It has been a challenging year for many with high mortgage rates eroding housing affordability, inflation putting a financial strain on family budgets, and investment portfolios decreasing in value. Various market and economic indicators have risen to levels not seen in years. The economy was hit with another steep 75-basis point (0.75%) increase to the Federal Reserve’s target discount rate at the November meeting and is pricing in a further 50- basis point hike in December at an 80% probability. The Fed clearly has a challenging road ahead, but there are finally some concrete signs in the economy indicating that the Fed has made progress. This was echoed in Jerome Powell’s most recent comments, sending a wave of optimism through the markets. While there are still some concerning signs indicated by the data, a less hawkish Fed is a clear sign of where we are in the tightening cycle.
The revised print for Gross Domestic Product (GDP) was released on Wednesday, November 30th and provided somewhat mixed signals. The number came in above expectations at a positive 2.9% year-over-year growth. While a positive print in a hiking cycle may indicate stronger than desired growth, much of this was driven by an increase in exports, increases that will likely fall off in the coming months due to weakening global demand and the strong dollar reducing foreign purchasing power. Spending on goods experienced a 0.2% decline, driven mainly by declines in durable goods (washing machines, computers, vehicles, etc.). Conversely, services saw a 2.7% increase, and government spending saw its first positive increase since the second quarter of 2021 of 3%. Altogether, the GDP release implied that goods spending has declined, but service spending has remained robust.
Balance Sheet Health
The overall financial health of households, businesses, and state and local governments has made things a bit more challenging for the Fed. Greater financial health increases the difficulty of the Fed’s job because higher savings levels reduce overall interest rate sensitivity. Nick Timiraos, known as the Fed Whisperer, wrote an in-depth piece on this issue, stating that households are “healthier than on the eve of any U.S. recession since the 1950s.” It is not just households; businesses spent 2021 collecting record profits and improving their balance sheets with record low-rate debt issuance. State and local governments used historic federal aid to improve balance sheet health. Corporate debt also has time on its side. There is no wall of maturing debt that will require refinancing due to the boom in issuance over the last two years as companies took advantage of low rates.
Labor markets continue to be one of the toughest challenges for the Fed as they act to ensure that we avoid a wage-price spiral. We are dealing with the residual effects from the pandemic putting upward pressure on wages and structural effects from a more highly educated population. In October 2022, the twelve-month average nominal wages growth was 6%, the highest rate thus far in the 21st century. Taking a more granular picture, low-skill workers’ average wage growth was 6.7% vs. 5.7% for high-skill workers. A large portion of the wage gains are occurring in the leisure, hospitality, transportation, and retail industries, areas where the job market has remained extremely tight. This observation parallels both an increase in service spending and a structurally smaller low-skill workforce. The number of job openings has fallen since its peak in March but remains well over the comparable pre-pandemic period. Even with the Fed’s aggressive tightening, job openings rose over 4% in September, highlighting that growth in this area remains much stickier than in others. Labor markets have remained a difficult area for the Fed and will be a closely watched indicator going forward.
Finally, inflation, one of the most closely watched indicators, has provided positive signs of slowing. The most recent inflation print came in lower than expected at 7.7%. Falling energy prices have greatly alleviated some stress, seeing negative month-over-month (MoM) prints for three of the last four months. Food prices are still seeing positive MoM changes, but the rate of change is slowing; price changes have fallen from above 1% to .6% in the past three months. Other areas like medical costs, used cars, and clothing fell in October. Housing costs will likely follow the already apparent softening in the housing market. While the MoM change in shelter appears to be increasing, it is well known that there is a lag in CPI housing. Unfortunately, prices of many core, non-food and energy, goods remain stubbornly high. However, there are signs that this pressure could subside in the coming months. Supply chains seem to be easing. Ocean shipping costs have fallen over 60% from their peak, but land transportation costs, while falling, remain above historical levels. All said, the inflation figures will likely show signs of easing pricing pressures over the coming months.
Powell’s most recent remarks on Wednesday, November 30th have reaffirmed the notion that the Fed’s actions are finally influencing the economy. He explicitly stated it would make sense to begin moderating the pace of rate increases, indicating we are closer to the end than the beginning of the tightening cycle. Stocks enjoyed a relief rally after his remarks, with the tech sector leading the rally. Given the evidently more dovish sentiment, the worst of the Fed-induced pain in the markets should be near its end. The strength of corporations and consumers should help the US economy weather a modest slowing of growth in 2023 and will likely result in an overall less volatile investment environment.