Future still foggy
Data point in different directions.
There’s little question in our minds that the odds of a successful soft landing have increased. Yet a deep dive into the economy shows conflicting and confusing cross currents, perhaps supporting the recent weakness we’ve seen in both stocks and bonds. It’s anything but clear.
Labor market tops the list Initial weekly jobless claims, an high-frequency leading indicator, hit a 7-month low at 216,000 last week, which suggests the labor market is strong. Yet the Job Openings and Labor Turnover survey (JOLTS) has fallen sharply this year and nonfarm payrolls, household employment and private employer hiring trends (ADP) have slowed. Challenger layoffs have more than tripled over the past year, and the unemployment rate has increased from a half-century low of 3.4% to 3.8% over the past four months. This is music to the ears of the Federal Reserve, which had forecast in its June Summary of Economic Projections that unemployment would rise to 4.1% by the end of this year and to 4.5% by the end of next year.
What about inflation? It peaked last year and has fallen sharply. But there’s a sharp divergence in the pace of that decline between headline and core inflation. Nominal CPI peaked at 9.1% year-over-year (y/y) in June 2022 and has fallen to 3.2% in July 2023. But core peaked at 6.6% y/y in September 2022 and has only fallen to 4.7% in July 2023.
The disparity with the Personal Consumption Expenditure (PCE) Index is more extreme. Headline dropped from a 7.0% peak in June 2022 to 3.3% in July 2023. But core PCE (the Fed’s preferred measure of inflation) peaked at 5.4% in February 2022 and has declined to just 4.2% in July 2023. The Fed expects core PCE to decline gradually to 2.2% by year-end 2025.
Energy on a tear Crude oil and gasoline prices have risen by 38% and 25%, respectively, over the past several months. This threatens to reverse the welcome decline in nominal inflation. If that spike is joined by rising food and shelter prices and wage gains, the Fed likely will stay hawkish for the balance of this year into next. We’re expecting the Federal Open Market Committee (FOMC) to forgo a hike at its meeting on September 20. But we expect another quarter-point rate bump on November 1. That may prove to be its last hike in this tightening cycle, but we do not expect it to cut rates before the second half of 2024.
Inflection point? Consumer confidence has been strong this summer, perhaps reflecting the health of the labor market. But August readings for Michigan and the Conference Board both declined sequentially. Low-end consumers appear to be stressed, as excess savings have plunged by nearly 90% over the past two years, personal savings rates have risen, credit card usage has increased, and credit-card delinquency has nearly doubled in less than two years.
Making up for lost time The ISM non-manufacturing index has been strong, hitting a 6-month high in August and running above the important 50 level for eight consecutive months. People are still traveling, dining out, bar hopping and attending concerts and movies (Taylor Swift, Beyonce and “Barbie”), as they make up for lost Covid time.
But consumer spending on goods has softened “Mapril” spending for March and April combined (the Easter and Passover season) rose by a tepid 1.7% y/y for 2023, compared with a more robust 8.6% y/y gain for 2022. With the first two months of the important Back-to-School (BTS) retail season that started in June complete, retail sales have risen by a muted 2.4% y/y, compared with a robust 9.8% y/y gain in 2022. We expect that August results will be much softer than July. But if BTS and Mapril are both soft, that raises questions about how robust the important Christmas shopping season will be from October through January, given their 73% positive correlation over the past 30 years.
Mixed signals in manufacturing While several of the Fed’s regional manufacturing indices were better than expected last month, the ISM manufacturing index has been below the critical 50 level in each of the past 10 months. Moreover, the Leading Economic Indicators (LEI) have now declined 16 months in a row though July. Historically, these have been reliable recession signals over the past 75 years.
Inverted yield curves The bond market has three important yield-curve relationships that remain inverted (2-year to 10-year Treasuries; fed funds to 10-year Treasuries; and 3-month to 10-year Treasuries). These inversions point to an elevated risk of an economic slowdown over the next year.
Growth equities remain overbought The S&P 500 rallied by 19.5% in the first seven months of this year and by 32% since last October’s low. This was driven by the performance of Big Eight technology stocks, which surged by 65% since the beginning of the year into the end of July. The other 492 stocks in the S&P rose by a pedestrian 7.5% during the first seven months of 2023. The S&P 500 has declined by about 4-5% over the past five weeks, the start of what we believe will be a healthy 8-12% correction. But we also expect a broadening out of this year’s rally, with domestic value and small caps and international stocks playing catch-up, while the growth and technology stocks erase some of their recent froth and revert to the mean.
Never mind At the same time, benchmark 10-year Treasury yields have soared over the past six months, from 3.25% in April to 4.35% recently, as investors have similarly grappled with the realization that “Immaculate Disinflation” and “Immaculate Pivot” were fairy tales.
Raising our GDP estimates The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met yesterday to discuss the confusing economic outlook:
- The Commerce Dept. revised its second quarter 2023 GDP down from 2.4% to 2.1%, which compares with GDP growth of 2.0% in this year’s first quarter and 2.6% and 3.2% in last year’s fourth and third quarters, respectively.
- Third quarter 2023 GDP will be flashed on October 26. We’re expecting the Fed to pause on September 20 after their quarter-point hike on July 26. The labor market remains strong, with initial weekly jobless claims at a seven-month low. So, we increased our estimate from 0.9% to 2.3%. The Blue-Chip consensus increased its estimate from 0.4% to 2.4% (within a range of 1.1% to 3.5%). The Atlanta Fed’ GDPNow estimate is at 5.6%.
- Consumer confidence firmed over the summer, and spending on services remains strong, despite our concerns about slower Christmas spending on goods. We raised our fourth quarter 2023 GDP estimate from 0.6% to 1.0%. The Blue-Chip consensus increased its estimate from -0.1% to 0.6% (within a range of -0.8% to 1.5%).
- That inched up our full-year 2023 GDP estimate from 1.8% to 2.1%. The Blue-Chip consensus raised its estimate from 1.6% to 2.1% (within a range of 1.9% to 2.3%).
- We left our year-end 2023 forecast for core CPI inflation unchanged at 3.9% (Blue Chip at 3.7%), compared with actual inflation of 4.7% in July 2023. (That’s down from a 40-year high of 6.6% in September 2022). We also left unchanged our year-end 2023 forecast for core PCE inflation at 3.6% (Blue Chip at 3.5%), compared with actual inflation of 4.2% in July 2023. (That’s down from a 39-year high of 5.4% in February 2022).
- We doubled our estimate for first quarter 2024 GDP from 0.4% to 0.8%. The Blue-Chip consensus reduced its estimate from 0.4% to 0.1% (within a range of -1.4% to 1.2%).
- We increased our estimate for second quarter 2024 GDP from 0.5% to 0.8%. The Blue-Chip consensus lowered its estimate from 0.9% to 0.5% (within a range of -1.0% to 1.7%).
- We raised our estimate for third quarter 2024 GDP from 0.8% to 1.1%. The Blue-Chip consensus reduced its estimate from 1.6% to 1.3% (within a range of 0.1% to 2.3%).
- We increased our estimate for fourth quarter 2024 GDP from 1.1% to 1.3%. The Blue-Chip consensus ticked its estimate down from 1.9% to 1.8% (within a range of 1.1% to 2.6%).
- As a result, we increased our full-year 2024 GDP estimate from 0.7% to 1.1%. The Blue-Chip consensus also raised its estimate from 0.7% to 1.0% (within a range of -0.3% to 1.9%).
- We inched up our year-end 2024 forecast for core CPI inflation from 2.9% to 3.0% (Blue Chip at 3.2%), and we ticked up our estimate for core PCE inflation from 2.6% to 2.7% (Blue Chip at 3.0%).