Fed rate hikes: Cause for pause?
Fed watchers see potential for a pause in rate increases, but recent reports show the economy still runs hot.
The latest batch of economic data continue to signal that a recession is on the horizon — we still foresee a downturn unfolding in the second half of the year. The Conference Board’s Leading Economic Index (LEI) posted its 12th straight monthly decline, falling to its lowest level since November 2020. From a year-ago, the LEI is down a sharp 7.8 percent, such performance in the past was consistent with recessionary conditions. Jobless claims are climbing higher, though they remain low on a historic basis. The latest housing readings show the sector remains moribund despite the modest rebound in housing demand earlier in the year sparked by the drop in mortgage rates. First-quarter earnings, with about 18 percent of companies in the S&P 500 reporting, so far have come in better than feared, but according to FactSet overall earnings are poised to decline the most since Q2 2020.
The Conference Board’s LEI has declined to its lowest level since November 2020 and is down 7.8% from a year ago. It signals a hard landing ahead for the broad economy.
Existing home sales declined in March, retracing some of the 13.8% jump in February. Sales are down a sharp 30% from January 2022.
Durable goods orders should post a moderate gain of 1.0 percent in March boosted by a rise in aircraft orders as Boeing received 60 orders on the month, the largest order in three months. However, durable goods excluding transportation should remain weak as businesses place less new durable goods orders due to the softening in economic activity. According to the National Federal of Independent Business Small Business Optimism Survey, only 20 percent of small businesses are planning capital outlays in the next three to six months, continuing a downward trend put in place since October 2021. This comports with the decline in real core new durable goods orders (nondefense capital goods orders less aircraft) since August 2022.
Economic growth remained resilient in the first quarter, with real GDP likely posting a 2.1 percent annualized advance, following a 2.6 percent annualized rise in the fourth quarter. Driving the rise is an expected 4.5 percent annualized advance in real consumer spending, the fastest gain since second quarter 2021. However, the strength was concentrated all in January, as real spending jumped 1.5 percent during that time and since then retrenched slightly in February and March. Still high inflation and interest rates are curtailing consumers’ abilities to spend. Consumer and business confidence remains moribund as signs of an impending recession weigh on the outlook. As such, business investment will remain sluggish, and inventories should detract over a full percentage point from first-quarter growth as companies worked down inventories given anemic aggregate demand. Residential investment will probably post its eighth straight quarterly decline, though the drag on GDP growth should be a more modest 0.3 percentage point versus the 1.2 percentage point drag in the fourth quarter of 2022.
The personal consumption expenditure (PCE) price index, the Fed’s preferred inflation measure, likely rose just 0.1 percent in March, in line with the same increase reported in headline CPI. A reversal in food prices and cooler energy price increases soften the rise in the headline PCE price index. That said, at the core level (excludes food and energy), PCE prices likely rose 0.3 percent as stubbornly high housing inflation boosts the core reading. However, even the core services sector excluding housing, or the super core services measure, should depict the stickiness of inflation among other services. The still rapid pace of inflation is weighing on consumer spending behavior as retail sales and the control group both fell in March. We expect nominal personal spending to be flat in March and adjusted for the rise in inflation, real consumer spending should be down 0.1 percent. Personal income likely rose 0.3 percent in March, supported by the solid gain in employment and wages.
The LEI declined 1.2 percent in March on broad-based weakness across the non-financial and financial sub-components. On a six-month basis, the index registered a 4.5 percent contraction, steeper than the 3.5 percent drop posted in the six-month period through February. Looking at the ten underlying sub-components, only two registered positive contributions in the past six months — manufacturing new orders for consumer goods and materials and the S&P 500 stock index. The gains in the manufacturing new orders for consumer goods reflect a still resilient consumer as the labor market and personal income gains remain solid. The staying power in the equity market reflects investors’ overly optimistic views of the economy, corporate earnings, and of the Fed cutting interest rates by year-end to forestall a hard economic landing. Regarding the latter, our view is that the Fed is poised to raise rates another 25bps on May 4th and hold the fed funds target range at 5 to 5.25 percent throughout 2023. A recession alone is not going prompt the Fed to cut rates, it must be accompanied by a significant slowing in inflation, especially in core services inflation that remains stubbornly elevated.
On the corporate earnings front, despite better-than-feared results over the past two weeks, first-quarter S&P 500 earnings are still expected to contract 6.2 percent from a year ago according to FactSet, which represents the largest decline since second quarter 2020. Earnings are being hurt by slowing demand for goods and to a lesser degree services, still high input costs especially on the labor front, and gradually slowing headline inflation that leads to less corporate pricing power. Earnings should continue to deteriorate throughout 2023.
While lower mortgage rates earlier this year provided a modest boost to home sales, the residential housing market remains severely depressed due to poor affordability, especially for first time homebuyers, and low housing inventories. Existing home sales dropped 2.4 percent in March to an annualized sales pace of 4.44 million units, retracing some of the 13.8 percent jump in February. The pace of sales is down a substantial 30 percent from January 2022, indicative of an ongoing recession in the housing market. Weaker demand is helping to cool prices, with the median sales price of an existing home now down slightly from March 2022, the first reported annual decline since 2012. Looking ahead, we expect mortgage rates to remain elevated over 2023, inventory levels to remain lean, and rising unemployment, as such there is little reason to expect much improvement in housing demand this year.
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The economic and market forecasts reflect our opinion as of the date of this report and are subject to change without notice. These forecasts show a broad range of possible outcomes. Because they are subject to high levels of uncertainty, they will not reflect actual performance. We obtained certain information from sources deemed reliable, but we do not guarantee its accuracy, completeness or fairness.
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