Economic Update โ First Quarter 2023
Dorothy Jaworski
Senior Vice President
Director of Treasury & Risk Management
Click to view PDF of Economic Update- Quarter 1, 2023
2022 – A Year to Forget
If you were an investor in 2022, it is a year you will want to forget. We saw some of the worst stock markets in years (the lockdown aside as stocks fell and recovered quickly). The Dow was down -9% last year, the S&P 500 was down -19%, and Nasdaq was down -33%. Bond investors had a miserable year, too. The Federal Reserve started its inflation fight, raising rates by 425 basis points between March and December. This led to the worst bond market performance since the 1800s (according to Vanguardโs CEO). The US Treasury index was down -12.5%, and the Barclays and Bloomberg indices were both down -13%. It was a year to experience huge bond price changes, not seen in almost 15 years, with prices down -10%, -15%, -20%. All bonds purchased during the low rate environment from 2010 to 2021 found themselves grossly underwater. The aggregate amount of rate hikes and the speed at which rates changes surpassed even the +300 basis point Fed tightening in 1994. As I write this in late February, itโs not over yet: we are experiencing another large selloff as stronger than expected economic data took center stage, with yields rising another .40% to .50%. Stocks were not immune to the selloff, as they fell-5% this month.
Inflation
โInflation is always and everywhere a monetary phenomenon.โ Milton Friedman
The money supply most targeted by the Fed, or M2, started 2022 by growing +12% year-over-year. It ended 2022 by falling -1.3% year-over-year, which is the first negative print in many years. M2 operates with a 12-month lag on inflation, so inflation should fall. The Fed actions consisted of increasing rates by 425 basis points last year and allowing their balance sheet to decline by $95 billion each month This is known as Quantitative Tightening, or โQT,โ and has likely caused the equivalent of another 100 basis points of rate hikes. M2 at -1.3%, when the โnormalโ average is +3% to +5%, is reason enough to pause the rate hikes. My concern is that the Fed is not pausing enough to assess the effects on the economy of actions already taken.
We all admit that inflation is too high and we all hate it. The Fed and the government stimulus were part of the cause. Now we have the Fed trying aggressively to be the cure. The Fed must choose the lesser of two evils- the fight against inflation saves hundreds of millions from the harmful effects of rising prices versus recession which will impact under 10 million people as unemployment rises.
Inflation is still high. Consumer prices, or CPI, which peaked at +9.1%, is +6.4% in January and the core (excluding food and energy) is +5.6%. Producer prices, or PPI, which peaked above +10%, is +6.0% with the core at +4.5%. Personal consumption expenditures, or PCE, found in the GDP report, was +3.7% in 4Q22 and +4.3% in 3Q22; core PCE was +4.3% in 4Q22 and +4.7% in 3Q22. These measures are going in the right direction. The monthly PCE deflator (A Fed favorite from the personal spending report) was +5.4% in January and +5.3% in December; the core deflator was +4.7% in January and +4.6% in December. Clearly, Januaryโs numbers broke the declining trend. The Fedโs target for core PCE is +2%; CPI would be about .50% higher at +2.5%. Despite the setback in the January deflators, there is still evidence that inflationary expectations are stable. The university of Michigan survey shows respondents believe inflation will be +4.1% in the next year and +2.9% for five to ten years.
Fed Chairman Powell indicated that we are in a disinflationary period for goods, due to excess capacity and elevated inventories, but services and housing rental costs are the primary concern. The latter numbers make up about 40% of CPI and have yet to decline in any meaningful way. There are exceptions to falling goods prices, most notably food prices, which remain high. Just look at the price of eggs at $3.59 a dozen in January versus a year ago at $1.72, for a year-over-year increase of 109%! We can blame bird flu for this!
Labor markets are still tight with the unemployment rate at 3.4%. Wages rose +4.4% for the year in January and this number has been declining. Labor is still in short supply and companies continue to have difficulty hiring, as the job openings to unemployed persons ratio is high at 1.7 times. The Fed would prefer to get wage growth down to +3.5%, which would consist of their inflation target of 2% plus 1.5% in productivity (if we can reliably and consistently achieve this).
Economy Not Cooperating
The economy, especially the consumer, is not cooperating with the Fed, who is raising rates to slow demand. They want the economy to slow dramatically to cool off inflation. But consumer spending in January was a surprise, at +1.8%, after declining by -.1% to -.2% in the last two months of 2022. Retail sales also surprised in January, at +3.0%, following two months where sales declined by -1.1% each. Consumers are benefiting from a strong labor market where Januaryโs payroll growth was reported at +517,000 for the month (if you believe in super big seasonal adjustments) following December growth of +260,000. If numbers like these continue, it may put the Fed back on the warpath, with outsized rate hikes again.
While the consumer looks healthy, some sectors of the economy have turned down, including manufacturing, real estate markets- both residential housing and commercial properties, and trucking/transportation. Inventory building was a big part of 4Q22 growth, so there may be attempts to cut prices, but only if demand is lower. The Fed desperately wants the economy to weaken. They want consumer spending to slow. They want housing price increases to slow and for rental costs to decline. They want unemployment to rise and wage growth to slow. They want corporate revenues to decline to trim spending. These are all the conditions for NBER to declare a recession. Most economists believe that only a recession will definitively bring down inflation.
And what if there is a shock of some kind? One example would be a debt ceiling negotiation crisis, where lawmakers will not increase the debt ceiling. If this would be the case, chaos would ensue for the pricing of all bonds which naturally price above a risk-free yield curve. What if Treasuries were no longer considered risk-free? Throw out the CAPMs!
If the economy does not slow enough, the Fed may raise rates more than the total .50% for 2023 that they projected in December, 2022, with Fed Funds getting to 5.25%. But be skeptical; these are the same people that projected three hikes, for a total of .75%, in December, 2021 to get Fed Funds to 1.00% in 2022. Instead we got to 4.50%, a massive standard deviation miss by any measure.
Leading Indicators
We donโt know what the future holds, but several economic indicators can give us clues as they are designed to project 6 to 9 months into the future. The message I am getting is a weaker economy and declining inflation, thanks to higher rates and a declining M2 money supply.
The index of leading economic indicators, or โLEI,โ has had a string of 10 months of negative readings (one month was flat). The latest report showed January at -.3%, following -.8% in December and -1.1% in November. We have never had this long a duration of declining LEI without a recession.
The FIBER leading inflation index began to decline on a year-over-year basis in May, 2022, and has continued to do so through January, which was -5.9%. Alas, the index itself ticked up in December and January, very moderately. The index is 6.4% below the recent high of December, 2021.
Stock marketsโ price declines are flashing a warning for projected recession, predicting that revenues and profit margins will be harmed by higher rates and declining activity. While the S&P 500 is still up +3.2% so far in 2022, it is down -5.2% from its recent high on February 2nd. Everything changed for stocks, and bonds too, during February.
The yield curve remains inverted in both key maturity points that we follow: 10 years less 3 months is -.85% and 10 years less 2 years is -.86%. I believe that the yield curve, along with the confirmation of LEI, is the best historical predictor of recession. Inversions also operate with a lag of 6 to 18 months and averaged -1.16% preceding the last four recessions. A look at history shows this is the ninth inverted curve since 1968 (measured by 10 year less 3 month) and it is eight for eight in predicting recessions. Itโs is also interesting that inflation expectations are inverted, too, per the University of Michigan survey, at 4.1% in year one and 2.9% in five to ten years.
Economist surveys show 61% believe we will have a recession in 2023. However, average economist and Fed estimates for 2023 are for real GDP of +.5%, slow but not negative, even with recession forecasts. Remember my old warnings about recession becoming a self-fulfilling prophesy, especially when 95% of corporate CEOs surveyed believe we will have one (according to the Conference Board).
2023
This year is off to a volatile start, with stocks and bonds alternating between rallies and selloffs, the latter of which is hitting us in February as investors saw the stronger than expected data releases for employment and consumer spending, which we know the Fed will hate. We saw the commotion caused by a Chinese spy balloon, that traveled over our country before being shot down by an F-22 fighter jet. The incident was quickly followed by shooting down several more โobjectsโ over Alaska and Canada. And our Eagles came up just three points short in the Super Bowl. It was disappointing after such a great season. And there has been much publicity about ChatGPT and other artificial intelligence โchatbotsโ and their research and writing abilities. Chatbot, are you our future? Answer: โMaybe.โ Thanks for reading!
Dorothy Jaworski
Senior Vice President
Director of Treasury & Risk Management
