Economic and Market Normalization: Key Trends for the Second Half of the Year

As summer sets in, the economy and labor market are showing signs of gradual normalization. This comes as economic growth continues, albeit more in line with easing inflation pressures, and major central banks begin to lower interest rates. 
These changes have driven interest rates down and pushed stocks to new highs. 

Here are four significant trends to monitor in the latter half of the year.

1. Economic Normalization: Growth Begins to Steady

Following a period of rapid expansion, economic growth is starting to stabilize. 
The potential growth rate for the U.S. economy is projected to be around 1.5% to 2% over the medium to long term, barring any major technological breakthroughs. 
Despite the challenges of high inflation and tight monetary policy, the economy managed to grow above 2% in the past six quarters. This resilience was supported by pandemic-era savings, substantial fiscal spending, and low fixed-rate mortgages, which have insulated the economy from sharp interest rate hikes.

However, the impact of high borrowing costs is becoming more apparent. Consumers with low and middle incomes are feeling the squeeze and pushing back against rising prices. While wage growth has outpaced inflation in the past year, boosting consumer spending, real wage growth has slowed recently due to a cooling labor market and stalled progress on inflation, affecting discretionary spending. Housing and manufacturing sectors also show signs of instability, though improvement is anticipated.

A slower economic growth rate can help mitigate inflation pressures, but a significant downturn could shift the current positive outlook. We predict a "soft-landing" scenario where growth slows just enough to control inflation without leading to a recession. The chances of either a "no-landing" (accelerated growth and inflation) or a "hard-landing" (recession) scenario appear less likely this year.

2. Labor Market Normalization: Strong But Easing

The labor market has been a defining feature of this business cycle, supporting economic expansion while driving inflation concerns. Recently, the U.S. added 272,000 jobs in May, far exceeding expectations. However, the unemployment rate ticked up to 4%, and more people reported being unable to find jobs.

Despite these changes, the labor market remains robust but less tight. The ratio of job openings to unemployed individuals has returned to pre-pandemic levels, reducing wage pressure. As a result, we do not expect the recent surge in wage growth to continue.

The resilience of the labor market reduces fears of stagflation and allows the Fed to keep policies unchanged this summer. As the labor market cools, slower wage growth could help control services inflation. We anticipate a slowdown in hiring but do not foresee a significant increase in layoffs.

3. Policy Normalization: Central Banks Start Easing

The Bank of Canada and the European Central Bank have initiated a rate-cutting cycle in response to sluggish growth and easing inflation. The Fed is expected to hold rates steady but may signal rate cuts later this year, possibly starting in September.

Global interest rates have likely peaked and are expected to gradually decrease as central banks pivot towards easing. This could lead to lower bond yields over the next year. Investors heavily invested in CDs and cash should consider diversifying into intermediate- and long-term bonds to manage reinvestment risk.

Conclusions

The gradual normalization of the economy and labor market suggests that interest rates will start to stabilize soon, maintaining the bull market and leading to more balanced portfolio gains. A moderate economic cooling this summer could be advantageous if it does not turn into a significant slowdown.