Outlook and Market Review - Fourth Quarter 2022

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The U.S. economy grew 2.1% in 2022 according to revised estimates by the Bureau of Economic Analysis. The fourth quarter 2.7% growth rate followed rates of 3.2%, -0.58%, and -1.63% in the prior quarters. The largest contributor to fourth quarter growth was inventory investment. Final Sales of Domestic Product, which adjusts for inventory investment, grew only 1.2% in the fourth quarter. Fixed investment, which is the most interest sensitive component of GDP, declined for the third quarter in a row. The economy is providing uneven signals early in 2023. Leading indicators are in a recession pattern but sentiment indicators and the ISM manufacturing index are not moving in unison. The labor market and overall economic performance continues to be too strong to lower inflation significantly. It now appears as if the Fed must deal with both inflation and the consequences that higher rates have on bank balance sheets. Even though defaults at Silicon Valley Bank and Signature Bank were due to poor management, it is not yet clear if there will be a game-changing contagion effect in the financial system.

The labor market remains very strong. Payrolls gained an average of 315,000 jobs per month in the fourth quarter, which will keep the Fed on a path of raising rates. The unemployment rate edged up slightly from a thirty year low of 3.4% to 3.6% in February of 2023. Wage growth in the fourth quarter was just over 4%, exceeding the 3.5% benchmark that would be more in line with an inflation rate target of 2%. Sluggish productivity combined with wage growth pushed unit labor costs up 6.5% for the year. Lower unit labor costs are necessary to make significant reductions in the inflation rate.

The Fed increased the Fed fund rate by 425 points over the past year and will likely continue raising rates to at least 5% by the end of the year. Even so, the economy is still a long way from achieving an inflation target of 2%. On a year-ago basis the PCE inflation rate was 5.3% in January following a 5.4% rate in December of 2022. The Consumer Price Index (CPI) increased 6.3% and 6.4% over the same period. Consumer spending is slowing as savings accumulated during the COVID shutdown are dwindling and wealth is falling due to stock market losses. The housing market continues to decline as borrowing costs are rising while housing prices remain relatively high. Households are increasing the use of debt to keep up with higher prices and higher rents. Existing fixed income assets are losing value as market rates rise, which is especially damaging to balance sheets of financial institutions holding fixed rate mortgages and long term bonds.

Looking forward, there are still concerns for a recession later in 2023. Risk factors are all on the down side. Both the IMF and World Bank recently lowered global growth estimates. Central banks are on a unified path of raising interest rates but government deficit spending continues to work in the other direction. The U.S. economy is highly levered at all levels with rising consumer debt now taking on a key role. The combination of higher prices of goods and services along with higher interest rate charges for debt have pushed outstanding balances near record highs. When the labor market cools there will likely to be significant increases in debt defaults. The Fed is walking a tightrope between too much or too little contraction to achieve a balance between full employment and low inflation. A soft landing for the economy will be difficult.