The Little Economy Who Could

The U.S. economy has remained resilient compared to the rest of the world, after it posted a real growth rate of 2.5% for 2023, which followed a 1.9% real growth rate for 2022. For the fourth quarter of 2023, the annualized real growth rate was revised up to 3.4%. The IMF is projecting GDP to grow at a rate of 2.1% for the U.S. in 2024. What happened to the impending economic depression, or at least recession, that economists and business leaders were calling for in 2023?

As I'm sure you've heard a million times by now, the Federal Reserve (Fed) has raised interest rates to a multi-decade high to combat the worst inflationary spike in the U.S. since the 70s and 80s. This wasn't a U.S. centric problem either, Central Banks across the globe have raised interest rates to reign in rapid price increases that have affected all of us (I can't seem to spend less than $200 on groceries, pls send help). Raising interest rates, in theory, reduces inflation because it raises the cost of borrowing money. You have probably noticed this with higher rates on your savings accounts. But, it has also increased mortgage rates, credit card rates, and any loan a consumer or business would take. The idea is to decrease the amount of borrowing, decrease the amount of spending, decrease economic activity as a whole, which will decrease prices for goods and services. 

If I could say the quiet part out loud... the Fed believes it may need to engineer a recession, or increase unemployment, to bring inflation down. As you'll note in this chart, this isn't ALWAYS the case. The shaded areas indicate a recession, and while it's not guaranteed to follow interest rate increases, it's clear there is a strong correlation between the two. This is both the fastest pace of increase in rates since the 70s and 80s, and the highest rates have been since the 2000s. But no recession? HUH? Buzz word alert: Is the "Soft Landing" scenario possible? Can the Fed raise rates, bring down inflation, and not spark a recession?

"Monetary policy operates with long and variable lags" (an indirect and poorly paraphrased quote from Nobel winning economist Milton Friedman). Translation: It takes on average 12-18 months before policy measures begin to affect economic activity.  We are currently in month 24 of this cycle, and there are three main and interlinked (INTERLINKED) reasons why we have not had a recession, and might not have one at all:

Savvy Little Consumer - One reason higher interest rates cause recessions is because the increase in the costs to borrow tends to increase defaults on loans. However, when the Fed lowered rates to 0% in 2020 due to Covid, there was a rush to buy new houses and cars at historically low rates. Consumers and Business alike also took the opportunity to refinance their loans into lower rates too. Now we're all locked in for the next 5, 10, 20 years and so higher rates are having less of an effect than they usually do. However, new housing purchases have slowed significantly and defaults on credit cards are beginning to increase; consumer and business balance sheets are in good shape but cracks are forming due to this extended period of high prices AND high rates.

Government Spending - Congress and the Biden Administration have signed into law very large spending bills that will increase investments in major projects over the next decade. With over $3T in spending on infrastructure, semiconductors, and other programs on the books, there is now a tug-of-war between the Fed tightening policy, and government spending. Fiscal policy and an increase in deficit spending has kept both economic activity elevated, and unemployment low. With much of this money still to be spent over the next decade, there is a lot of fuel for the fire here. In the immediate term, fiscal spending may slow as we entire an election year with a divided congress.

JOBS! JOBS! JOBS! - That government spending is actually creating a lot of jobs, despite the mass layoffs we see in the technology and financial services sectors on a monthly basis. Construction, Education, Healthcare, Manufacturing - and a few other sectors that are more directly connected to government spending - have seen job growth every month for almost two years now. There are also recent studies showing that immigration has been a huge help in supplying labor to certain industries, which has also kept unemployment low. The Fed believes it needs to see a higher level of unemployment to help bring inflation down further. Unemployment ticked up to 3.9% at the end of February, average hours worked per week has been on a slow decline, and demand for temporary work is falling off. There are signs emerging that unemployment may begin to go higher from here. 

Conclusion?

Economic and employment resilience has surprised to the upside. The U.S. is faring much better than every other developed country on a relative basis. Interest rate increases in Canada, the U.K., France, Germany, and others, are doing exactly what they are supposed to do - economic activity is slowing, inflation is coming down, and unemployment is increasing. The U.S. is an outlier, but I do think there are major risks still ahead, and we may soon follow the same economic path of other countries as our fiscal picture begins to normalize. 

The Fed is also walking a very fine line. Remember those bank failures last year? Five banks with over $500B in assets went insolvent in 2023, and there's an estimated 280 additional banks with over $900B in assets that are considered in stress. These banks have large exposures to commercial properties that have been struggling since work-from-home and hybrid-work trends have caused companies to rethink their office footprint. Over $900B in commercial and multi-family property loans come due in 2024. Without a clear source of revenue, these companies may be forced to refinance these loans at the aforementioned high interest rates, causing additional stress. 

The Fed is aware of these risks, and as of their most recent meeting, are trying to pencil in three interest rate cuts this year. They remain hesitant to cut too early because inflation has remained stickier than they anticipated - they don't want to cut too early and risk prices increasing again, but they don't want to remain too high for too long and cause a blow up. There are a number of geopolitical factors out of the Fed's control that could keep inflation higher too. There's no guarantee that three cuts this year will be enough to offset any problems. CPI (Consumer Price Index) rose 3.2% year-over-year in February. Core CPI, which does not include food and energy, rose 3.8%. PCE (Personal Consumption Expenditures) is the Fed's preferred inflation gauge. PCE for February rose 2.5% year-over-year, and 2.8% if you exclude food and energy. The Fed's target is 2%.  There is a lot of conflicting data and uncertainty here; we'll know more as the year progresses.

Financial Market Review and Outlook:

Wowee, with all this bad news and uncertainty ahead, surely stocks (equities) must be doing poorly?... What's that? The Dow, S&P 500, and Nasdaq are all at an all time high? Haha sick. This is a perfect time to say: The stock market is not the economy, the two are correlated but not equal. The stock market is a collection of the largest public companies in the U.S. The S&P 500 specifically includes the largest 500 companies. These companies are not representative of the whole, but they could be affected by what happens economically. You can also think of the stock market as a forward projection - the valuations you see already have all known information priced in, along with the crowd consensus of what's most likely going to happen over the next year or two priced in. Based on this logic, equity markets think the Fed will achieve the soft landing scenario. 

To be fair, the equity markets have been mostly correct. Earnings for 2023 turned out not bad; earnings growth for 2023 was still 1.0%, and earnings growth projections for 2024 sit at 10.9% as of today. Equities think the Fed will successfully cut interest rates this year without causing further harm. You can read the full revenue and earnings estimates for both the overall market and the individual sectors if you are curious here. Valuations are a different story. The current P/E ratio, or the value (price) investors are willing to pay for $1 of earnings, sits at 28x. The 12-month forward P/E ratio sits at 21x. A 10-year inflation adjusted earnings ratio, also called the Shiller PE Ratio, sits at 35x. If you were curious, these are all well above their 5 and 10 year averages (but just below their peaks, for what it's worth!) No matter how you choose to slice it, the market looks expensive here.

After the bear market bottom in late 2022, the market traded sideways for some time before being supercharged by expectations over Artificial Intelligence. OpenAI dropped ChatGPT into the hands of the public in March 2023, and we've been off to the races ever since. There is a lot of data to show that the majority of the rally in 2023 was top-heavy; large stock rallies in Nvidia, Meta, Amazon, Apple, and Google (the usual suspects..) propelled most indexes higher last year. Check out the difference in the returns between the S&P 500, and its equal weighted counterpart. The rally to begin 2024, however, has been much more broad based, leading investors to believe this bull market has room to run. 

The bond market tells a different, yet very mixed story. Yields on treasury bonds are off their highs from October of 2023, but have rallied again recently. Bonds are suggesting that we've made progress on inflation, but they are not convinced the Fed has it fully under control. The yield curve is still inverted at almost every point along the curve (long-term yields are lower than short-term yields) which is another indicator of recession. Check out this interactive graph to see where we stand, and set the date to 12/31/2021 to see what a more 'normal' curve looks like. The famous 10-year / 2-year spread has been inverted for a record 628 days and counting. Bonds have been flashing warning signs for some time now, and are not fully convinced we are out of the woods.

Conclusion? 

I would not be shocked if we had an equity market correction this year, and risks remain for a more protracted bear market. The biggest risk to equities continues to be the path of interest rates (if it wasn't obvious already). 10-year treasury yields are more connected to equity valuations - when the 10-year yield rises, stocks tend to fall. If the Fed decides to cut less than three times this year, yields could go up. If the Treasury continues to issue debt the market cannot absorb, yields could go up. If inflation remains too high, yields could go up. If the Fed causes a liquidity crunch with its continued balance sheet reduction of treasuries and mortgages, yields could go up. If other developed countries begin to grow as the U.S. begins to slow, yields could go up. If the Central Bank of Japan (BoJ) begins raising rates and Japanese investors sell their treasury holdings to repatriate funds to Japan, yields could go up.