Conflicting signals

Bottom Line

Investors are now grappling with a critical multi-part question regarding the pace of reduced inflation, the direction of monetary policy and the trajectory of the U.S. economy. Will we experience a hard landing or a soft landing? Maybe it will be a rocky landing instead, or perhaps no landing at all, which would mean that the economy has successfully reaccelerated and skirted the recession question entirely.

The reality is that we are navigating several confusing cross currents in the economy. With two negative GDP prints in the first half of 2022, the media thought we were already in recession. But with domestic private final sales strongly positive at that time, we were not. Some economists are expecting a recession now, but with the labor market still strong, that’s unlikely. Others—like us here at Federated Hermes—are looking out 6-12 months to an economic slowdown and a possible shallow recession, but those odds have diminished in recent months.

Fed higher for longer? Inflation clearly peaked last year and is receding. But there is a sharp divergence in the pace of that decline between headline and core inflation. Nominal CPI inflation peaked at 9.1% y/y in June 2022 and has fallen sharply to 3.0% in June 2023, for an impressive cumulative decline of 6.1 percentage points over 12 months. But core CPI peaked at 6.6% y/y in September 2022 and has fallen to 4.8% in June 2023, for a cumulative decline of only 1.8 points over nine months.

The split is even more extreme with the Personal Consumption Expenditure (PCE) Index. Headline PCE dropped from a 7.0% peak in June 2022 to 3.8% in May 2023, for a 3.2-point decline over 11 months. But the core PCE (the Fed’s preferred measure of inflation) has declined from its peak at 5.4% in February 2022 to 4.6% in May 2023, for a cumulative decline of only 0.8 points over 15 months. The Fed estimates that core PCE may approximate 2.2% by year-end 2025. So, after its expected quarter-point rate hike next week (which would take the fed funds target range up to 5.25%-5.50%), the Fed may have another hike in its quiver before pausing later this year.   

Labor market still healthy The labor market appears healthy, with June’s 3.6% rate of unemployment just off its 53-year low of 3.4%. Importantly, the July survey week for initial weekly jobless claims just hit a 5-month low at 228,000. As a result, business and consumer confidence metrics have firmed in recent months, and housing and auto sales have been solid in the first half of this year. But after a strong January surge, consumer spending appears to have weakened during the subsequent “Mapril” and early Back-to-School (BTS) seasons, with excess savings dwindling and savings rates increasing.

Mixed signals in manufacturing While some manufacturing data has firmed in recent months, the ISM manufacturing index has been below the critical 50 level in each of the past eight months, and the Leading Economic Indicators have now declined 15 months in a row though June. Both metrics have been reliable recession signals over the past 75 years.

Inverted yield curves The bond market has three important yield curve relationships that have been inverted by more than 100 basis points over the past year (2-year/10-year Treasuries; fed funds/10-year Treasury; and 3-month/10-year Treasuries. These yield-curve inversions are still pointing to an elevated risk of an economic slowdown, rocky landing, or recession at some point over the next year.

Are growth equities overbought? The S&P 500 has rallied by more than 31% since last October’s intraday low to this week’s overbought cycle high at 4,578, while benchmark 10-year Treasury yields have declined from to an oversold 4.09% earlier this month to 3.83% now. The volatility index (VIX) is now plumbing a 3-year low at 13.7. With technology stocks trading at 30 times forward earnings, the S&P 500 at a 20 P/E, and value stocks at 10 times, we could see a broadening out of this 9-month rally, with value stocks playing catch up, while growth stocks revert back to the mean.

Raising our GDP estimates The liquidity, equity, and fixed-income investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to discuss the improving economic picture:

• The Commerce Department revised its first quarter 2023 GDP up to a final gain of 2.0%. That compares with GDP growth of 2.6% and 3.2% in the fourth and third quarters, respectively, so the economy is slowing gradually.
• Second quarter 2023 GDP will be flashed next Thursday, July 27. The Bloomberg consensus is at 1.8%, and the Atlanta Fed’ GDPNow estimate is at 2.4%.  The Blue-Chip consensus raised its estimate from 0.4% to 1.3% (within a range of 0.3% to 2.0%). We also raised our estimate from 0.5% to 1.7%, as the labor market remains healthy, and housing and auto sales were relatively solid in the second quarter.
• We’re expecting another quarter-point rate hike from the Fed on July 26, we’ve noted the slower pace of “Mapril” spending, and we’re concerned about the sluggish start to the important BTS season. But with offsetting rebounds in net trade due to the weaker dollar, lean inventories, housing and autos, we increased our third quarter 2023 GDP estimate from -0.05% to 0.9%. The Blue-Chip consensus increased its estimate from -0.6% to 0.4% (within a range of -1.0% to 1.4%).
• Consumer confidence has firmed in recent months, despite our concerns about slower Christmas spending.  So, we raised our fourth quarter 2023 GDP estimate from -0.8% to 0.6%. The Blue-Chip consensus reduced its estimate from 0.1% to -0.1% (within a range of -1.8% to 1.3%).
• As a result of these quarterly changes, that increased our full-year 2023 GDP estimate from 1.1% to 1.8%. The Blue-Chip consensus raised its estimate from 1.1% to 1.6% (within a range of 1.2% to 1.9%).
• We left our year-end 2023 forecast for core CPI inflation unchanged at 3.9%, compared with actual inflation of 4.8% in June 2023. (That’s down from a 40-year high of 6.6% in September 2022).
• We ticked up our year-end 2023 forecast for core PCE inflation from 3.5% to 3.6%, compared with actual inflation of 4.6% in May 2023. (That’s down from a 39-year high of 5.4% in February 2022).
• We initiated our estimate for first quarter 2024 GDP at 0.4%. The Blue-Chip consensus is also at 0.4% (within a range of -1.2% to 1.7%).
• We initiated our estimate for second quarter 2024 GDP at 0.5%. The Blue-Chip consensus is at 0.9% (within a range of -0.8% to 2.0%).
• We initiated our estimate for third quarter 2024 GDP at 0.8%. The Blue-Chip consensus is at 1.6% (within a range of 0.6% to 2.5%).
• We initiated our estimate for fourth quarter 2024 GDP at 1.1%. The Blue-Chip consensus is at 1.9% (within a range of 1.1% to 2.6%).
• Largely because of base effects, we reduced our full-year 2024 GDP estimate from 1.1% to 0.7%. The Blue-Chip consensus left its estimate unchanged at 0.7% (within a range of -0.2% to 1.5%).
• We left our year-end 2024 forecast for core CPI inflation unchanged at 2.9% and we ticked up our estimate for core PCE inflation from 2.5% to 2.6%.

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