Economic Outlook

Economic Landing: Soft or Hard?

• The Fed will continue to tighten as long as inflation persists

• Can inflation return to 2% without a recession?

• Consumers and jobs continue to sustain growth

• Monetary policy has produced the highest short-term rates since 2007

Two scenarios on the US economy presently dominate economic forecasts. In one scenario, recession is a foregone conclusion—the Fed has raised interest rates so far so fast that a downturn is inevitable, given normal lag times. In the second scenario, a “soft landing” or even “no landing” is still possible. In this version of events, growth slows but does not go negative. Employment is too strong for a full- blown recession; the consumer remains too resilient. Both scenarios can be supported with data, and only time and additional facts will determine which view proves more accurate. The observation that the US economy has proven surprisingly resilient in the face of some of the most dramatic monetary tightening in Fed history is fully supported by sales figures and unemployment numbers. However, it is also true that if we assume a normal lag time between monetary tightening and its impact, the effect of rate increases and reduced liquidity may be just beginning.
 

In our view, the probability of recession is determined in large part by just how persistent US inflation proves to be. By the end of last year, it appeared that inflation was responding quite rapidly to monetary tightening. Annualized CPI for the final quarter of 2022 came in below 3%. However, much of the improvement was attributable to a decline in gas prices. It also turns out that subsequent adjustments to seasonal factors in the CPI data show that the decline in inflation, while real, was not as dramatic as initially indicated. Even without these factors, it was probably destined to be the case that the easy victories over inflation would come early, and the more entrenched issues would take longer to address. If the tougher elements that are driving inflation require rates to rise to a 6% level and stay there for some time, it is difficult to imagine how we might avoid a full recession. If, however, we are close to the end of this cycle of monetary tightening and inflation continues to abate through this year, we may be able to power through a period of relatively flat growth without a full-blown recession.
 

US real GDP ended 2022 on a relatively strong note—final quarter GDP came in at 2.7% and full-year GDP came in at 2.1%, despite two negative quarters at the beginning of the year. Current measures of growth are more mixed. Manufacturing ISM for February came in at 47.7%, a slight uptick from January, but still in “contraction” territory (ISM is a “diffusion” index; any read below 50% signals contraction). Services ISM came in at 55.1%, following a similarly strong January number. ISM numbers have signaled contraction in manufacturing for four months running. They have also signaled expansion in the services sector consistently since the end of COVID lockdowns. Demand for goods was pulled forward during COVID, and manufacturing was disproportionally impacted by supply chain issues. Services, which comprise a much larger portion of the US economy, are catching up to demand that was pent up during lockdowns. Personal spending increased 1.1% in January, and retail sales jumped a surprising 3%. Retail sales are not adjusted for inflation.
 

Housing may be the sector most sensitive to increasing interest rates. Thirty-year mortgage rates currently stand at 6.65%, down from over 7% last November, but well above the sub-3% levels of 2021. New home sales jumped 7.2% in January, but that was a one-month reversal of a more protracted downward trend. The three-month average volume of new home sales is 626,000; down from over 1 million in 2020, but not out of line with volumes seen before the pandemic. Existing home sales came in at an annualized volume of 4.0 million units, over 36% below their pace in January 2022. Median prices have come down marginally, perhaps because inventories remain very tight.
 

As is typically the case, the US consumer continues to drive growth in the domestic economy. However, savings rates are down, household debt is up, and confidence is waning. The growth is real, and so are the headwinds.

Payrolls jumped a surprising 517,000 in January. Monthly employment gains had been running between 260K and 360K and declining. The number, which would normally be received as a strong positive indication of economic strength, was almost universally seen as an indication that the economy is running “too hot” to allow for any further deceleration in inflation. It was also seen as a motivator for the Fed to keep raising interest rates. Fed Chair Powell has consistently pointed to strength in the employment numbers as evidence of imbalances in the labor market that necessitate further monetary tightening in order to avoid a wage-price spiral. Others have cited the employment results as evidence that the US economy is nowhere close to a recession. There is no question that unemployment remains at historically low levels: 3.4% in January. However, unemployment is a lagging indicator that sometimes only moves up after the economy is already in recession. Wages were up 4.4% for the 12 months ending in January. If the Fed is looking for reasons to stop raising rates, they won’t find them in these numbers.

Inflation remains well above the Fed’s 2% target but is still showing signs of moderating. The “All Items” Consumer Price Index declined to 6.4% in January; it was above 9% last June. The “Core” CPI (less food and energy) came in at 5.6%, down from 6.6% in September. These were the smallest measures of annualized price increases since late 2021. Energy increased 8.7%, and food was up 10.1% YOY. Gasoline, which had declined in November and December, was up 2.4% in January. Overall inflation appears to be declining. However, the improvement also appears to be slowing, and we are still a long way from that 2% target.

The Federal Open Market Committee (FOMC) met on January 31 and February 1 and once again raised their target for short-term rates, but this time by the smaller increment of 0.25%. The upper end of that target is now 4.75%. Short-term rates were essentially at zero last February. Chair Powell took pains to emphasize during his press conference that the slowing of interest rate increases should not be seen as signaling an end to policy tightening. The Fed continues to drain liquidity from the financial system at a rate of $95 billion per month via its “quantitative tightening” policies. Banks that were flush with cash a year ago are now hungry for deposits.
 

The yield curve remains inverted, with the 2-year Treasury yielding 4.86% and the 10-year Treasury at 3.97% at this writing. One-year Treasury rates are above 5%. Historically, an inverted yield curve has been a precursor to recession.

The S&P 500 stands at 4,045 at this writing, having started the year at 3,998. January was strongly positive in the stock market, February was negative, and March has turned positive again, so far. There has been considerable volatility for a marginal gain. The PE Ratio of the S&P 500 currently stands at 21.6, so stocks are not cheap by historical standards, but they are cheaper than before the bear market of 2022. Markets will remain choppy, perhaps with some bias to the downside, until the monetary tightening cycle is behind us. At some point, markets will begin to anticipate the next expansionary cycle, and this may well occur before strong positive changes show up in the economic data. A lot turns on the persistence of inflation and the Fed’s ongoing efforts to tame it.
 

The Treasury yield curve has an upward slope out to one year then declines all the way out to the 10-year. 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– 18-month time frame. Short-term bond rates are as attractive as they have been in some years. The one-year Treasury is above 5%. However, long-term bond investors may want to also start locking in some intermediate-term rates. At some point, if the economy does tip into recession, or if inflation comes down, we may eventually see lower yields on short to intermediate-term bonds. For now, the bias on rates is to the upside, but cycles do turn, and securing some of today’s attractive rates is a reasonable objective for a longer-term investor.
 

Please contact us if you would like to discuss your particular situation.