High-water mark

Bottom Line 

The Federal Reserve now believes that the U.S. economy will likely slip into a mild recession later this year, according to the minutes released on Wednesday from its most recent policy-setting meeting on March 22. Despite the downbeat outlook, the Fed still hiked rates by a quarter point at that meeting—the ninth consecutive time—to a target range of 4.75-5%. It also signaled a bias toward another quarter-point bump at the upcoming meeting on May 3. 

The Fed’s economic assessment is consistent with our view that at 1.3%, 2023 gross domestic product (GDP) growth may have reached its high-water mark in the recently completed first quarter. The Commerce Dept. will flash that figure in two weeks. We expect growth will slip into negative territory during the third and fourth quarters due to the lagged impact from the hikes and the tightening of bank lending standards and lower loan volumes likely to follow in the wake of last month’s banking industry stress. 

Inflation slip-sliding away Price pressures clearly peaked last year and are starting to recede. The nominal Consumer Price Index (CPI) plummeted from 6% year-over-year (y/y) in February to 5% in March, though core CPI rose a tick to 5.6%. But Fed policymakers do not believe it will settle to their 2% target until year-end 2025. They may respond with an “insurance” hike on May 3 of one more quarter-point before pausing. That’s an outcome the market views as more than 80% likely. 

Due to the sticky and persistent nature of inflation, however, we expect them to take a data-dependent, wait-and-see approach regarding policy action at their June 14 meeting. The market, however, still harbors visions of “Immaculate Disinflation” and the Fed’s “Immaculate Pivot.” This unrealistic scenario requires the economy to sharply weaken, forcing officials to cut rates in the last four meetings this year, a view that we do not share. 

Phillips Curve trade-off The Fed continues to hike rates to reduce inflation at the expense of the labor market, the policy seesaw named as the Phillips Curve. But will the unemployment rate, sitting just off a 53-year low at 3.5% in March, rise to Fed’s year-end target of 4.5%? Clearly, the Fed is willing to pay the price of weaker economic growth and higher unemployment to crush inflation. But the Leading Economic Indicators (LEI) have now declined 11 months in a row, and the manufacturing ISM index has fallen below 50 for five months in a row—both of which are reliable recession signals. So with a 2/10 Treasury yield-curve inversion of 58 basis points, there’s an elevated risk of a rocky landing or recession over the next year. 

Consumer spending slows While the labor market remains relatively healthy, consumers have slowed noticeably over the past two months. Although nominal retail sales in January rose by the largest gain in nearly two years at 3.1% month-over-month (m/m), February and March declined by 0.2% and 1%, respectively. The savings rate has risen from a 17-year low of 2.7% last June to 4.6% in February, which suggests that lower-income consumers are building dry powder amid an economic slowdown. 

Challenging earnings season ahead The first-quarter reporting season is just starting, and our expectations are low. According to FactSet, revenues should rise about 1.8% y/y in the first quarter, down from a 13.9% gain in the first quarter of 2022. That would be the weakest quarter since the third quarter of 2020. Earnings are expected to decline again in the first quarter of 2023 by -6.8% y/y because of elevated inflation, rising interest rates and slimmer profit margins due to higher labor, commodity, transportation, and warehousing costs. This would potentially mark the weakest quarter since the second quarter of 2020 during the pandemic. By comparison, earnings rose in the first quarter of 2022 by 10.3% y/y. Profit margins are expected to decline by about 8.5% in the first quarter, which would represent their fifth consecutive decrease. 

Management guidance has been running negative by a 3-to-1 ratio. We recently cut our outlook for S&P 500 earnings from $200 to $190 in 2023, versus $209 in 2021 and $219 in 2022. Consensus S&P earnings for 2023 have declined from $250 to $225, suggesting risk to the downside in coming months. 

Are equity investors whistling past the graveyard? The S&P has rallied more than 8% so far this year. From its oversold trough in mid-October, the index has enjoyed a powerful rally of more than 19%. This makes little sense to us, given the challenging fundamental backdrop for stocks: slowing economic growth, persistent inflation, a hawkish Fed, weak earnings and the threat of recession. We continue to believe that stocks could retest their October trough in coming months, as investors reduce their earnings estimates. Over the last six weeks, however, benchmark 10-year Treasury yields fell from 4.05% to 3.30%, which suggests that the bond market fully appreciates these macroeconomic concerns. 

Tweaking our GDP estimates The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to discuss the trajectory of inflation, bank-lending stress and the Fed’s likely response: 

• The Commerce Dept. revised fourth quarter 2022 GDP growth down from 2.7% to 2.6%, versus 3.2% in the third quarter. There was no change in the full year growth rate of 2.1% in 2022 compared with 5.9% in 2021. 
• First quarter 2023 growth will be flashed on April 27. The Fed downshifted to a pair of quarter-point rate hikes on February 1 and March 22. Consumer spending was robust in January, but decelerated in February and March. We increased our first quarter 2023 growth estimate from 1.1% to 1.3%. The Blue Chip consensus raised its from -0.1% to 1.5% (within a range of -0.3% to 2.5%). The Bloomberg consensus is at 2.7%, and the Atlanta Fed’s GDPNow estimate is at 2.2%.
• “Mapril” spending got off to a slow start, so we lowered our second quarter 2023 forecast from 0.3% to 0.2%. The Blue Chip consensus raised its estimate from -0.5% to -0.1% (within a range of -1.4% to 1.1%).
• We anticipate the Fed to execute a rate hike on May 3, so we reduced our third quarter 2023 projection from -0.5% to -0.6%. The Blue Chip consensus lowered its from -0.1% to -0.3% (within a range of -2.2% to 1.5%).
• We left unchanged our fourth quarter of 2023 estimate at -0.7%. The Blue Chip consensus lowered its from 0.6% to 0.2% (within a range of -1.8% to 2%).
• We left unchanged our full-year 2023 GDP growth estimate at 1.1%. The Blue Chip consensus raised its from 0.7% to 1.2% (within a range of 0.7% to 1.7%).
• We left our full-year 2023 forecast for core CPI inflation unchanged at 3.9%, compared with 5.6% in March 2023. (That’s down from a 40-year high of 6.6% in September 2022). We also left our full-year 2023 forecast for core PCE inflation unchanged at 3.5%, compared with 4.6% in February 2023. (That’s down from a 39-year high of 5.3% in March 2022).
• We left our full-year 2024 GDP growth estimate unchanged at 1.1%. The Blue Chip consensus lowered its from 1.2% to 0.9% (within a range of 0.0% to 1.7%).
• We left unchanged our full-year 2024 forecast for core CPI inflation at 2.8% and for core PCE inflation at 2.5%. 

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