Chugging Along
At the beginning of this year, many economists forecast a significant recession to materialize by now. Instead, the economy has continued to grow despite the strong headwind from much higher interest rates. With inflation waning and continued broad-based momentum in the economy, it is possible that the Federal Reserve may be on its way to successfully engineering the unicorn of economic maneuvers, a “soft landing,” whereby price increases are reduced close to the Fed’s 2% target without causing a recession. While it remains premature to confidently predict that ideal outcome, consensus opinion now anticipates a mild recession at worst. This shift in thinking is a major force behind the strength in stocks this year.
Economic growth has surprised to the upside this year. GDP grew at a 2% annual rate in the first quarter, driven by strong consumer spending. Second quarter growth was even stronger at 2.4%. The Fed’s GDPNow model is tracking real GDP growth at 5.8% for the third quarter. Surprisingly, even pockets of the economy sensitive to higher interest rates, such as the housing market, have continued to grow. Higher interest rates have been much better absorbed by the economy than most would have anticipated.
While the economy continues to be resilient, inflation has slowed significantly. Consumer prices rose 3.2% year-over-year in July, slower than expected and down from a peak of 9.1% in June of last year. Excluding shelter costs, June’s inflation rate plunged to just 2.0%. Rent inflation is a large component of the index and tends to lag in the CPI calculation as it reflects rents on all outstanding leases. Rental price increases peaked last year and have slowed dramatically since then. Therefore, the more current data should help drag down inflation readings in coming months.
Meanwhile, the Fed continues to believe that the battle against inflation rages on. Not content with having raised interest rates ten times since March of last year, the Fed increased rates again last month by another quarter-percentage point. With inflation down substantially and continuing to recede, peak interest rates are likely not far off. However, the Fed says it intends to hold rates high well into next year. Time will tell if that is required. Investors are anticipating rate cuts to begin next year.
Recent strength in the economy has simultaneously benefited from and supported the job market. The Fed’s interest rate hikes were enacted to slow economic growth to tackle inflation. Historically, the knock-on effect has been higher unemployment and slower wage growth. While more jobs are available than people to fill them, the gap between the two has shrunk, bringing labor supply and demand into better balance. Consequently, the unemployment rate remains low at 3.5% with average hourly earnings increasing 4.4% over last year.
Businesses are also finding the situation is not as dire as predicted. Earnings in the first quarter of this year were slightly lower than the same period of the prior year, however, they were projected to be considerably worse right up until they were released. Second quarter earnings have followed the same pattern: low expectations and upside surprises exceeding historical norms. After troughing in the second quarter, earnings are forecast to turn slightly positive in the third quarter and then become much more robust in the final quarter of this year and continuing into next year.
Odds of a recession have gone down considerably. If our economy could speak, it might quote Mark Twain: “Reports of my death have been greatly exaggerated.” Not surprisingly, investors have again gravitated to the stock market. As inflation continues to abate and interest rates eventually head lower, additional gains will likely follow.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
