Telemus Weekly Market Review December 4th - December 8th, 2023
Going into 2023 the consensus across the market was that the U.S. economy would enter a recession in the second half of 2023. Our view wasn’t any different given our concern that rising interest rates would eventually lead to slower economic activity. Despite the Federal Reserve increasing rates above what many had even expected going into 2023, the economy defied expectations and in the third quarter we saw U.S. Gross Domestic Product exceed 5%, a far cry from a recession.
What created the surprising boom for the U.S. economy was the resilience of the consumer. Consumer spending far exceeded expectations with spending habits shifting away from goods toward services. More specifically, spending has been greatest around healthcare, travel, and entertainment. In the case of the later, the summer of Taylor Swift, Beyonce and Barbenheimer had a meaningful contribution to GDP growth. Per research conducted by Morgan Stanley, these three collectively had an $8.5 billion impact on the U.S. economy in the third quarter alone.
What lies beneath the surface on the strength of the consumer is how they’ve been able to afford their spending habits. First, consumers have been spending down the excess savings they were able to amass during the pandemic. Per the Federal Reserve Bank of San Francisco, by August of 2021 consumers had excess savings of $2.1 trillion. That had fallen to a little over $1 trillion going into 2023 and is estimated to be down to $0.4 trillion as of November. A second source supporting higher spending has been a lack of savings of current income. Prior to the pandemic, the consumer savings rate hovered between 7-8%. Most recently the savings rate sits a 3.8%, roughly half of pre-pandemic levels. Thus, consumer spending has remained strong as individuals are electing to spend more rather than save. Compounding this is the third contributor, an uptick in credit card balances which have risen roughly 15% over the past year. Collectively, these factors indicate to us that the rate of consumer spending has been fueled by sources that would indicate it’s unsustainable. However, when excess levels of spending have occurred in the past, they have tended to go on longer than one might expect. Given the current strength of the labor market, where individuals feel confident in their financial future, we don’t see any impending catalysts that may lead to an immediate change in consumers’ willingness to spend.
Looking past the consumer and to the health of businesses, corporate earnings would indicate a less than robust year in 2023. Through the first half of 2023, the constituents of the S&P 500 ended up with earnings that had declined from the previous year. That flipped to a modest rate of growth in the third quarter with fourth quarter earnings also expected to expand. However, management teams have begun to indicate they are more cautious on their pace of revenue growth in the coming quarters.
An overarching concern that has yet to be a notable hinderance is the level of interest rates. Since the Federal Reserve started its campaign to raise interest rates in the spring of 2022, borrowing costs have shot higher by over 5%. Such a significant move was expected to constrain spending levels thereby reducing demand in the economy. That impact has yet to roll through the economy. The Fed didn’t stop raising interest rates until this summer. Economic lore states there is often a 12-18 month lag between when interest rate policy is enacted and when its fully reflected in the economy. Therefore, it could be argued that the full impact of higher rates has yet to be felt in the economy. We think there is some truth to this as metrics used to assess the health of borrowers, such as interest coverage ratio, are looked at in arrears. It seems likely that interest coverage metrics will gradually deteriorate in 2024 and this may constrain incrementable borrowing. However, given the strength of the economy, borrowers in aggregate appear positioned to withstand higher rates without any outsized systemic impact.
Focusing more directly on interest rates, we think that more likely than not the Federal Reserve is done with its rate hiking campaign. A larger, unexpected spike in inflation would need to occur for the Fed to resume raising rates. That said, we don’t expect the Fed to be active in cutting rates in 2024. Should it happen, it would likely be late it in the year. The Federal Reserve is acutely aware of the challenges faced in the 1970’s when policy was eased too early and subsequent inflationary episodes occurred. We think the market is too optimistic in its expectations for when the Fed will cut. Unless there is a compelling reason, such as a greater than expected pullback in the economy, we expect the Fed to have greater patience than the market assumes in keeping interest rates higher for longer.
Outlook
Our expectation is for a softer economy in 2024 with a more muted level of economic growth. The pace of consumer spending is likely to pull back at some point during the year. Given that the consumer represents roughly 2/3 of economic activity, we don’t project business or government spending increasing to a level that will be able to offset this.
The possibility for a mild recession exists, but its not our base case scenario. A muddle along economy with GDP growth at or around 1% is most likely in our view. That said, there are some opportunities for unexpected upside. A rebound in China’s economy could help to reignite growth across the globe. Domestically, a challenge for the economy during 2023 has been softness in manufacturing activity. We expect at some point the manufacturing sector will rebound providing a boost to the economy. Lastly should longer-term interest rates trend lower, that would support the housing sector where more affordable financing costs would align with the long-term structural demand for homes.
On the inflation front, we expect the recent downward trend in the rate of inflation (disinflation) to continue, for now. There are several categories that comprise the common inflation measure, the Consumer Price Index (CPI), that are likely to decelerate in the months ahead. First, shelter costs make up over 40% of the CPI and lower rents and moderating housing costs should collectively lead to a deceleration in this category. Used car prices have also been elevated due to a lack of supply. This situation may be reversing as the surge in car purchases coming out of the pandemic are now maturing to a point where many will be coming off lease. This will add to the supply of used vehicles and should lead to an easing of used car prices. Lastly, lower oil prices have not only been helpful to costs for consumers at the gas pump, but will continue to benefit freight costs which often get passed on to customers at a lag. Collectively these items give us comfort that for now inflation will remain in check and more likely than not will trend lower during 2024.
We see the challenges with inflation not occurring in 2024 but in the years beyond, likely 2026 and 2027. The impact of higher rates is beginning to influence investment spending. For example, within real estate there is likely to be a big drop in construction activity after projects designed in prior years are delivered in 2024. At this time there is drastic reduction in spending on projects expected to be completed in 2025 and beyond. Should the economy accelerate into 2025 and beyond, it could stoke an increase in demand while supply is constrained. The impact will be an uptick in pricing and a resumption of inflation. The affect is likely to extend beyond real estate and include commodities, durable goods, labor costs and even freight costs. This is an intermediate to long-term consideration we are conscious of but aren’t yet positioning for it given our expectation for an improving inflationary picture in 2024.
From an investment standpoint, we view the overall economic backdrop as lukewarm. We believe current economic fundamentals are supportive of continued growth ahead, but at a more modest pace. A lukewarm year in 2024 does set the economy up for more attractive growth in the years that follow, but these come with the risk of a resumption in inflation and a return to more restrictive policies. As we learned in 2023, the magnitude of stimulus that was injected into the economy during the pandemic has made it much harder to forecast as the numerous influences don’t fit traditional economic models. We are prepared for unexpected outcomes but take comfort that the economy is exiting 2023 in strong shape, although several risk factors exist, as they do at the start of any year.
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