Economic Outlook

Fed to Slow Rate Increases; Economy, Inflation, and Hiring also Slowing

• Federal Reserve preparing to slow rate increases
• Inflation slowing, but still high
• Consumer spending sustaining slow growth
• Probability of recession is elevated

The second estimate of Real GDP revised US growth upward to 2.9% for the third quarter of 2022. The first estimate had come in at 2.6%. Although personal consumption was revised up in this release, net exports remain the primary driver of the current GDP results. Personal consumption (+1.7%) has been positive, but not strong enough to sustain robust growth in the overall economy. Personal consumption is the most important driver of domestic growth. Personal spending on goods was down slightly; spending on services was up 2.7%. Residential investment was down 26.8%. Government spending was up 3.0%, driven primarily by defense spending at the Federal level. The core PCE deflator, one of the Fed’s most closely watched inflation measures, was up 4.6%. Although inflation is showing signs of decelerating, it remains too hot for the Fed’s liking.
 

We continue to see evidence that the post-COVID problems in the supply chain are healing. Shipping container costs have declined by two-thirds this year, after increasing ten-fold in 2021. The cost of moving a container from China to the US West Coast has declined over 80% since April, however it still remains significantly higher than in 2019. Port congestion is easing. Globally, only 8% of vessels are being delayed at ports, compared to 14% at the beginning of the year. That number would have to trend down to 3% to match pre-pandemic transportation efficiency. China continues to experience periodic shutdowns due to COVID, and China is the critical supplier of parts and goods to the world. As China reopens, supply problems should resolve. However, a more productive China will also put upward pressure on commodity prices. Recent declines in commodity prices have been a bright spot in the inflation picture.
 

Investors and business leaders should remain on recession watch for 2023, and that is the consensus view of most analysts. Right now, employment and consumer spending are strong enough to carry us through without recession, but employment is decelerating, and consumers are spending down a strong reservoir of savings at a pace that would not appear sustainable. The Fed remains tightly focused on inflation and has already applied a dose of medicine that may prove to be a good bit stronger than is presently apparent. This year’s rate increases have been unusually fast and steep, and as Raphael Bostic, President of the Atlanta Fed, has recently reminded us, it can take 18 months to two years or more for tight monetary policy to materially impact inflation. When such lags follow steep and sudden rate increases, it is easy for the Fed to get ahead of itself. It is possible to describe a scenario where monetary tightening impacts inflation without triggering a recession, but the probabilities are low. Typically, monetary tightening operates by dampening demand, which in turn slows down the economy—resulting in lower inflation.

Furthermore, we must keep in mind that higher rates are not the only measure that the Fed has taken to combat inflation. The Fed is also reducing the money supply by $95 billion every month through “quantitative tightening”. Quantitative tightening is the reverse of “quantitative easing” and is the process of reducing the vast portfolio of bonds the Fed holds on its balance sheet in an effort to mop up excess cash in the financial system. Quantitative easing involves creating new money to purchase bonds in the open market. It has the effect of flooding the financial system with new money. The Fed used quantitative easing to stimulate the economy in the aftermath of the Financial Crisis and during COVID. Quantitative tightening is the opposite process of reducing the portfolio of bonds held by the Fed and draining excess money from the economy. Because quantitative tightening is a tool that the Fed has not used extensively in the past, its impact on the economy and on inflation is less well understood by both policymakers and analysts. However, economists at the San Francisco Fed have recently estimated that quantitative tightening may have the same effect as adding 2% to the Fed Funds target rate, if rates were the only tool used to combat inflation. Imagine that we are heading into 2023 with short-term rates already at an effective 6%, instead of the 4% markets are currently anticipating.

Payrolls increased by 263,000 in November. The number was perceived by some as being “still too strong” for inflation-fighting purposes. The jobs number remains well ahead of the average achieved during the last expansion, but it is well down from the very strong pace recorded at the beginning of the year. So, employment remains strong, but it is decelerating. The unemployment rate was unchanged at 3.7%. 
 

Other important measures of employment strength are moderating. The Job Openings and Labor Turnover Survey (JOLTS) indicates that there are now 1.71 openings for every unemployed worker—a strong number, but well down from over two openings per worker earlier this year. Quits have been declining steadily since mid-year, a sign that workers are less confident of being able to “trade up” their jobs. 
 

With strong demand for jobs and wages increasing, we might expect to see the supply of workers also increase. However, labor-force participation remains at 62.1%, and the employment-population ratio remains at 59.9%--both low by historical standards. There are plenty of jobs, and wages are improving, but there are not enough job seekers or job takers to help counter the effects of a tight labor market.
 

Perhaps the best hope for a “soft landing” in 2023 would be that tightness in the labor market is alleviated by a reduction in the number of open positions, coupled with an improvement in the participation rate. If this result could be achieved without a significant increase in the unemployment rate, wage inflation might moderate without exacerbating one of the more painful features of a recession.

Inflation remains too high but is showing signs of moderating. The “All Items” Consumer Price Index declined to 7.7% in October. It was above 9% last June. Just as encouraging, the “Core” CPI (less food and energy) came in at 6.3%, down from 6.6% in September. Energy increased 17.6%, and food was up 10.0% YOY. Fuel oil is up over 68%, and gas piped to homes is up 20% YOY. Despite the high level of some of these numbers, inflation is all about the rate of increase in prices, and that is slowing down. Most commodities are down from their recent highs, and rents have broken to the downside.
 

Inflation has a long way to go before it reaches levels acceptable to policymakers, but it is trending in the right direction. It is possible that as much as half of the 9% inflation experienced earlier this year is attributable to imbalances produced by the various COVID shutdowns and their impact on the supply chain. However, even if half of that inflation rate could be resolved by a full reopening of the international economies, it would still leave us with an inflation rate well above the Fed’s 2.00% target. The remaining part of the inflation picture may prove harder to address. That said, given the lags between policy implementation and its impact on the economy, as well as the leverage implicit in quantitative tightening, it is also possible that the Fed will overshoot its target. It is difficult to say today whether the bottom half of record-breaking inflation can be addressed without throwing the economy into recession. The odds may be against us. However, if the reopening of the global economy has a positive effect on the supply side while monetary constraint tamps down demand, we just might be fortunate to skate through 2023 with only a moderate slowdown.

The Federal Open Market Committee (FOMC) met on November 1 and 2 and once again raised their target for short-term rates by 0.75%. The upper end of that target is now 4.00%. Short-term rates were essentially at zero last February. Recent comments by the Fed Chairman indicate that there may be a slowing of the rate of increase at future meetings. The next meeting is on December 14. We now believe that the Fed will raise rates by 0.50% at their December meeting and revert to a regimen of 0.25% increases in early 2023. The question is: how long will they keep increasing and how high will they go? We believe that sometime in 2023 something will give: either the Fed’s resolve, the economy, inflation itself, or some combination of these. It remains to be seen whether the Fed will truly insist on 2% inflation if the economy falls into a severe recession. On the other hand, if we get to 4% inflation, with further improvement on the horizon, and 4% unemployment without a deep recession, maybe that will be deemed “good enough.”
 

The yield curve is profoundly inverted, with the 2-year Treasury yielding 4.69% and the 10-year Treasury at 3.51% at this writing. The fact that Treasury yields fall off so sharply beyond the 1-year maturity seems to suggest that the bond market feels, as we do, that the Fed will not be able to keep raising rates throughout 2023.  Historically, an inverted yield curve has been a precursor to recession.

The stock market bounced in recent weeks—the S&P 500 continues to trade around the 4000 level after dipping below 3600 in September and October. While these rallies are welcome, it may be too soon to declare an end to the bear market of 2022.  The forward PE Ratio of the S&P 500 currently stands at 15.1. At the bottom of the bear market following the financial crisis, the ratio was 10.4, and the COVID crash saw a multiple of 13.3. The ratio peaked early this year at 21.4. Based on this measure, we can certainly say that stocks are cheaper than they have been—but they may not yet be cheap in absolute terms. Furthermore, earnings estimates may still be too high. For the time being, profit margins are historically wide. In the early stages of an inflationary period, companies often have the ability to pass on increased costs to consumers. This ability will get tested as household budgets get strained and consumers cut back on spending. At the same time, markets normally anticipate changes in the economy well before those changes show up in the data, so markets may begin to anticipate the next expansion sometime in 2023. 
 

The Treasury yield curve already has a steep upward slope out to one year, at which point it declines and then goes flat. I believe this indicates that the Treasury market is already anticipating a time when the Fed will be forced to cut rates, somewhere out in a 12-month time frame. All markets can be subject to incorrect forecasts and sudden reversals, but in my experience, the bond market is a better prognosticator than the stock market. For investors with cash on the sidelines, now is a good time to make attractive short-term rates work for you. Bond investors may also want to start considering intermediate bonds. The muni bond yield curve has a nice, positive slope all the way out to 30 years. The corporate bond yield curve is slightly inverted between one and five years. At some point next year, we believe that it will also make sense to commit more capital to risk assets such as stocks. Unfortunately, these moments are never announced in advance.

We realize that the current environment is very challenging. Negative markets do not persist forever, but it can seem that way when we are in the midst of a downturn, especially one that impacts both stocks and bonds. If we can be of any help to you during this time, please don’t hesitate to reach out.
 

We are grateful all year ‘round, but especially during this season, for all our wonderful clients. May you all enjoy a wonderful holiday season surrounded by loved ones.