic era. Even though the labour market has shown some signs of loosening lately – with a rise in the unemployment rate and slowing wage growth – it remains tight relative to pre-pandemic levels (Figure 2). 

Figure 2: Labour market has loosened but remains tight relative to pre-pandemic levels

Gross private domestic investment, often the second largest contributor to GDP growth, is likely to be resilient as well. On the corporate front, many companies also took advantage of the pandemic to refinance their debt at lower rates and for longer durations – resulting in less refinancing needs in the near-term. 

As a matter of fact, most of the existing corporate debt is slated to mature after 2025, allaying fears that US corporates may get crushed by the growing debt maturity wall (Figure 3). Most of the corporate debt in the US also carries an investment grade rating, which means that the increase in interest expense should not be significant even with higher interest rates. 

Figure 3: A large chunk of corporate debt matures after 2025, most of which carries an investment grade rating

Besides these factors, an acceleration in government spending through policies such as the Inflation Reduction Act (IRA) and the CHIPS and Science Act should also help to sustain the US economy. Besides its direct impact on GDP, higher levels of government spending can also have meaningful second order effects as it may spur an increase in private investment. 

For instance, following the announcement of the CHIPS and Science Act several domestic chipmakers such as Micron, Qualcomm and GlobalFoundries have announced massive investments to increase their manufacturing capacity on US soil. These policies are also expected to have a positive impact on companies from the infrastructure/materials sector as noted by several of them in their recent earnings calls. 

Outlook may be improving but risks remain 

While the recent data does show that the US economy is doing better than expected, it is not completely out of the woods yet. Waning excess savings, tighter credit conditions, elevated inflation levels and the risk of any new external shocks (e.g. geopolitical) still pose a threat to the economy. Investors should bear these risks in mind as they position their portfolios.

But unlike previous recessions such as the Global Financial Crisis (GFC) in 2008 and the dot-com bubble in 2001, any recession that occurs today is unlikely to be credit driven, thus limiting its severity. And as we have pointed out earlier, both household and corporate balance sheets remain robust. 

With that being said, we are not overly worried even if the US does enter a recession. As a matter of fact, a recession could even be a “healthy reset” for the economy, setting the stage for an even stronger rebound. It may also be beneficial as valuations are likely to come down, providing investors with a better entry opportunity. Most importantly, investors should look beyond the near-term headwinds and focus on the long-term outlook of the US. 

Big tech, semiconductors to power the next leg of growth 

Looking ahead, one of the most promising growth drivers of the US economy lies in its tech sector. The US tech industry has grown by leaps and bounds over the past few decades and has become one of the largest and most advanced in the world. Today, it is home to numerous global leaders, such as the likes of Microsoft, Amazon and Nvidia. As of 2022, the sector is estimated to account for more than 10% of the nation’s GDP. 

Looking far ahead, we think that the tech sector is primed for a multi-decade period of explosive growth, powered by the advent of AI and the continued digitalisation of the global economy. These megatrends should have positive spillover effects to the broader US economy (such as through increased productivity and job creation), as well as its equity market given that the tech sector comprises nearly 30% of the S&P 500 index. 

Big tech stocks in particular, are poised to lead this charge. With their deep pockets and vast experience dealing with AI, big tech companies are best positioned to harness everything AI has to offer. Coupled with their wide economic moats, strong balance sheets and cash flow generating ability, big tech stocks are also likely to do well even in a higher for longer interest rate environment (Figure 4). 

Figure 4: Big tech companies have a ton of cash reserves

Related article: The earnings recession is over. Big Tech is set to lead the next phase of growth.

Aside from big tech, we also expect chipmakers to be one of the biggest beneficiaries of the abovementioned megatrends. Thanks to the rapid adoption of AI, the semiconductor industry once again finds itself at one of the most pivotal turning points in history. Just like the PC and mobile revolutions in the past, we believe that the AI revolution will bring tremendous opportunities for chipmakers over the next decade. 

In the long run, we expect to see a massive structural increase in demand for chips, driven by (i) an increase in the number of semiconductor applications and (ii) the higher silicon content in them. In the near to mid-term, we expect a recovery in the inventory cycle to drive higher sales growth, potentially going beyond 40% year-on-year by 2Q25 (Figure 5). All in all, this should bring better earnings prospects and hence share price performance for chipmakers. 

Naturally, this bodes well for the American semiconductor industry (and the broader economy) which is the largest and arguably the most advanced in the entire world. In 2022, US chipmakers held a market share of close to 50%. Semiconductors are also an integral part of US commerce. The country exported USD 61.1 billion worth of chips in 2022 – its fifth largest export. 

Figure 5: Chip sales to hit 40% year-on-year growth by 2Q25

Related article: Chip sales to top 40% year-on-year by 2Q25. Here’s how you can capitalise on this opportunity 

Overall, we believe that the tech sector is likely to be in the recovery phase, having already gone through a recession last year (marked by a surge in layoffs and an earnings slump). It also helps that the US economy is highly diversified, lessening the impact a shock in one sector has on the overall economy. On the whole, we think that the US is unlikely to experience a broad-based recession, but rather a rolling recession where different sectors experience a downturn on different occasions.  

Focus on sectors with greater upside potential 

Even though we are more optimistic about the US economy compared to other markets, the same optimism cannot be extended to its equity market given the high valuation it trades at. Ever since the Covid-19 recession, the S&P 500 index has been on a tear as economic data kept surprising on the upside, adding to investors’ confidence on the health of the US economy and its stock market. 

Based on our estimates, the S&P 500 index is currently trading at 16.5X 2025 earnings, which implies an upside potential of just 9% (based on a fair PE of multiple of 18X). As such, we will be maintaining our current rating of 2.5 Stars “Neutral” for the US.

Table 1: Valuations for the broader US equity market are not the most enticing

While the broader US equity market is looking relatively unattractive from a valuation standpoint, investors can still uncover opportunities by focusing on areas such as big tech and semiconductors, which not only has tremendous earnings growth potential, but also room for multiple expansion. Furthermore, in line with our expectation that interest rates are going to stay higher for longer, investors should also keep an eye out for quality stocks, which are likely to do well not only in a slowing growth environment, but in the longer term as well. 

Table 2: Recommended products for US equities 

All in all, our long-term outlook for the US economy remains favourable, due to an acceleration in fiscal spending, and the presence of growth drivers such as AI and digitalisation - both of which should lead to an increase the productivity and job creation. In the near-term, we think that the US stands a good chance of avoiding a broad-based recession, as certain sectors (such as tech) have already gone through a recession and are currently in the recovery phase.

When it comes to investing, investors should always look beyond the near-term and focus on the longer-term growth prospects of the market. 

Figure 6: Share prices are driven by earnings growth in the long run 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report holds a position in the VanEck Semiconductor ETF.