For many years, the U.S. economy has grown at a modest pace of just under 2% a year, a pattern often called a "Muddle Through" economy. Recent data suggest things may be picking up. The Atlanta Federal Reserve's real-time estimate points to third-quarter growth of close to 5%, driven by solid consumer spending and a surge in business investment tied to artificial intelligence. Corporate earnings have been very strong, and the stock market has been trading near all-time highs.
But, as in many galleries, some pictures aren’t uniformly rosy. The Federal Reserve's own survey of business conditions across the country describes growth as "slight to moderate," and second-quarter GDP came in at only 1.5%. Part of that weakness is an accounting quirk: imports reduce GDP, and the U.S. has been importing huge amounts of computer hardware to build AI data centers. Data centers give with one hand and take with the other.
Jobs: Better Than Expected
The August jobs report was the best in some time. Employers added 162,000 jobs, far above the 58,000 expected, and earlier months were revised upward. Unemployment stands at 4.1%. Most encouraging, more than half a million people re-entered the workforce, reversing a worrying decline in labor force participation. Some private-sector surveys show weaker hiring than the government's numbers, so we'll watch for confirmation in coming months.
Inflation: The Fly in the Ointment
Inflation remains the economy's biggest challenge. Consumer prices rose 3.4% over the past year, well above the Fed's 2% target. Energy prices are up sharply, about 27% year over year, largely because of geopolitical events. Mortgage rates, while still within historical norms, have crossed 7%, which may seem like a psychological barrier to home ownership or moving for some, and a very real financial barrier for others. Wholesale prices, which tend to flow through to consumers later, have been rising at more than 5% annualized for six months. Higher shipping and diesel costs add to the pressure, since they affect the price of nearly everything that has to be moved.
The Fed Raises Rates and Changes Its Approach
In September, the Federal Reserve raised short-term interest rates by 0.25%, with a unanimous 12–0 vote. That unanimity was notable given the political pressure of raising rates just weeks before the November midterm elections.
Just as important is how the Fed under Chairman Kevin Warsh is making decisions. For decades, markets hung on every word from Fed officials to guess where rates were headed. Warsh has signaled that he wants the Fed to follow what the markets are already telling it rather than lead them. In this case, bond markets had already pushed rates higher before the Fed acted. He has also downplayed the idea that economists can precisely calculate a "neutral" interest rate, which means the Fed will be less predictable about when a rate-hiking cycle is finished.
Historically, when rate-hike cycles begin, markets tend to underestimate how far they will go. With energy, housing, and wholesale prices all putting upward pressure on inflation, further increases are a real possibility. Markets currently put the odds of another hike at the late-October meeting at roughly 44%.
Housing: In the Doldrums
With 30-year mortgage rates near 7%, buying a home is difficult for many families. The supply of single-family homes is at a 10-year high, and prices are slipping in many markets, though not enough yet to meaningfully improve affordability. Today's mortgage rates are actually close to their long-term historical average; it was the unusually low rates of the past 15-plus years that were the exception.
A Global Shift: Rising Rates in Japan
For decades, Japan's near-zero interest rates made it a major source of cheap borrowing and encouraged Japanese savers to invest abroad, including heavily in U.S. bonds. That era is ending. The Bank of Japan is raising rates, and Japan's 10-year government bond now yields about 3%. As Japanese investors find better returns at home, some of that money is coming back from overseas. This is contributing to higher long-term interest rates around the world, including in the U.S. Foreign money still flowing into the U.S. is going mostly into stocks rather than bonds.
AI, Data Centers, and Jobs
Many Americans are worried about AI. A recent Pew survey found 71% expect AI to mean fewer jobs. So far, however, the hard data don't show broad job losses. A Yale Budget Lab study found essentially no change in employment or wages in occupations most exposed to AI. The one real warning sign is among young workers: entry-level hiring in AI-exposed fields like software development has dropped about 16% for workers aged 22 to 25, and unemployment for recent college graduates is around 5.6%. That deserves attention, because entry-level jobs are where people learn the skills that lead to future careers.
Meanwhile, data center construction is a major engine of growth. Spending reached an annualized $68 billion in June, up nearly 50% from a year earlier, while most other types of construction declined. The current AI buildout is estimated at 3.5–4% of GDP, which would make it larger relative to the economy than the railroad boom, rural electrification, or the interstate highway system. Not every company investing in AI will earn its money back, but so far demand for computing power continues to exceed supply.
Government Debt: The Long-Term Concern
The federal government is spending roughly $2 trillion more than it collects in taxes. That spending supports the economy today, but it also adds to inflation pressure and pushes long-term interest rates higher. Bond investors aren't worried about being repaid by the U.S. government; they are worried about what those future dollars will be worth after inflation. Until Congress addresses the deficit, long-term rates are likely to stay elevated.
The Stock Market: Strong Gains, Backed by Strong Earnings
U.S. stocks have had a remarkable run over the last several years. The market's long-term average return is about 10% a year, so recent years have been well above normal.
Rising stock prices are being driven by rising corporate profits. Wall Street analysts expect S&P 500 earnings to grow roughly 32% this year and about 14% next year, which is an unusually strong outlook. Part of this year's figure comes from an accounting effect: some of the largest technology companies must report gains on investments they hold in other companies, such as SpaceX. Even excluding those gains, underlying earnings growth is estimated at around 25%. Unusually, analysts have been raising their estimates throughout the year rather than trimming them, as they typically do.
Stocks are not cheap. The S&P 500 trades at about 20 times expected earnings, compared with a long-term average of roughly 16. That is down from more than 23 times earlier, because profits have grown faster than prices, but they are still above average. Whether today's prices are justified depends on whether companies can actually deliver the strong earnings now expected. Several major Wall Street firms have raised their year-end targets, though their forecasts vary widely and have not always been accurate.
Two long-term reminders are worth keeping in mind. First, wars and geopolitical conflicts have historically caused only brief market dips, averaging about 4% since 1939. Sustained bear markets have usually been caused by recessions, and most economists do not see one on the near horizon. Second, market declines are the price we all must pay for long-term returns. The problem is that we don’t know when the bill will come due, and for how much. Stocks have compounded at roughly 10% a year over the past 90 years, but investors had to ride out every crisis and downturn along the way. That’s the only way to make good returns!
The Bond Market: Back to Normal
After more than a decade of unusually low interest rates, bond yields have returned to levels that look normal by historical standards. The 10-year Treasury yield is in the mid-4% range, which is close to its long-term average and well above the record lows of 2020. For savers and bond investors, this means bonds are once again providing meaningful income.
The yield curve, which compares short-term and long-term interest rates, is also returning to normal. For several years, short-term rates were higher than long-term rates. This "inversion" has often been a recession warning, but this time no recession followed. Its return to a normal shape is generally a healthy sign for the economy.
Encouragingly, bond investors still expect inflation to average about 2.25% over the next 10 years. That suggests markets believe today's elevated inflation is temporary and that the Fed will eventually bring it under control. As discussed above, however, rising global interest rates and large government deficits could keep pushing long-term yields higher, and that can weigh on existing bond prices.
What This Means for You
The economy is stronger than many expected, corporate profits are healthy, and the job market has improved. At the same time, inflation and rising interest rates are real headwinds, particularly for bonds, housing, and borrowing costs. We continue to emphasize diversification, attention to inflation protection, and keeping enough cash and short-term reserves on hand so short-term market swings don't force changes to your long-term plan. As always, if you have questions about how any of this affects your situation, please reach out.
