Our Q2 outlook called for an economic downturn commencing in 2024. However, based on the strength of more recent data, we are revising our forecast. It now appears that the Fed may succeed in engineering a soft landing, a feat that has eluded the central bank in the past. To be sure, there are still headwinds facing the economy, and we can’t ignore the fact that the yield curve remains inverted, as it has been for more than a year. However, there is no cause-and-effect relationship between an inverted curve and recessions; in other words, the bond market can be wrong, and it has been wrong before. And conditions today are different than in the past, as some sectors of the economy are still recovering from the pandemic shutdown (notably, employment).
Yield Curve and Monetary Policy:
The two-year Treasury yield has risen by more than 20bp since the end of Q2 at this writing, to the highest level since 2007. The ten-year yield is also at the highest level since that year, having increased by more than 55bp. As noted previously, the yield curve remains inverted, with the ten-year yield exceeding the two-year yield by more than 70bp.
The FOMC hit the pause button at its most recent meeting, but Chairman Powell’s comments were somewhat hawkish. He indicated that future policy decisions would be data-dependent, and that the committee would consider the “totality of the data,” meaning they will look at not only inflation, but the strength of the economy and employment trends. As a result, Fed funds futures immediately priced in more than a 40% probability of one more 25bp rate hike by the end of 2023. However, the futures market is pricing in accommodation by mid-2024, a further signal of market expectations of emerging economic weakness.
Housing Market Trends:
Another shift in our outlook is that we no longer consider the U.S. housing market in decline. While the S&P/Case-Shiller Composite Index remains negative on a year-over-year basis as of June, and ten of the 20 markets in the index are negative year-over-year, all 20 markets posted monthly gains in May and June, and 19 of the 20 posted gains in April. More than half the markets in the index have seen monthly increases since February.
We should note that these increases are on a seasonally-adjusted basis, and in a few instances, the gains are solely due to the seasonal adjustments. Also, the gains appear to be due to limited supply, rather than robust demand. Existing home sales have declined steadily since February, dropping by nearly 11% through July. At the same time, new home sales are up 32% year-over-year as of July, and the six-month moving average is up 8%. This indicates that buyers are being driven to the new construction market due to a lack of inventory of existing homes, and builders are capitalizing on that demand by charging higher prices.
We expect that the nascent rebound in home prices will be short-lived. The average 30-year fixed mortgage rate is above 7.25% for the first time since the early 2000s. Combined with higher prices and rising property taxes in many markets, this is putting a serious crimp in affordability. Further, the pace of home price appreciation in any market is mean-reverting, and after the widespread home price bubble that persisted for more than 20 months while mortgage rates were at record lows, prices did not complete the mean reversion process in the majority of markets. Thus, a return to price appreciation will result in a resumed correction.
Auto Sales:
New vehicle sales have trended near 15.7 million units (annualized) throughout 2023, which is below the pre-pandemic trend level of around 17.0-17.5 million units. Used car prices reached record levels in late 2021 and early 2022 thanks to supply chain disruptions that curtailed new car inventories. However, the Manheim Used Vehicle Value Index has declined sharply since then. The July reading was the lowest since April 2021. The index rebounded slightly in August and September, but remains below any level seen from September 2021 through May of this year.
Labor Market:
The unemployment rate unexpectedly rose in August to 3.8%, the highest level since February 2022. Nonfarm payroll gains have been below-trend for the three months ended in August. We have long maintained that any job gains since the pandemic shutdown do not actually represent gains, but rather recoveries, and we’ve noted that it was not until June of 2022 that the labor market recovered all of the jobs eliminated in the two-month shutdown. We’ve also noted that, had the economy not been shut down, and had job growth continued apace, we’d be about four million jobs ahead of where we are today. In other words, we have yet to reach equilibrium between the supply and demand for labor. The slowing trend in nonfarm payrolls means that that gap is now widening.
However, most employers are seeing an easing of the staffing challenges that plagued businesses for the past two years. This is due in part to softening business conditions. Job openings reached a record level of more than 12 million in March 2022. Since that time, they’ve fallen by more than 3 million. And the so-called “Great Resignation” is over; voluntary quits have fallen from a record of more than 4.5 million in late 2021 to about 3.5 million as of July, which is near the pre-pandemic level.
GDP Growth and Economic Expectations:
GDP grew at a surprising 2.4% pace in the second quarter, boosted by strong consumer spending, in spite of consumer sentiment at near-recessionary levels. Spending is being driven by record credit card use. Previous forecasts called for output growth to weaken into the end of the year and 2024. However, the back-to-school shopping season – second in importance to retailers only to the bellwether holiday spending season – was a record, which should bolster consumption for Q3. That also augurs well for holiday spending, which should keep Q4 output growth from declining significantly. Indeed, the Fed revised its growth estimates upward at the latest FOMC meeting.
Based on recent growth trends, resilient consumer activity, and expectations that the Fed may begin accommodation in 2024, we anticipate slowing growth in 2024, but we place a lower probability on a recession next year. Possible headwinds include the effect of student loan repayments on consumption and credit and the aforementioned challenges to the housing market, as well as cooling labor market conditions and the risk that continued inflation may force the Fed to raise rates into 2024.
Inflationary Pressures:
CPI year-over-year increased by 3.7% in August following an unexpected increase in prices for the month. Higher gas prices in particular are placing pressure on overall consumer inflation. That trend is likely to continue, as key OPEC nations are reducing supply, and the U.S. has depleted the Strategic Petroleum Reserve to the point that it has little room to leverage it further. Absent resumed U.S. energy production, which is very unlikely before the 2024 election, energy prices will continue to put upward pressure on inflation, which may jeopardize the expected pause in Fed tightening.