As we enter 2023, the U.S. economy is still beset by high inflation, and the Fed’s policy response threatens to stall economic growth. A housing correction is fully underway, and there are continuing signs of cracks in an otherwise apparently robust labor market.
CPI is up 7.1% year-over-year (yoy) as of November, the lowest annual rate since January. However, prices remain undeniably high. Moreover, the “numbers behind the numbers” are troubling: food prices are up 10.6% yoy, and energy prices are up 13.1% yoy – and that was before the recent winter storm that saw a large swath of the country facing double-digit negative wind chills.
In addition, the war in Ukraine continues to put pressure on energy and food prices. And the recent massive spending bill will also likely keep the Fed’s bias toward tightening. As of this writing, Fed funds futures suggest an implied probability of 68% of a 50 basis point (bp) rate hike at the February FOMC meeting, and a 32% chance of a 75bp hike. (That could change with the December jobs report, due out January 6.) Looking further out, there is a 40% implied probability of another 75bp in rate hikes by mid-year, which would bring the Fed funds target range to 500-525bp. The Fed’s own “dot plot” concurs with the 500-525bp range for 2023.
Recall that the Fed funds target range was 0-25bp, a policy reaction to the COVID-19 pandemic, in March 2022, when the current round of tightening began. In hindsight, it’s clear that central bankers held monetary policy too low, too long, which has been a problem for the Fed in the last several low-rate cycles, fueling the dot-com and housing bubbles. This time, it appears to have fueled an inflationary spike that the Fed is now wrestling to control without plunging the economy into recession.
On that front, the indicators are something of a mixed bag. On the negative side, the yield curve is inverted, which is a fairly reliable predictor of recessions; the two-year yield currently exceeds the ten-year yield by 53bp, but the inversion has been as wide as -84bp. Some manufacturing indicators show weakness. Consumer sentiment is at recessionary levels already, though spending has been resilient (but more on that later). Layoff announcements have picked up, and are now extending beyond the tech sector into Wall Street and other areas of the economy, and continued jobless claims have been trending steadily upward. And job openings, while still elevated, have declined by more than 1.5 million since March.
On the positive side, employment has remained fairly healthy, with non-farm payroll gains averaging more than 300k/month over the six months ended in November. The labor market has recovered all of the jobs eliminated when the economy was shut down in response to the pandemic in March of 2020. However, we have not yet replaced the jobs that would have been added due to normal growth during the ensuing 32 months. Assuming average payroll growth of about 200k/month in a “normal” economy, that would leave us about five million jobs short of where we should be today. This in part explains the fact that job openings remain several million higher than the pre-pandemic trend level.
It also tells us that signs of strength in payroll growth should not be taken as indicators that a recession is not in the cards, as current payroll growth is still largely a function of recovery from the pandemic shutdown. In fact, it may take a recession to bring the labor market back into equilibrium by curbing the demand for labor, instead of waiting for supply to catch up with growth. Such are the consequences of shutting down a functioning free market economy; hopefully this will become a lesson well-learned, albeit a painful one.
Another positive sign is consumer spending, which is running counter to sentiment. While consumption yoy has been declining, it remains relatively strong. Discretionary spending – especially travel – has been at record levels, exceeding even 2019 spending. And projections for 2022 holiday spending also suggest record levels.
However, it appears that this spending is being fueled by credit. Revolving credit outstanding is the highest yoy since 1996. Fortunately, record-low mortgage rates from 2020 through early 2022 helped keep debt burdens manageable; household debt service payments as a percent of disposable income remain at historically low levels. But the debt service burden has risen sharply since the beginning of 2021, and at the same time households are faced with considerably higher prices. And the stockpile of savings that accumulated from stimulus payments in 2020 has disappeared: the personal savings rate is at the lowest level since 2005, and is near a record low, having fallen from 10% as recently as mid-2021 to just 2.4% as of November.
The widespread housing bubble that started in mid-2020, fueled by record-low mortgage rates, stalled out in June, and home prices have retreated since then. The S&P/Case-Shiller Composite 20 Home Price Index has fallen 4% since June (the most recent data is as of October), although prices are still up 8.7% yoy, which is about average historically. Among the individual markets in the composite index, San Francisco is faring the worst, up just 0.7% yoy, while Miami is still up 21% yoy, in spite of prices there having fallen 2% since July.
All of the 20 markets in the composite index have posted declines for three consecutive months, a phenomenon that has not occurred since late 2008. However, as we’ve previously noted, we do not see a repeat of the 2008-09 aftermath of that housing market crash, even though some economists project another 20% or so decline in home prices on average. First, borrowers have more skin in the game today, owing to more realistic appraisals and higher down payment requirements. Second, there is far less subprime lending today than there was in the early 2000s, along with less securitization and insurance thereof, which will limit the cascading effects on Wall Street and the insurance industry that we saw in 2008-09. And third, there has been less unsold speculative construction than there was in that bubble.
Still, lenders should keep an eye on credit trends. Black Knight recently reported that a quarter of a million borrowers who took out a mortgage in 2022 currently have negative equity, and another million borrowers have less than 10% equity. Many of those borrowers hold government-program mortgages that feature lower down payments. If we do see a further decline in home prices of as much as 20%, the negative equity pool will be much larger in 2023. According to Black Knight, $1.3 trillion in equity was lost in Q3, the most recent data available.
Additional data from Black Knight:
- mortgage prepayments in November fell to a third consecutive record low in November
- delinquencies rose to more than 3% in November
- foreclosure starts rose 19% over October, but are still 30% below pre-pandemic levels.
Other housing indicators also paint a negative picture. Building permits are down 22% yoy, the most since 2009. Housing starts are down 16% yoy, the most since 2011 excluding the drop during the pandemic, and single-family starts are just 58% of total starts, the least since 1985. Existing home sales are the lowest since 2010 excluding the pandemic, down 35% yoy, which is a record.
Vehicle sales are largely treading water. November’s sales total on an annualized basis was 14.1 million units, which is consistent with the trend level since mid-2021. However, the pre-pandemic trend was around 17 million units. Supply chain issues and inflation have taken a toll on new vehicle sales, along with the fact that the average age of vehicles on the road has reached a record high of 12.2 years. Used vehicle values ticked up in the first half of December, according to Manheim, reversing the steady decline that began in January.
The Manheim Index of used vehicle values was 202.6 in mid-December. It averaged 216 in 2022; 200 in 2021; 151 in 2020, and 139 in 2019. Thus, while used vehicle values are down nearly 15% from their peak at the beginning of 2022, they’re still about 40-45% above normal, thus they’re likely to fall quite a bit further. This is likely going to be a bigger problem for most lenders than the housing correction. The good news is that the shorter duration of auto loans means that the loans may well be off the books by the time the brunt of the correction is fully felt.
U.S. GDP grew by 3.2% in Q3 after contracting in the first and second quarters, which met the traditional definition of a recession. (That definition was subjected to some debate, which was more political than theoretical.) The Atlanta Fed’s GDPNow estimate for Q4 is 3.7%, vs. the most recent Blue Chip consensus forecast of just over 1.0%.
Many economists are forecasting a brief, mild recession in 2023. As noted earlier, some indicators point to a recession, while others do not. The inverted yield curve, the equity markets, and the Index of Leading Economic Indicators yoy, which is currently negative, all point to a recession (LEI yoy has been a generally reliable indicator of recessions). We noted earlier that Fed funds futures have priced in a target range of 500-525bp by mid-2023 (June). Looking beyond that date, the consensus probability is lower: by the end of 2023, the highest implied probability is 32%, of a target range of 450-475bp, just 25bp higher than today’s level. That suggests that the futures market believes that the Fed will continue to tighten in order to curb inflation, albeit at a moderated pace, through mid-2023. At that point, the market is pricing in a recession that will force the Fed to immediately reverse course and begin easing, such that the target range will be back to near-current levels by year-end.
Of course, several things could change the market’s outlook: stronger labor markets, additional government spending, and a reversal of the downward trend in inflation numbers could all bias the market – and the Fed – toward a longer and/or more aggressive course of tightening, and thus higher rates. On the flip side, that would increase the likelihood of a more imminent and perhaps deeper and longer recession.
Faced with all this uncertainty, caution is the watchword of the day, and financial institutions would be wise to closely monitor credit trends and adjust underwriting and collections accordingly. Lending strategies will also need to be adjusted given that mortgage lending has all but dried up. Investment and liquidity strategies, too, need to be addressed, with the collapse of prepayments, and sharply higher unrealized losses for some credit unions.
In his interview with ABC’s George Stephanopolous, Sam Bankman-Fried, the former head of the failed FTX cryptocurrency exchange, said, “If I had been spending an hour a day thinking about risk management on FTX, I don’t think [the FTX crash] would have happened.” Food for thought.