1Q23 Market Outlook

The Resilient U.S. Economy & Implications for Fed Policy

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com

Summary:

• Despite a variety of adverse factors, our economy rolls on.
• Most mortgages are now fixed, muting the effects of higher interest rates.
• Consumer demand is still growing and has shifted to services which are not as interest rate sensitive as consumer goods.
• Shrinking labor supply has kept employment high.
• When all factors are considered, a “no landing” scenario is starting to take shape.

Another Economic Surprise

Last week, in a never-ending succession of economic surprises, the Personal Consumption Expenditures Price Index (PCE), the preferred inflation measure of the Federal Reserve, came in hotter than expected with a 0.6% jump from the December reading. Of course, no one should have expected that inflation would come down linearly, but losing ground to inflation was disappointing.

The year began with the hopeful anticipation that the Fed would cease interest rate increases and allow the lag effect of interest rate increases to continue to reduce the adverse effects of inflation on our economy. Unfortunately, those hopeful beliefs were dashed in February in the face of these persistent inflation readings.

However, despite the Ukrainian war, geopolitical tension between the U.S. and China, inflation, and tightening monetary policy, our economy rolls on steadfastly. Consumer spending continues to rise, the unemployment rate fell below its pre-pandemic low, and the economy grew 1% in the 4th quarter of last year.

Understanding the Strength of the U.S. Economy

Understanding the strength of the U.S. economy is critical to predicting the outlook.

The old rules do not apply the same way they did before the Covid-19 pandemic and many factors played a role.

For example, fiscal stimulus has provided a lift for much longer than expected. In addition, excess consumer savings and strong employment provided demand for consumer services which still has room for additional growth.

Next, years of low-interest rates have provided U.S. households the ability to refinance debt at low fixed rates which leaves them shielded from the impact of the Fed’s interest rate increases.

The result is an economy that has not reacted entirely to the policy tools designed to slow inflation.

The “No Landing” Economic Scenario

The positive economic data has provided hope of a “no landing” scenario in which the economy continues to expand, but inflation remains higher for longer than expected.

Interest rates will likely stay higher for longer to tamp down stubborn price growth. That means the risk of an economic recession remains a possibility due to the increased potential of a Fed error.

Higher Interest Rates are Not Working to Reduce Economic Activity

When the Federal Reserve raises interest rates, it’s attempting to slow consumer and business activity which reduces inflation by making things more expensive. Big-ticket items like homes and cars start to cost more because buyers are paying higher rates for their mortgage or auto loan.

Years of low-interest rates, dating back to the aftermath of the 2008-09 financial crisis, have allowed for a transformation of much of the debt in the U.S., both household and corporate, away from variable rates that rise as the central bank tightens policy.

That meant that even as the Fed raised interest rates eight consecutive times over the past year, most businesses and households were slow to feel its impact.

The Current Structure of Mortgage Debt

Before the 2008-09 financial crisis, nearly 40% of mortgages were variable rate, so Fed rate hikes drove payments up and served to reduce household spending.

Today, that share is just 10%, meaning most homeowners hold mortgages at 15 or 30-year fixed rates, and aren’t being heavily affected by rising interest rates. In addition, rates on student debt payments and most auto loans are similarly locked in.

The graph below shows that households are now at all-time lows of debt service on all consumer loans (mortgage, car, education, etc) as a percentage of disposable household income. Notice the two downward spikes during the pandemic which coincided with the two major stimulus packages. We now appear to be settling back into the historically low percentage of less than 10% of household income allocated to servicing debt.

Chart, line chartDescription automatically generated

The changing debt profile allowed consumers, still cash-rich from the flood of fiscal stimulus unleashed in the wake of the pandemic, to keep up their soaring spending on services in particular, as Americans shifted away from the goods they had been buying during Covid shutdowns.

The behavior change is another reason the Fed‘s rate hikes appear to have a limited impact in that consumer spending on services isn’t affected as heavily by higher rates as demand for big-ticket items and other goods.

Higher Demand for Consumer Services

Also lifting consumer spending is pent-up demand. These days we do not worry as much about Covid and its restrictions that had limited spending on services. As of December, services spending remained 1% below its pre-pandemic trend suggesting the sector still has more room to grow.

But spending has also been provided by excess savings built up partly because of the more than $5 trillion the government spent on stimulus programs in response to the pandemic.

That government stimulus, a sum equivalent to roughly a quarter of the U.S. gross domestic product, has continued to stimulate the economy years after the first packages were passed. Moreover, some programs are only now winding down, while other spending is just beginning to work its way into the economy.

Employment

Service industries are labor-intensive, so as consumer demand soared, employers staffed up in response. This kicked off a cycle of recovery where more jobs pushed total income higher, which allowed for further spending and, as a result, more jobs.

A shrinking labor supply, as seen by the low labor force participation rate below, has made hiring difficult, prompting employers to hoard workers they might have laid off in a slowing economy.

Graphical user interface, applicationDescription automatically generated

When All Factors are Considered

Each of these factors has contributed to creating an economy that so far is seemingly immune to the harmful effects of high inflation and a rapid pace of monetary policy tightening. And it all helps to explain how an economy whose days were numbered a year ago has so far been able to avoid a long-anticipated recession.

The arguments favoring the “no-landing” view encompass many of the fundamentals that have carried the economy so far. Consumers, broadly speaking, remain healthy. Excess savings, though somewhat depleted, will continue to fuel spending. And the labor market shows almost no signs of cracking, having added more than a half-million new jobs in January alone.

However, the harder the central bank must work to see the reduction of inflation, the higher the risk rises of a policy error that forces a recession.

Portfolio Construction

For now, stronger-than-expected consumer spending and economic growth favor consumer cyclical stocks, but pricing power is critical. Accordingly, we invest in firms that can pass along higher costs and maintain and expand profit margins.

Growth companies will come back into favor on a sustainable basis when the market becomes convinced that the end of Fed tightening is in view. The run in January was partly predicated on this belief, but sooner rather than later, the Fed will agree that a pause in monetary tightening is in order.

But only growth companies with reasonable valuations, strong cost controls, current earnings, and strong balance sheets will be invited to the growth rebound. Young growth companies with distant earnings that still need access to capital will find tough footing in a higher interest rate environment.