Outlook and Market Review - First Quarter 2023

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The Bureau of Economic Analysis announced a revised annualized GDP growth rate of 1.3% for the first quarter of 2023 following a revised 2.6% annualized rate in the fourth quarter of 2022. Strong consumer spending led the way in the first quarter, adding 2.5% to the growth rate. A reduction in inventory investment accounted for a 2.1% reduction in GDP growth. Much of the support for consumer spending came from a boost to real disposable income by cost-of-living adjustments and a reduction in the savings rate from 4.5% to 4.1%. An exceptionally strong job market has yet to show significant signs of weakening. Payrolls grew by 339,000 in May and the three-month moving average for payroll gains reached 283,000. Job openings also increased to ten million in May. Overall, labor demand continues to exceed labor supply. The Bureau of Labor Statistics reported that wages and salaries increased 5% on a year-ago basis, which roughly matched the inflation rate. Even though job creation expanded at a very strong rate the unemployment rate edged up to 3.7%. The labor market and consumer spending have yet to show the kind of movement that the Fed is looking for. However, the labor market tends lag behind Fed contraction policies by as much as 12 months. In order to make sure that past policies do not push the economy too far toward recession, a pause in June is most likely with a reassessment in July.

The Fed policy of increasing interest rates from approximately zero to a range of 5%-5.25% has lowered inflation pressure overall, but a lot of work remains to reach the 2% target. In the first quarter the headline personal consumption expenditure index (PCE) increased 4.2% and the core PCE (excluding food and energy) increased 5%. Both rates are higher than in the prior quarter of 2022. Inflation data in April were higher than expected with a 0.4% increase in the PCE Index. On a year-ago basis in April, the headline and core PCE deflators were up 4.4% and 4.7%, respectively. Economists in the Survey of Professional Forecasters expect the PCE to be 2.5% and the core PCE to be 2.9% in the fourth quarter of 2023. Both forecasts are based on a weaker economy in the second half of 2023. Going forward, both food and energy prices are expected to be higher. Most analysts expect the Fed to pause in the June meeting to evaluate the impact that the ten prior rate hikes made on the labor market and inflation. History suggests that inflation may be more stubborn than analysts and the markets are predicting.

Consumer sentiment and confidence indicators do not offer a unanimous view, but there are clear signs that the economy is weakening. The University of Michigan Consumer Sentiment Index is consistent with a low growth scenario while the Conference Board’s Consumer Confidence Index is in recession territory. This difference is largely due to the sensitivity of Michigan’s index to the labor market, which continues to be strong. The Index of Leading Economic Indicators has declined to a point consistent with a recession. These indicators are not fool proof, but the economy is likely to barely skirt a recession in the second half of 2023.

Any shock from oil prices or geopolitical risks would tip the odds toward a more severe economic outcome. The economy is likely to slow with a growth rate of about 1% for the remainder of the year. Job growth should eventually slow to less than 200,000 jobs per month and the unemployment rate is likely to continue moving closer to 4%. However, if any of these expectations are not met the Fed will enter into added rate hikes this year. Market expectations of lower rates in the longer-run continue to keep the yield curve very flat.