Editorial comment
Successive supply shocks are testing the price of growth and leading to a gradual erosion of economic momentum in the US. Fortunately for the economy, the three ‘A-pillars’ of growth – affluent consumers, AI investment and asset price appreciation – continue to provide a robust, albeit narrow, foundation for growth. The risk is that an economy with a narrow base is more susceptible to headwinds. Layered supply shocks from tariffs, immigration restraints and a lingering geoeconomic shock in the Middle East have led to persistent inflationary pressures that give the appearance of solid nominal growth but mask much weaker growth in inflation-adjusted terms.
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Despite an easing in direct military confrontation in the Middle East following a ceasefire, trade flows through the Strait of Hormuz remain effectively constrained and a broader Middle East peace agreement has yet to materialise. With every day that passes, we are moving closer to our adverse scenario. While we continue to anticipate a gradual normalisation of energy and commodities production and trade flows in the coming months, we maintain our below-consensus call for real GDP growth of 1.8% this year. We have raised our inflation forecast, with headline PCE peaking around 4.0% y/y before falling to 3.7% in Q4, while core PCE is expected to end the year at 3.0% y/y.
Risks remain tilted to the downside. Rising long-term interest rates, driven by persistent inflation pressures, higher term premia, fiscal concerns, and growing political pressure on the Federal Reserve, represent a notable risk to the US outlook. A slowing labour market, mounting strains in private credit markets, and uncertainty around the pace and magnitude of AI-related labour displacement also warrant close monitoring. We continue to place the probability of a US recession over the next 12 months at approximately 40%. The labour market remains stuck in a fragile, low-growth equilibrium. Hiring has cooled and become more selective, while the steady unemployment rate reflects ongoing labour supply constraints and the absence of broad-based layoffs. The result is a labour market that is no longer a growth engine, but also one that is not signalling a material deterioration. We expect payroll growth to average around 30 000 per month in 2026, with the unemployment rate drifting toward 4.7% by year-end.
With wage growth easing to 3.6% y/y in April, real wage growth (adjusted for CPI inflation) turned negative at -0.2% y/y. The combination of job growth averaging 21 000 per month over the last 12 months and negative real wage growth means that real disposable income is contracting: a real income squeeze. Household budgets are coming under increasing pressure from higher inflation and a softer income backdrop, with slower wage and job growth limiting purchasing power. As a result, more consumers are turning to savings and credit to sustain spending, trends that are becoming increasingly difficult to maintain, particularly for lower-income households. Looking ahead, we expect real consumer spending to grow at a below-trend pace of 1.8% in 2026, down from 2.6% in 2025.
Business investment remains strong on average, but is being led disproportionately by AI-related investment categories. Information processing equipment investment is currently rising at an annual pace of around 25%, the fastest since the early 2000s, while investment in software and research and development is also increasing rapidly. Unfortunately, the breadth of growth is lagging, with structures investment and equipment investment excluding information processing equipment declining year-over-year.
The longer the Middle East conflict lasts, the more severe and broad-based inflationary pressures are likely to become. In the coming months, we anticipate higher fertilizer prices will contribute to higher food price inflation, while higher transportation and production costs, stemming from elevated energy and input costs, are likely to be passed through to goods and services prices.
Incoming Fed Chair Kevin Warsh faces a challenging backdrop as steady labour market conditions alongside rising inflation risks raise the bar for rate cuts and support a prolonged pause. Despite Warsh’s dovish leanings, recent Fed communication suggests the June FOMC statement could feature a two-sided formulation acknowledging that rate hikes could be appropriate if inflation remains above target, and we would not be surprised to hear some policymakers suggest a rate hike as the next policy move. Our expectation remains that the Fed will stay on hold throughout the rest of the year, and we do not exclude the possibility of more regular two-sided dissents at upcoming meetings, including from the Fed Chair.
