Crosscurrents: Economic Uncertainty

In the first quarter of 2023, the U.S. economy grew by 1.3% on an annualized basis and expanded by less than 0.3% on a quarterly basis. That growth was down from a 2.6% rate in the last three months of 2022, but nonetheless represented a third straight quarter of growth after output contracted in the first half of last year. (For context: the U.S. economy grew at around 2.2% annualized in the decade before the COVID-19 pandemic hit in 2020.) The American shopper continues to be a relentless force. Consumers have been buoyed by a strong job market and rising wages, which have helped offset high prices. Personal consumption is up 3.8% annualized, showing that higher interest rates have yet to deter the ongoing spree.

However, monthly consumer spending slowed towards the end of the first quarter but picked up again in April, as the Fed continued raising interest rates. The Federal Reserve fights inflation by slowing the economy through raising rates, which causes tighter financial conditions such as higher borrowing costs, lower stock prices, and a stronger dollar.

Inventories dragged the Gross Domestic Product (GDP) down by 2.1%. If inventories had stayed unchanged, annualized growth would have been over 3%. When businesses deplete inventories in one quarter, they tend to replenish them in the next one. Also, the inflation component is strong—the price index for Personal Consumption Expenditures (PCE), the Fed’s preferred inflation measure, rose by 4.2% annualized, accelerating from 3.7%, which is stubbornly high.

So, if growth was relatively good—even if slowing—in the first quarter, what does that mean for the economy and the market for the rest of 2023?

There are five major crosscurrents that will affect the economy and the markets going forward: the recent banking crisis, inflation worries, Fed moves, the debt ceiling drama, and the earnings outlook. These crosscurrents blur the financial vista, as it feels like the economy is simultaneously hitting the gas and stomping on the brake.

Implications of the Banking Crisis

The recent bank failures have obviously unsettled investors. Even though equity markets have rebounded from the initial turmoil, there is still widespread belief that these failures could lead to a more aggressive slowdown in economic activity that could result in a recession much sooner than would otherwise be the case.

Regional banks in the U.S. are further tightening their lending standards in the wake of increasing turmoil within the banking sector. Tighter credit conditions in the banking sector can do the same job as rate hikes, which means that the Fed probably doesn’t have to raise interest rates as much as it otherwise would have. That said, sticky inflation is still an ongoing concern.

Even if market volatility subsides, banks will probably lend less—but just how much less is still an open question. Small banks have driven most of the lending over the last six months and are likely to make loans to small businesses, which employ 80% of the workforce. In all, less credit flowing into the economy tends to mean lower growth, and this could accelerate the path to recession.

Anxiety has been growing around commercial real estate (CRE). The sector has already come under pressure as interest rates have risen, but this dynamic is now in acute focus given CRE makes up almost half of small banks’ loans.

The most vulnerable area looks to be office space. Disrupted by the rise of remote work (which is still seven times what it was before the pandemic), office CRE is likely to go through a real reckoning. Yet, it’s worth noting that the office subsector represents less than 14% of all CRE (and office construction is just 0.4% of overall GDP). Furthermore, not all CRE is created equal: segments such as data centers, hospitals, apartments, and retail don’t seem to be facing the same pressures as office spaces.

The Fed’s biannual Financial Stability Report warned of deteriorating conditions in the bank sector in general. According to the report, the main risk is that commercial borrowers will not be able to refinance their loans when the loans reach the end of their term. This could increase “the magnitude of a correction in property values [which] could be sizable and therefore could lead to credit losses by holders of commercial real estate debt,” the report said.

It’s getting more difficult to borrow, the report said, and this could “lead banks and other financial institutions to further contract the supply of credit to the economy.” The Fed report added that “a sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity.”

Banking stresses are expected to further tighten financial conditions, but the magnitude of any credit crunch is hard to predict and might not be apparent for months.

Inflation Worries

The Fed is raising interest rates aggressively to bring down inflation but also trying not to spark a U.S. recession. Rising interest rates increase borrowing costs for companies and consumers, which then weighs on economic activity.

Current inflation is drastically different from the price increases that first appeared in 2021, which were driven by stubborn price increases for services. Fed officials had expected goods shortages to fade, but the combination of faster inflation for services and accelerating wage growth captured their attention.

A slowdown in consumer spending, which drives most of the U.S. economy, could help ease inflation in the coming months. At the same time, average paychecks are still rising rapidly. Though beneficial for workers, that trend likely means that many companies will keep raising prices to offset their higher labor costs.

The core PCE continues to reflect uncomfortably high inflation. Wages continue to be sticky. Steady job growth and brisk wage gains could sustain higher inflation. The Fed targets 2% inflation over time.

Fed Moves

Fed Funds futures had been implying a summer pause and autumn easing. However, economic data released in late May have raised the possibility of pause to a rate in increase at the next Fed meeting. The yield curve remains inverted, but Fed Funds futures imply that this tightening cycle, the steepest in over 40 years, may not be quite over. In fact, while bond markets have priced in rate cuts by the end of the year, there’s been no such signal from the Fed, which remains laser-focused on getting inflation under control, seemingly above all else.

A pause by the Fed could still be viewed as a step in the right direction that results in equity markets holding their own and continuing to trade in range-bound fashion over the next couple of months. But that also likely depends on how long interest rates stay unchanged if the Fed takes a pause starting in June. After all, if the current disconnect persists, markets are bound to get antsy if economic conditions deteriorate from here without a more aggressive response from the Fed.

Fed officials dropped wording from their previous policy statement saying they “anticipated” some additional rate increases might be appropriate. This wording was replaced with new language saying they would “carefully monitor” the economic effects of the agency’s rapid rate increases over the past year. “That’s a meaningful change, that we’re no longer saying that we ‘anticipate’ [additional increases],” said Fed chair Jerome Powell at the U.S. central bank’s May 2023 meeting.

Until now, officials have been looking for clear signs of a slowdown to justify ending rate increases. But Powell indicated that calculation could shift now, and officials would need to see signs of stronger-than-expected growth, hiring, and inflation to continue raising rates. Investors will now turn their attention to the next set of economic data releases. Other data will also matter, including corporate earnings and updates on the health of the housing sector. The Fed’s next meeting is June 13 and 14.

Powell pushed back against expectations of rate cuts this year, but he acknowledged that investors expecting inflation to fall quickly could take that view. “We on the committee have a view that inflation is going to come down not so quickly. In that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates,” he said.

Repeating the Debt Ceiling Drama

The putative legislators in Washington continued to maneuver for partisan advantage over lifting the debt ceiling, ratcheting up the manufactured drama these political performance artists have staged far too many times over the years.

Treasury Secretary Janet Yellen had testified that the X date—the point at which the Treasury runs out of funds to pay obligations—could come as soon as June 1, then changed it to June 5.  A precise X date is difficult to forecast, as it depends on unpredictable daily cash flows in and out of the Treasury General Account, the government’s operating account. However, Yellen’s prediction has been seen as realistic, since the negotiators quickly brought the curtain down on the show, with neither side getting a clear advantage (which generally indicates a satisfactory deal). A truly bipartisan deal (imagine that!) was reached and passed on June 1. Of course, it may also be true that the politicians needed to shift their focus to the next show, the 2024 presidential election (yes, it is already underway).

At this point, it’s important to reiterate something our elected officials either don’t know or choose to ignore for political purposes: the debt and the deficit are not the same. The debt is money the government has borrowed and already spent (for example, on fixing roads and bridges), and is thus owed to the lenders. The deficit reflects spending exceeding revenues collected (from, say, taxation) or liabilities exceeding assets. In a given fiscal year, when spending (for example, money for roads) exceeds revenue (for example money from federal income tax), a budget deficit results.

Raising the debt ceiling (an artificial boundary, remember, imposed in 1939) does not increase the debt; setting the ceiling below what is owed does not reduce the debt, but does risk default.

The federal government always runs a structural deficit. The nation requires new debt to be continually issued for the government to operate. Interest payments crowd out the opportunities for lowering taxes or spending on more productive government programs. Capacity to issue debt is valuable in downturns and crises when government spending can offset declines in the private economy.

Because a U.S. government default on its debt obligations would be potentially catastrophic, even the threat of refusing to raise the debt ceiling has an effect. During the drama, investors showed a preference for securities maturing toward the end of May, rather than anything maturing in June. So, we still see dislocations which are just inefficient in the markets and create extra costs for the taxpayers. Taxpayers are paying a higher rate for issuing one-month bills now than they really should have to because of these political shenanigans.

Underpinning the entire issue is that the U.S. budget deficit has been growing while rising interest rates have made it much more expensive for the country to borrow. The nonpartisan Congressional Budget Office (CBO) projects that annual interest costs will rise from $399 billion in 2022 to $1.2 trillion in 2032. As a percentage of gross domestic product (GDP), those costs would double from 1.6 percent of GDP in 2022 to 3.3 percent in 2032, which would be the highest level ever recorded.

Once the deal is passed, the Treasury will have to refill its coffers. The debt-ceiling standoff has left the coffers of the Treasury at a level below $50 billion compared with an average balance of more than $500 billion. The raising of the debt ceiling is expected to be followed by the issuance of over $1 trillion in new Treasury’s over the next seven months, a relatively large amount for that short a period.

This expected burst of Treasury issuance could have consequences for liquidity in other markets, depending on who buys the Treasury’s. Money market funds would normally be the primary buyers but would likely require higher yields, which would add to the challenge of a high cost of funding facing the regional banking system. On the other hand, if other investors were to buy the Treasury’s, they would need to do so using funds invested in other assets, which could drain liquidity in the system for those assets. Either way, the risk of heightened market volatility looms large.

Earnings Outlook

With 85% of the S&P 500 reporting as of early May, first-quarter earnings had fallen 2.2%. That compares with the 6.7% drop predicted as of March 31, according to the Connecticut-based financial data firm FactSet Research Systems. We continue to see balance in the discussion of recent trends between companies highlighting softness and those referencing strength and resiliency. Both cohorts referenced the uncertain macro backdrop. A few companies highlighting weakness in March also referenced improvement or stabilization in April.

Given concerns in the market about a possible economic slowdown or recession, have analysts lowered EPS estimates more than normal for S&P 500 companies for the second quarter? The answer is no. During the month of April, analysts lowered EPS estimates for the second quarter by a smaller margin than average.

The consensus earnings forecast for S&P companies over the next 12 months is $219 a share, according to data compiled by Bloomberg. An earnings recession is typically defined as two consecutive quarters of corporate profits below their year-earlier level. Excluding energy, which skewed estimates for the broader index last year due to higher commodity prices and elevated inflation, S&P 500 earnings have been declining year-over-year since the second quarter of 2022.

While many companies across different industries are forecasting a softening of demand, no strong recession indicators are visible. Earnings growth in 2023 will remain challenged despite resilient revenue growth, as companies will find it harder to pass price increases on to their customers thus narrowing margins.

Conclusion: Keep Calm and Hang On

Because these crosscurrents are interlinked, it is difficult to have a strong sense of exactly what will happen going forward. This is especially true with respect to a geopolitical or Black Swan event.

As we expected, the debt ceiling drama is once again being resolved at the last second without the U.S. defaulting, but with some economic effect, nevertheless. We expect inflation will be sticky coming down, meaning a pause for the Fed but no rate cuts this year. We think the economy will slow in the second half of the year and if we have a recession, it will be short and shallow. Since no one is sure what the result of these crosscurrents will be, we expect the market to be volatile.

The best advice is to stick with your investment plan. History suggests that this too shall pass, and investors are less likely to suffer losses over longer periods—especially in a diversified portfolio.

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