Economic Commentary

It was bound to happen sooner or later. After five straight months of gains, and a year-to-date return of more than 20% through July, the S&P 500 retreated 1.6% in August. Arguably, investors’ optimism may have exceeded reasonable levels after key risks that presented earlier in the year including the debt ceiling and the regional banking crisis broke favorably. With moderating inflation and a resilient labor market, the elusive “soft landing” scenario seemed possible. While stocks and bonds both moved lower in August, the outlook for the economy has continued to improve. This has implications for the future of monetary policy, which will likely play a key role for investors in the balance of the year.

When I said investors may have gotten too optimistic, it’s not just a feeling I have. There are several indexes that track investor sentiment which, oddly enough, tend to be contra-indicators for market performance. In 2022, surveys of investor sentiment reached extreme levels of bearishness, meaning most investors expected stocks to fall further in 2023. Obviously, that hasn’t happened – the S&P 500 has returned 18.7% this year even including the August doldrums. Sentiment improved throughout 2023 into relatively optimistic, though not extremely optimistic, territory in July before settling back into a more balanced posture in August.

Meanwhile, the outlook for US real GDP growth has continued to improve. Economists’ forecasts for GDP growth steadily rose throughout the quarter.

At the start of Q3, the median economist forecasted 0% growth for Q3 and a 0.5% decline for Q4.
By the end of July, those figures increased to 0.5% growth in Q3 and a 0.3% decline in Q4 before returning to growth in 2024.
Today, expectations call for 2.0% growth in Q3 and 0.4% growth in Q4 (all figures are presented as quarter-over-quarter Seasonally Adjusted Annualized Growth Rates).
The “valley” keeps getting shallower and pushed further into the future.

As it stands, economists assign a 60% probability that the US will enter a recession at some point in the next twelve months, down from a recent high of 65%. These recession forecasts now stand in contrast with improving growth forecasts. For economists who provide a binary ‘yes’ or ‘no’ answer to the question of recession, several have changed their opinions this quarter. Remember, the official definition of a recession requires “a significant, widespread, and prolonged downturn in economic activity,” which would be hard to achieve given the current resiliency of the labor market.

The most recent jobs report showcased accelerating job gains and moderating wage growth. The U.S. labor market added 187K jobs in August, up from +157K (revised down from 187K originally reported) in July and +105K (revised down from +209K originally reported) in June. U.S. employment has grown by an average of 235K per month in 2023, moderating from an average of 400K per month in 2022. In essence, we have transitioned from an extremely outsized level of monthly job gains to a more normal and hopefully sustainable level. Wage growth decelerated with average hourly earnings up 4.3% over the last year (down from 4.4% in July) and 0.2% month-over-month (down from +0.4% in July). The unemployment rate rose 0.3% to 3.8%, which remains near a fifty year low, largely owing to an increase in the labor force participation rate. Our analysis suggests it would take a sustained period of monthly job gains below 100K for the unemployment rate to rise meaningfully.

The most recent retail sales report suggests that American consumers, supported by a strong labor market and rising wages, continue to sustain a growing economy despite inflationary pressures and higher interest rates. US retail sales came in better than expected on a month-over-month basis, and posted the strongest year-over-year growth since February. Adjusted for inflation, retail spending in July increased 0.5% compared to June and was unchanged year-over-year.

Turning to inflation, July inflation data, reported in August, showed overall annualized price increases accelerated slightly to 3.2% (from 3.0% in June). The increase was largely due to base effects of a tougher (lower) prior year comparison as the yearly calculation dropped the month of June 2022, when inflation registered 1.3% in a single month as well as peak yearly inflation levels of 9.1%. More reasonable current inflation levels are being driven by declining energy prices, which were down 12.5% compared to July 2022. Meanwhile shelter costs (housing) were up 7.7% from a year earlier. Shelter inflation is driven by housing prices with a lag. Recently, home prices have stalled or even declined, but the CPI calculation is incorporating the period of sharply rising home prices from 2022. Over time, the current period of stable prices will work its way into the shelter component of the consumer price index (CPI), which should help to reduce inflation moving forward.

We’re not out of the woods yet (I’m not sure if we ever truly are) and the monetary policy making environment remains challenging. On the one hand, inflation has come down significantly, but remains far from the Fed’s 2% target. On the other hand, the job market remains firm which means wage inflation has yet to subside. Given the circumstances, officials are grappling with the risks and tradeoffs of further monetary tightening. Inflation remains a primary focus, which could portend more rate hikes, but pushing interest rates too high could drive the economy into a recession. After pausing in June, the Fed moved to raise interest rates by another quarter point to a range of 5.25%-5.50% in July. While the median FOMC projection is for 5.50%-5.75% by year-end, market participants place 50/50 odds on one additional increase in 2023 with rate cuts priced in for early 2024.

Other risks remain of course. After a spike in activity earlier this year following an about face on COVID-19 lockdowns, the world’s second largest economy (China) is experiencing a slowdown due to a worsening property slump, weak consumer spending and rising unemployment among younger populations. Here at home, student loan payments are set to resume beginning in October, potentially creating a headwind for consumer spending. In addition, we continue to monitor the health of the banking sector as higher interest rates are creating a challenging operating environment for banks and August saw a slew of credit rating downgrades and negative headlines.

Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals. On behalf of the entire team, thank you for allowing us to serve on your behalf.