October 9, 2023
After two big steps forward in the first half of the year, the third quarter was arguably a half step back for the markets. The S&P 500 advanced more than 7% in the first quarter and more than 8% in the second quarter before retreating 3.4% in the three months ended September 30. Core bonds also backtracked in the third quarter as interest rates continued to rise. Still, it’s hard to feel too bad about a year-to-date return of more than 12% for domestic stocks and a neutral outcome for bonds. It’s even harder to feel bad about the last twelve months which included more than a 19% total return for the S&P 500 and a 1% return for bonds.
Throughout most of 2023, the outlook for real US GDP growth has continued to improve. Economists’ forecasts for GDP growth rose steadily throughout the third quarter, but a confluence of potential headwinds may complicate the picture heading into the fourth quarter. Entering Q3, the median economist forecasted 0% growth for Q3 and a 0.5% decline for Q4. Today, economists believe the economy likely expanded by 3.0% in Q3 and are forecasting 0.5% growth in Q4 (all figures are presented as quarter-over-quarter seasonally adjusted annualized growth rates). Over the last several months, the economic “valley” has gotten shallower and pushed further into the future.
Looking to the fourth quarter, three different events are converging in a way that could threaten continued growth. These events are:
- The scheduled resumption of student loan repayments.
- A historic autoworkers strike.
- A potential federal government shutdown.
This trifecta has the potential to hamper fourth quarter growth by a little, or a lot, depending on the extent of the combined fallout.
The potential impact of resuming student loan repayments is perhaps the easiest risk to quantify. Average monthly student loan payments are estimated at $200-$350 per month per borrower, which equates to total additional collections of $5B-$6B per month, or $60B-$70B per year. If we assume that every dollar used to repay student loans would have otherwise been spent (not saved, not invested) then we might expect to see a 0.4%-0.5% reduction in annual personal consumption expenditures. This reduction which would have a direct impact on the 68% of the US economy driven by consumer spending.
The United Auto Workers’ (UAW) strike against the Big Three automakers is likely to have ripple effects across the economy, but it is much harder to gauge the severity of the impact. In large part, the answer will depend on how big the strike gets and how long it lasts. First order impacts to the economy include reduced spending by striking workers who aren’t receiving paychecks. As of this writing only about 25,000 of the 150,000 UAW members are actively on strike, leaving significant room for expansion and even spillover effects into the industry’s broader network of suppliers. Concurrently, renewed supply chain disruptions for the Big Three would likely have an inflationary effect on new and used vehicle prices.
Lastly, the economic impact of a potential government shutdown will depend mostly on how long it lasts if it happens at all. With only hours remaining before a shutdown that would have begun on October 1, House Republicans and Democrats struck a surprise deal to fund the government for another 45 days – avoiding a shutdown, at least for now. While not a permanent solution, the deal buys more time for the House and Senate to complete further funding legislation. It is important to distinguish a government shutdown from the debt ceiling standoff that was resolved in May. The potential impacts from government shutdowns are much milder than the potential impacts from the federal government failing to make timely payments on its debt and other obligations. To assess the potential impact of a shutdown, keep in mind that government spending represents about 17% of the US economy and about 25% of the federal government is affected by the shutdown. In addition to the direct impact on government spending, there can also be secondary effects in the form of delayed private investments (18% of economy) amid policy uncertainty, and lower consumer spending due to lower consumer confidence and weaker spending from affected government employees. All in, the White House’s Council of Economic Advisers estimates that a federal government shutdown can reduce economic growth by about 0.13% per week. The longest shutdown in history lasted 34 days from late 2018 to early 2019 while most have been resolved within a week.
Our analysis suggests that, collectively, these three events could negatively impact fourth quarter growth by anywhere from 0.25% to 1.5%. Current forecasts call for quarter over quarter deceleration of about 2.5%, but it is not clear how much of the anticipated slowdown is attributable to these or other factors. Fortunately, the labor market remains strong, the consumer remains on reasonably solid footing, and inflation is well off of peak levels.
The most recent jobs report showcased accelerating job gains and moderating wage growth. The US 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. US 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 most recent retail sales report came in better than expected on a month-over-month basis as higher gasoline prices offset lower spending in discretionary categories. In real terms, retail spending increased 0.3% compared to July, but was down 1.2% year-over-year. While the report was still indicative of a relatively healthy consumer, it also highlighted the implications of higher prices at the pump for discretionary budgets.
Turning to inflation, August inflation data, reported in September, showed overall annualized price increases accelerated to 3.7% (from 3.2% in July), but remain much improved from the June 2022 peak of 9.1%. At +7.3% year-over-year, shelter costs decelerated from +7.7% in July and a peak of 8.2% in March 2023. We continue to keep a close eye on shelter costs, which represent nearly one third of the consumer price index (CPI) and tend to impact the index 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, which should help to reduce measured inflation moving forward.
Considering all the points discussed earlier, the monetary policy-making environment continues to be exceptionally tenuous. In their efforts to facilitate a soft landing, Fed officials must continue to pursue a 2% inflation target, possibly keeping interest rates high for an extended period, while considering external factors like student loan resumption, the UAW strike and the government shutdown. In September, policymakers maintained the current Federal Funds Rate at 5.25%-5.50%, as expected, but signaled one more increase coming in 2023 and moved median rate forecasts 0.50% higher for 2024 and 2025. The “higher for longer” message was not well-received by the markets. As it stands, the market is split 50/50 on whether another hike is coming in 2023 and pricing for cuts in 2024 down to 4.50-4.75% – below the median Fed forecast of 5.00-5.25%.
We will continue to monitor headline events and economic health heading into the fourth quarter and look forward to sharing our perspective as the narrative evolves. As always, we encourage investors to lean on discipline and the benefit of a long time horizon during periods of uncertainty. On behalf of the entire team, thank you for allowing us to serve on your behalf.