U.S. Economy — The Great Uncertainty
— Scott B. MacDonald, Ph.D., Chief Economist
Forecasting the U.S. economy has become much more challenging, increasingly akin to reading tea leaves than analyzing the results of finely tuned algorithmic models. Part of the problem is that the U.S. economy has drifted into the Great Uncertainty, which is being defined by a multitude of contradictory data signals, a greater emphasis on state-led industrial policy (with massive amounts of money being pumped into targeted sectors over a relatively short period of time), and the popping-up of unexpected geopolitical problems. We believe that chances for a recession have grown, but there is still a good chance that the U.S. economy can muddle through a patch of slower growth before recovering and inflation is brought down to around 2 percent and rates will fall later in 2024.
Lost in the recent headlines this October was that the IMF held its annual meetings in Marrakech, Morocco. The IMF's official forecast is worth noting: Growth will continue, but the extended rate tightening by global central banks, key among them the U.S. Federal Reserve, will result in deflationary pressures, tightening bank lending standards, and higher unemployment. World economic growth will cool (see table below). For the U.S., economic growth in 2023 will be the same as in 2022 at 2.1%, but will fall to 1.5% next year.
One of the more interesting takeaways from the IMF meeting came from one of the participants. He said: "They have a lot of different variables coming at them, many of them geopolitical, but the feeling among the IMF's economists is that forecasts are like throwing darts. They just hope they land in the right spot."
That fits for the calls on the U.S. economy. Many Wall Street mavens have been consistently wrong about interest rates through 2023, repeatedly calling for an end to rate rising cycle. The same has been true regarding calls for the next recession: several Wall Street economists called for one in the summer. Now the call is for Q4 2023 or Q1 2023.
In the short term, one of the things to watch is Q3 2023's real GDP growth rate. Some expectations have placed this around 2%-2.5%. The Conference Board is putting the number at 3.6%. However, there are indications that parts of the economy maintain robustness and are giving the economy greater than expected momentum. Indeed, the Federal Reserve Bank of Atlanta is calling for 5.4% real GDP growth for Q3. Other forecasts are higher. Bearing this in mind, will forecasts of a drastic cooling in Q4 and recession predictions hold up?
In all fairness, those calling for recession have good reasons:
Higher interest rates are beginning to hurt. Interest rates hikes have resulted in a major slowdown in new debt origination, which raises questions about those parts of the corporate bond market that need refinancings, which, in turn, is expected to hit corporate bottom lines and cause employment reductions as well as bankruptcies. According to S&P Global, corporate default rates are creeping up and are expected to hit 4.5% in the U.S. by June 2024 (from 3.5% in June 2023). That could roll over in labor markets.
The housing market is being hard hit by higher interest rates. Looking at existing home sales, the market has not been this bad since 2009-2010, the aftermath of the Great Recession. Existing home sales declined by 15% in September. There is a "deep freeze" in the housing market, characterized by rising mortgage rates, elevated home prices and constrained housing inventory. Affordable housing is not on the cards anytime soon, especially if the Federal Reserve raises rates one more time and leaves rates higher for longer (which we believe will be the case).
Pandemic savings have largely been depleted, raising questions over the sustainability of the American consumer in the months ahead. According to Deloitte, household savings rates have dropped from an average of around 9% before the pandemic to around 4.5% in Q2 2023.
There are several other headwinds, which do not easily fit into economic forecasting – the potential for a government shutdown and debt default, the UAW strike (which could spread), the resumption of student loan payments, and the end of any delays for the payment of taxes for 2022 in California.
Corporate earnings fade. Another point of worry is that the outlook for corporate earnings is weakening and could remain subdued through the last quarter of 2023 and into 2024. We caution on this as many companies provide more pessimistic future earnings, which makes it easy to beat earnings.
But there are contradictory data that points to continued economic expansion:
Labor markets remain strong: On October 19, the U.S. Department of Labor announced that the number of Americans filing new claims for unemployment benefits fell to a nine-month low compared to the prior week. While most economists expected a softening in labor markets, what they got instead was weekly jobless claims decreasing 13,000 to 198,000. Unemployment remains at a low 3.8%, reflecting ongoing demand for workers, retirement of baby boomers and smaller numbers of Millennials and Gen Xers. Tightness in the labor market is not going away any time soon, even with greater application of AI and robotics.
Services remain expansive. Although the ISM Manufacturing Index has been on an extended (though improving) downturn, the ISM Services Index has maintained a strong performance. Economic activity in the services sector expanded in September for the ninth consecutive month as the Services PMI came in at 53.6%. As one index respondent in the construction sector stated: "Conditions remain favorable for mechanical contractors. New construction projects continue to launch. We are still seeing opportunities for cost reductions across many commodities. Inventory levels on finished goods remain strong." https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/september/.
Retail sales remain solid. In September, retail sales continued to expand, despite consumers facing mounting economic pressures. According to the National Retail Federation, core retail sales in September were up 0.5% month-over-month and 2.2% year-over-year.
Industrial policy means big bucks and jobs: The major factor for continued growth is structural — the Biden administration's massive push for energy transition, addressing climate change and decoupling with China. Although some of the programs started under the Trump administration, the combination of the CHIPS and Science Act, the Inflation Reduction Act and other programs is pumping over $2 trillion into the economy in a short period of time. Although this federal stimulus runs counter to the Federal Reserve's effort to tighten monetary supply, parts of the U.S. are seeing the construction of battery gigafactories, EV plants and lithium battery recycling plants. The pipeline of federal cash is not going to go away any time soon and will be hard to reverse even with a change of administration.
Looking ahead, the direction in the U.S. economy remains uncertain. Geopolitical risks loom large in this regard, including the threat of a wider war in the Middle East, related spikes in energy prices, a U.S. government shutdown and/or default, and tensions with China over Taiwan. At the same time, energy transition and decoupling from China represent positives for U.S. labor markets and industry, which can overcome the bite of higher interest rates. We look to slower growth in 2023, but not a recession.
Our advice: buckle up, the ride through the Great Uncertainty is only going to intensify, especially with elections looming on the horizon in 2024.