4Q22 Market Outlook

We Expect the U.S. to Narrowly Escape Recession in 2023

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

Summary

• The Federal Reserve is the biggest remaining risk to a soft landing
• Unlike past recessions, GDP, real personal income, employment, and falling inflation support our position
• Debt service as a percentage of disposable income is at 40-year lows. When combined with improving real personal income, consumer spending could provide better-than-expected results

2023 Economic Forecast
We are projecting that the world’s largest economy will narrowly avoid a recession as inflation fades, gross domestic product shows slower growth, and unemployment increases but not enough to declare a recession.

We estimate there’s a 35% probability that the U.S. will tip into recession over the next year, an estimate that’s well below the median of 65% among forecasters in a recent Wall Street Journal survey. However, recession risks remain, and the Federal Reserve will largely determine if we can achieve a soft landing by not increasing the Federal Funds rate above the 4.75-5% range or keeping it there too long.
The U.S. may avoid a recession in part because data on economic activity is nowhere close to recessionary. GDP grew 2.6% (annualized) in the third quarter, real (after inflation) disposal income is rising, and the country continues to add jobs.

Finally, as we have discussed, there are fundamental reasons centered around falling housing and transportation costs for the continued reduction in inflation. This morning’s surprise CPI report showing that inflation fell to 7.1% in November from 7.7% in October was no surprise to readers of these notes. We will find out tomorrow during Fed Chairman Powell’s press conference what the Fed is thinking now, but I expect their narrative of “higher from here and staying there for longer” will not change much at this time. They’ll be encouraged but will need to see continued improvement in inflation.

Outlook for Consumer Spending
Real personal income (adjusted for inflation) is springing back from the drop during the year’s first half when fiscal tightening and a sharp increase in inflation took their toll.

Real disposable income should increase by more than 3% over the next year. Even as interest rates have tightened and are subtracting about two percentage points from gross domestic product growth, the rise in real income will likely be the more potent force next year, providing better-than-expected consumer spending outcomes.

Employment
During previous tightening cycles, especially during the 1970s and early 1980s, central bank tightening to contain inflation caused significant increases in unemployment. However, the reopening of supply lines and increased demand in the job market has shown up as an unprecedented increase in job openings rather than a further reduction in unemployment which stands at 3.7%.

Openings surged between 2020 and 2021 as employers tried to keep up with the most substantial economic recovery amid ongoing covid concerns and exceptionally generous unemployment benefits. But employment as a share of the population only rose to several percentage points less than the pre-pandemic level, not above.

Inflation
Expectations for long-term inflation have come down significantly. They are presently trending towards the 2% inflation target according to surveys of households and economic forecasters, as well as the expectations implied by inflation-protected bonds as evidenced by the 5-year breakeven inflation rate which now stands at 2.2%.

The expectations for short-term inflation are still well above the 2% target, but much of this reflects the spike in commodity prices and should wane as these prices level off.
For example, wholesale gasoline prices have dropped below those of a year ago. As a result, the transportation component of inflation will continue to be disinflationary in the CPI results and will take larger bites out of inflation was we start comparing 2023 levels to the highly inflated period between February and November of 2022.

Fed Wage Concerns and Rate Cuts
The Federal Reserve isn’t likely to turn relatively dovish as inflation decreases. Instead, we expect inflation-adjusted incomes to continue to recover, which will require the central bank to ensure financial conditions stay tight enough to keep economic growth below its full potential to contain inflationary wage growth.
The first Fed cut in the median hiking cycle has come roughly six months after the last hike. Moreover, with a resilient labor market and still elevated inflation, we don’t see any rate cuts in 2023 unless the economy enters a recession.

Reports of a Consumer Credit Crunch are Overstated
Many forecasters have reported the increase in consumer credit as a harbinger of bad outcomes. But let’s widen out the lens. With a longer term perspective, you will see that household debt service payments as a percent of disposable income are still below pre-pandemic levels and appears to be flattening out as household marshal their resources and spending in response to all the news they are hearing about a potential slowdown in the economy.

Most importantly, household debt service payments as a percent of disposable income are at 40-year lows. Every recent recession has seen consumers heavily indebted coming into the economic slowdown which resulted in a pronounced reduction in consumer spending which exacerbated the economic slowdown. Presently, households are in great shape having paid down debt with their pandemic stimulus funds.

The combination of increasing real (after inflation) disposable income and low debt service obligations relative to income will lead to better-than-expected consumer spending as the economy continues to slow down in the face of higher interest rates. This underappreciated point of view is another reason that we are cautiously optimistic about the prospects of avoiding a recession during 2023.