Bracing for Impact: Analyzing the US Economy and Markets

The latest data released by the U.S. Department of Commerce show that the U.S. gross domestic product (GDP) grew at an annual rate of 2.4% in the second quarter of this year, higher than the first quarter and stronger than market consensus expectations.

In the first seven months of this year, the three major U.S. stock indexes rose collectively, and the Nasdaq index rose by 37%. The “big seven” set off a big bull market in technology stocks. Among them, Nvidia rose by 219% and Microsoft rose by 40%.

It’s hard to imagine that this is a story that happened during the Fed’s most aggressive tightening cycle in nearly 40 years — a ghost story.

From March last year to July this year, the Federal Reserve raised interest rates by a total of 525 basis points, pushing the federal funds rate to a range of 5.25%-5.5%, the highest in nearly 22 years, and reducing broad money (M2) by more than 1 trillion Dollar.

At present, the overall inflation rate in the United States has dropped to 3%, while the unemployment rate remains at a historically low level of 3.6%. The consumer confidence index has returned to the highest level in the past two years. The economy is showing a “soft landing” trend, and the technical recession has not yet come. That has disappointed many investors betting on recession trades.

In the second half of the year, will the U.S. economy still be in recession? How is the financial market going?

From the perspective of the balance sheet, this article analyzes the reasons for the economic resilience under high interest rates in the United States, and the economic and financial market trends in the second half of the year.

1

Balance Sheet Optimization
Looking at the data in the second quarter first, the main growth of the US economy comes from business investment, government spending and personal consumption, with net exports being the drag.
Among them, corporate non-residential fixed asset investment increased by 7.7%, a substantial increase of 7.1 percentage points from the first quarter; personal consumption expenditures, which accounted for 70% of the US economic aggregate, increased by 1.6%, and the growth rate narrowed by 2.6 percentage points from the first quarter. But still resilient.
What confuses investors is that in the second quarter, under the high interest rate, why did companies expand investment? Residents also expand consumption?
This has a lot to do with the balance sheet adjustments of the three major sectors of the US business, households, and government in the past 15 years.
When the financial crisis broke out in 2008, the US household sector and corporate sector experienced violent deleveraging. The leverage ratio of the household sector dropped from a peak of 96% to 75% in 2019. The leverage ratio of the corporate sector first fell rapidly from 72% and then gradually rose to 76% in 2019. In order to save the economy, the U.S. federal government has greatly expanded spending, and the government leverage ratio has risen rapidly, from 66% to 100% in 2019.

With the outbreak of the new crown epidemic in 2020, the leverage ratios of the three major sectors in the United States experienced the second major adjustment.
In the early days of the outbreak, the leverage ratios of both the household sector and the corporate sector rose rapidly. Immediately afterwards, the Federal Reserve implemented an unlimited quantitative easing policy and lowered the federal funds rate to near zero. Subsidizing the household sector and small and medium-sized enterprises, the leverage ratio of the household sector further dropped to 74%, and the leverage ratio of the corporate sector fell back to 78%, which is comparable to the level between the epidemics. The federal government’s leverage ratio will rise further to 122%, falling back to 112% in 2022.
During these two major crises, the U.S. government’s operation was to actively increase leverage and actively take risks through the government to avoid the Great Recession and the breakdown of the balance sheets of enterprises and households, and to help enterprises and households reduce leverage and optimize assets and liabilities. surface. Therefore, household assets are stronger, debt ratios are lower, and corporate balance sheets are healthier. This is the key to maintaining a relatively strong U.S. economy under high interest rates.
Consumption is a function of total income, and the resilience of consumption basically comes from the resilience of household balance sheets.
During the epidemic, the Biden administration’s bailout bill distributed a total of about 2.1 trillion in cash to ordinary families, equivalent to 9% of the total US GDP in 2021. This “big red envelope” was quickly converted into the excess savings of ordinary families, and then invested in the consumer market at a monthly consumption rate of 60-90 billion, driving a fiery economic recovery.
In the United States, the number one household expense is housing. According to the experience from 2004 to 2007, when the federal funds rate rises rapidly, the interest expense of personal mortgage loans rises rapidly, which in turn weakens the purchasing power of households. This year, the federal funds rate has exceeded its current level, and the 30-year fixed mortgage rate is above 6%, but the suppression of household purchasing power has been much weaker than expected.
The reason is that American households have learned the lessons of the subprime mortgage crisis, chose to borrow money to buy houses during the low-interest period, and adopted fixed loan interest rates-the fixed interest rate of 30-year mortgage loans remained between 3.5% and 4% for a long time from 2012 to 2017 During the epidemic period, it will remain between 2.5% and 3% for a long time.
The same is true for consumer credit, with most credit card and auto loans in the U.S. locked in a low rate range between 2012 and 2022.
Therefore, the interest payment costs of housing, car loans and consumer credit of many families have not increased due to interest rate hikes.
At the same time, due to the rise in stock and real estate prices on the asset side, the balance sheet of American households is stronger and the debt ratio is lower. From 2009 to July 2023, the Nasdaq index rose from 1265 to 14346, an increase of more than 10 times. 70% of the assets of American households are allocated in the financial market, and the substantial appreciation of stocks and real estate assets has greatly improved the balance sheet status of households.
Look at the balance sheet of the corporate sector.
In the past 15 years, the leverage ratio of American companies has only increased by 5 percentage points, the proportion of subprime debt has decreased significantly, and the appreciation of assets such as stocks and real estate has made their balance sheets stronger.
During the epidemic, strong consumption in the household sector and the Biden administration’s financial subsidies to companies have stimulated US companies to expand investment.
This year, U.S. manufacturing investment is booming, and analysts call it “the super cycle of U.S. manufacturing.” Federal Reserve Economic Data (FRED) shows that investment in U.S. manufacturing rose from $133.2 billion at the end of 2022 to $194.3 billion in May this year. Investment in manufacturing plants increased by 80%, driving GDP growth in the first half of the year by about 0.4 percentage points.
This round of manufacturing investment in the United States is mainly concentrated in the chip, electronics, and computer industries. In May, nearly 60% of manufacturing investment came from computer and electronics manufacturing in the Southwest of the United States.
This has something to do with the chip bill and the manufacturing return policy implemented by the Biden administration. In August last year, Biden signed the chip bill, which provides about $53 billion in federal subsidies to chip companies willing to build factories in the United States.
The report of the American Semiconductor Industry Association shows that from May 2020 to April 2023, more than 50 semiconductor projects will start in the United States, with a total investment of approximately US$210 billion. Major investors in these projects include TSMC, Texas Instruments, Intel, Micron, Samsung, and others.
Investment in chip manufacturing creates more jobs. According to estimates by Reshoring Initiative, the number of jobs created by the return of manufacturing in the United States in 2022 will be as high as 228,723, and the number of jobs created by the return of manufacturing and FDI will total 351,431, both hitting record highs.
Since 2008, the global economy has experienced the financial crisis and the epidemic crisis. The monetary and fiscal policies of governments in response to these two major crises are worthy of repeated comparative study. The operating idea of ​​the US federal government and the Federal Reserve is that the federal government will take the initiative to increase leverage, help the household and corporate sectors to reduce leverage, and increase the balance sheet of the private sector. The overall macroeconomic leverage ratio has basically not increased.
The two operations are different:
During the financial crisis, the Federal Reserve cut interest rates and quantitative easing, mainly to save the financial market and large enterprises, households and small and medium-sized enterprises were cleared of violence, and the leverage ratio dropped rapidly.
The result is to avoid the collapse of asset prices and break down the balance sheet, avoiding falling into the Great Depression; financial assets and real estate gradually rebound, and usher in a big bull market-asset price inflation; households and small and medium-sized enterprises are quickly cleared, and gradually repaired The gap widens.
During the epidemic crisis, the Federal Reserve decisively cut interest rates and purchased unlimited bonds to deal with the sudden “stock market crash”, provided loans to any company (not only large companies), and attached great importance to employment goals; The household sector issued 2.1 trillion cash subsidies.
The result was an avoidance of a collapse in financial asset prices, but a great commodity inflation; households and businesses were bailed out, balance sheets were stronger, wage prices rose rapidly, and inequality was suppressed.

How does inflation weaken household purchasing power? In this round of inflation, before May 2023, inflation growth outperformed wage growth, and the actual inflation rate (inflation growth – wage growth) was only 2.2%; starting from May, wage growth outperformed inflation growth. In turn, household incomes benefited from lower headline inflation. If the Biden government’s 2.1 trillion fiscal subsidies are added, the real purchasing power of households will be stronger.
Can the U.S. economy avoid recession?
2

structural recession
Over the past 15 years, the U.S. government has actively increased leverage, taken the initiative to take risks, and helped companies and the household sector optimize and strengthen their balance sheets, laying a “thick cushion” for this year’s “soft landing” of the economy.
My recently published ” Special Report on Structural Risks in the U.S. Economy ” suggests that in the second half of the year, hidden structural risks in the U.S. economy cannot be ignored. Moreover, whether the Fed continues to raise interest rates or when it will cut interest rates determines whether this risk is triggered.
The U.S. economic recession this year should be more accurately defined as a structural recession. Looking at indicators of employment, core inflation, services and technology stocks, the U.S. economy has cooled but remains strong.
However, judging from the three industry indicators that are more sensitive to interest rates, manufacturing, real estate and the bond market, the US economy is rapidly declining.
The U.S. manufacturing index continued to decline. In June, the final value of Markit’s manufacturing PMI fell to 46.3, below the line of prosperity and contraction; the US Institute for Supply Management (ISM) manufacturing PMI fell to 46, the lowest level since May 2020, below the prosperity for eight consecutive months. Below the dry line. In June, the Philadelphia Fed manufacturing index fell to -13.7, lower than the expected -14 and lower than the previous value of -10.4. Among them, the new orders of enterprises further dropped to -11 from -8.9 in the previous month.
Since 2000, the U.S. manufacturing PMI and the Philadelphia Fed manufacturing index have touched this position three times, and both are in economic crisis, namely the Internet bubble crisis in 2000, the financial crisis in 2008 and the new crown epidemic crisis in 2020.
Since the beginning of this year, the 30-year mortgage interest rate has been above 6% for a long time, which has little impact on the stock of fixed-rate mortgages, but has significantly inhibited real estate investment. The S&P 20-largest and mid-city housing price index fell 1.7% year-on-year in April, the lowest since 2012. Residential fixed-asset investment fell 4.2 percent, falling for nine consecutive quarters. Housing starts fell from 1,803,000 units in April last year to 1,340,000 units in April this year, falling to pre-epidemic levels, but rebounded in May.
In the first half of the year, regional bank risks appeared in the US financial market, and US debt continued to maintain a relatively high risk. In July this year, the U.S. 2-year Treasury yield reached 5.12%, a new high since 2007. The yield on the 10-year U.S. Treasury bond rose from a low of 3.25% this year to 3.95% in early July, approaching last year’s high of 4.33%, much higher than the level before the epidemic.
The U.S. 10-year/2-year Treasury yields have been inverted since the second half of last year, and the divergence trend has continued to expand. According to historical experience, the U.S. economy will experience a recession within one to one and a half years after the inversion of long-term treasury bond yields. Based on this calculation, there is a high probability that the U.S. economy will enter a recession cycle in the second half of this year.
The inversion of U.S. bond yields on economic recession is not only based on historical experience, but also in line with basic logic. The rise in long-term and short-term treasury bond yields indicates market risk, while the short-term treasury bond yield exceeds the long-term treasury bond yield, indicating that investors are bearish on short-term investment, and banks and lenders are more reluctant to lend funds to short-term investors, which means short-term Investment will fall.
This year, the U.S. economy has shown obvious structural characteristics, and many economic indicators have deviated seriously.
The service industry deviates from the manufacturing industry. In June, the Markit service industry PMI still reached 54.1, while the manufacturing PMI only recorded 46.3. The trends of the two are seriously divergent. In addition, there is also a clear differentiation within the manufacturing industry. The PMI of the manufacturing industry has declined, but the investment in chips, electronics and computers has increased on a large scale.

The price trends of major categories of assets in the financial market diverge. As of the beginning of July, the total market capitalization of the “Seven Sisters” (Apple, Microsoft, Alphabet, Amazon, Meta, Nvidia, Tesla) in the S&P 500 has soared by nearly 60%, reaching 11 trillion US dollars, accounting for the entire S&P Nearly a quarter of the market value of the 500 index is equivalent to three German GDPs; while the total market value of the other 493 companies in the S&P 500 has basically not risen. In addition, U.S. bonds fell sharply. It can be seen that the victory of “a few mega-caps” is masking broader pain in financial markets.

On the whole, there are serious structural problems in the U.S. economy, and structural problems are also the result of repeated strengthening of the Federal Reserve system (target) and loose-tight monetary policies. Expansionary policies during the financial crisis caused financial inflation and real deflation; policies from extreme expansion to radical tightening during the epidemic crisis caused financial deflation and real inflation.
In the second half of the year, interest rate hikes are coming to an end, and some markets are approaching the edge of fragility. The Fed’s decision-making has reached a critical moment. Whether to raise interest rates or how long they will not lower interest rates will determine whether a financial crisis will erupt.

In particular, we need to pay attention to two points: the rapid decline in inflation rate this year, the rapid rise in real market interest rates (nominal interest rate – inflation rate), and the suppression of investment by real market interest rates in the second half of the year will appear; Costs will increase, profits will be cut, and investment incentives will continue to decline—although real wage increases may increase consumption to form a certain hedge.
Therefore, under the structural risks of the economy, the Federal Reserve cannot only observe the macroeconomic trend from employment and inflation and then implement policies. In fact, there is a certain degree of distortion in the two indicators of current employment and inflation.
In July, the Federal Reserve raised interest rates by another 25 basis points, which is estimated to be the last rate hike by the Federal Reserve. There is such a sentence in the policy statement: “Inflation is still high, but the integrity of the data is very important.” This shows that the Fed has shifted from an inflation target to a balance of overall targets, including employment and financial risks. Next, let the bullets fly for a while, and observe the suppression of the manufacturing, real estate, and bond markets by the rise in real market interest rates (currently expanded to 3.7%), and the risks that may arise.
A simple review of the US fiscal and monetary policies during the financial crisis and the epidemic crisis.
First of all, we need to think about the mission and goals of fiscal and monetary policies from the perspective of “the purpose of state existence”. Why was this country formed? What is the value of the Treasury and the central bank now? What does its policy aim to achieve? Then, we considered facing a different crisis—in 2008 it was a financial risk, and the epidemic crisis was more like a “big snowstorm” and adopted different policies.
From an economic point of view, the country is a hedging market, and fiscal and monetary policies are used as hedging products to meet the hedging needs of the people. The key to the effectiveness of such hedging products is whether the balance sheets of households and companies are broken down.
In other words, when risks come, fiscal policy and monetary policy should basically protect the balance sheets of households and enterprises. Its cost is the cost of national production of this hedging product – taxes, debts and hidden taxes (money printing overdraft). Competitive central banks (interest rate and exchange rate liberalization) and competitive governments (political democracy, decentralized checks and balances, constitutional constraints and liberalization of government bond interest rates) are more effective hedging markets.
3

asset cyclical inflection point
How will the financial market go in the second half of the year?
July is likely to be the last time the Fed raises interest rates. With three more interest rate meetings this year, traders see only a 30 percent chance of another rate hike.
This aggressive interest rate hike is also a “special case” of asymmetric operations in the past 40 years. From 1983 to the present, the Federal Reserve has adopted asymmetric operations in each round. The rate of interest rate cuts is faster than that of rate hikes, and the rate of interest rate cuts is larger than that of rate hikes. In 2004-2006, this round of interest rate hikes was faster, and when the federal funds rate was close to the peak of the previous round, the subprime mortgage crisis was triggered. The speed of this round of interest rate hikes is the fastest in the past 40 years, and the rate of interest rate hikes is the highest in the past 22 years. The peak interest rate is more than twice as high as the previous round.
Therefore, in the second half of the year, the Fed needs to stop to see how the market digests high interest rates and rising real interest rates.
Once the interest rate hike pause button (expected) is pressed, the market will start to pay attention to when the interest rate will be cut. Federal Reserve Chairman Powell reiterated at a recent press conference that he will not cut interest rates this year, and some members expect to cut interest rates next year.
Since 2000, the Federal Reserve has implemented a total of three rounds of interest rate hike-rate cut cycles, and the time interval from the end of the rate hike to the start of the rate cut has not exceeded one year, and two of them took only half a year. It should be noted that all three interest rate cuts were triggered by financial risks. The Internet bubble crisis broke out in 2000, the subprime mortgage crisis broke out in 2007, and liquidity risks emerged in 2019.
There are two important reasons why this round of aggressive interest rate hikes by the Federal Reserve has yet to trigger a financial crisis: one is high inflation, which depresses real market interest rates and real wage costs, and stimulates companies to expand demand; the other is that during the financial and epidemic crises, households and businesses In deleveraging, the U.S. government took the initiative to increase leverage, discover cash, and help households and companies strengthen their balance sheets, which is equivalent to enhancing the resilience of the economy.
In the second half of the year, the inflation rate dropped to a low level, real market interest rates rose, real wage costs increased, investment suppression became more pronounced, liquidity remained tight, broad money shrank rapidly, and structural risks rose, requiring great attention to financial risks.
If financial risks arise, the door to rate cuts will naturally open. If we have to wait until the core inflation slowly drops to 2% and the unemployment rate gradually rises to a certain level, the Fed will cut interest rates again. This process will be extremely long, and the financial market may not be able to wait for that day. Based on historical experience, it is more likely that the emergence of a “black swan” will trigger a surge in bond yields, an outbreak of liquidity risk, and the Fed will be forced to cut interest rates quickly. In other words, the Federal Reserve expects market risks to continue to accumulate, and then takes the initiative to cut interest rates, balance financial risks and inflation risks, slowly lower interest rates, and finally land safely.
It is expected that the Fed will cut interest rates at the end of this year at the earliest and in the first half of next year at the latest.
In the second half of the year, if the Fed maintains high interest rates and does not cut interest rates, what impact will it have on the financial market?
Look at the dollar first.
The dollar peaked and weakened sideways. The U.S. dollar index will naturally weaken when the Fed stops raising interest rates; but before (expected) interest rate cuts, the U.S. dollar will not fall rapidly. It should be noted that the operations of the three major central banks, the European Central Bank, the Bank of England and the Bank of Japan, will weaken the US dollar index. Since the inflation rate in continental Europe and the UK is still relatively high, the European Central Bank and the Bank of England may continue to raise interest rates about 2 times, which will promote the rise of the euro and pound, which in turn will weaken the dollar. The Japanese yen will also appreciate against the dollar after the Bank of Japan recently adjusted its yield curve control policy due to inflationary conditions. Benefiting from the weakening of the U.S. dollar index, the renminbi has bottomed out against the U.S. dollar, but considering the domestic economic and export situation, the renminbi is more likely to rise slightly.
Look at US stocks again.
In the first half of this year, the Federal Reserve raised interest rates, and U.S. stocks rose sharply, far exceeding market expectations. There are two important reasons for this:
First, the artificial intelligence revolution has driven technology stocks to soar. The stocks that soared in the first half of the year are the seven giants such as Microsoft, Nvidia, and Google. The others have not risen much, so there is an obvious structure in the stock market.
The second is that the market has created a kind of moral hazard. When inflation comes down, if there is a financial risk, the Fed will definitely cover it. This made investors bold and optimistic, and the Big Seven became “moral hazard stocks.”
In the second half of the year, the US stock market was tangled.
In July, the market welcomed (anticipated) the last interest rate hike by the Federal Reserve, and the three major U.S. stock indexes closed up collectively. At this stage, the market interprets recession signals (inflation cooling) and strong signals (second-quarter GDP exceeding expectations and non-farm payrolls) as good news, and enters loose trading ahead of schedule. However, as high interest rates go deep into the economy and the trend of structural recession strengthens, the loose trade will switch to recession trade.
In the second half of the year, U.S. stocks still face triple risks: first, economic recession and performance decline, and we need to pay attention to the third quarter financial report; second, the risk of decline in the popularity of artificial intelligence concept stocks; third, liquidity risk.
U.S. stocks rallied before the Fed cut interest rates. If there is a risk, the U.S. stock market will fall rapidly, and the Federal Reserve will rescue the market, and the market will rebound quickly.
In addition, Japanese stocks rose sharply in the first half of this year. It is mainly driven by multiple forces: first, Japan’s post-epidemic economic recovery, consumer stocks rose; second, “daily special estimates”, technology companies made good profits and repurchased stocks; third, the depreciation of the yen attracted hot money. However, in July, the Bank of Japan adjusted the yield curve policy, shifting from unlimited easing to limited easing, the yen will appreciate, liquidity will also decline, and Japanese stocks are likely to peak in stages. In the second half of the year, if Tokyo’s CPI continues to stay above 3.5%, Japanese stocks will pull back; if Tokyo’s CPI falls below 3%, and the Fed cuts interest rates again, Japanese stocks will rebound.
Hong Kong stocks were under the double attack of the Federal Reserve’s interest rate hike and the cooling of the domestic economic recovery. The starting point for Hong Kong stocks to establish a new round of growth market should be the Fed’s interest rate cut or expected rate cut.
Finally, look at U.S. debt.
The risk of U.S. bonds this year is higher than that of U.S. stocks. In the first half of the year, 2-year U.S. bonds continued to fall sharply, and the risk of 10-year U.S. bonds was not small. In the second half of the year, before the Federal Reserve cuts interest rates, the risk of U.S. debt has not been eliminated, and there are still liquidity risks, and one possibility of triggering interest rate cuts is that the black swan event triggers liquidity risks in the bond market. If there is a liquidity risk in the bond market, it will be the time when financial panic is the highest, and it is also the time to buy bottoms in U.S. bonds and U.S. stocks.
If the market has been unable to enter the recession trade, solid balance sheets and excessive optimism, so that household consumption and business investment do not cool down, then the Fed will start to raise interest rates. And the Fed will raise interest rates again, which will further strengthen the economic structure, exacerbate financial risks, and cut interest rates will come earlier.
If there is no liquidity risk in the second half of the year, the U.S. economy has a safe “soft landing”, and the Fed will cut interest rates in stages next year, then before the rate cut, it is a good opportunity to enter U.S. bonds and U.S. stocks and short the dollar at any time. Once a liquidity crisis breaks out, it will be the best opportunity for the greedy.
Therefore, in the second half of the year, before the Federal Reserve cut interest rates, the global financial market became tense, and the prices of major asset classes are dangerously entering a cyclical turning point. Bottom, rising slightly, U.S. stocks and Japanese stocks peaked and slightly corrected, Japanese bonds fell, and U.S. bonds have liquidity risks.