“The only constant is change” is a quote that is mistakenly attributed to the Greek philosopher Heraclitus, but the misattribution doesn’t make the axiom any less true. In the 2023 Q2 report, we anticipated an economic downturn beginning in 2024. By the following quarter, we had revised our outlook to consider the strong possibility that the Fed might achieve a soft landing. Now, however, we return to the expectation that a recession will ensue in the coming year, with better than a 50% likelihood of that occurring. (Economic outlooks are sometimes like the weather forecasts in my native Kansas: just wait a while, and they’ll change.)
The headwinds that face the economy remain largely the same, but some conditions have worsened. And the Fed’s monetary policy balancing act will be made more challenging by market expectations and the very real possibility of fiscal stimulus in an election year that runs counter to what the FOMC is trying to accomplish on the monetary side.
Yield Curve and Monetary Policy
The two-year Treasury yield fell 78 basis points (bp) in Q4 to end the year at 4.25%, the lowest level since May. The ten-year yield dropped 73 bp, to 3.86%, the lowest since July. Yields had originally risen during the quarter to the highest levels since prior to the Great Recession. However, following the December 13 FOMC meeting, bond yields plunged on hopes that the Fed would commence easing in early 2024, and that the central bank would ease aggressively.
“Hope” is the key word, because Chairman Powell offered no promise of the kind in his comments following the meeting. He did indicate that the Fed is “likely at or near the peak [Fed funds target] rate for this cycle.” However, he also said that FOMC members “didn’t want to take the possibility of additional hikes off the table.” In short, he said that the economy remains relatively strong; inflation has come down significantly but remains above the central bank’s target; and the Fed is probably done raising rates, but they won’t rule out further rate hikes. He made no mention of easing.
Yet the bond market immediately rallied, with a 27 bp one-day drop in the two-year yield. Stocks also rallied, with the Dow Jones Industrial Average gaining more than 500 points. And Fed funds futures priced in six rate cuts in 2024, twice as many indicated by the Fed’s own “dot plot.”
In the week following the meeting, several Fed officials went on the stump in an effort to rein in the markets’ optimism, noting that the Fed had not mentioned easing, and in fact had not ruled out further rate hikes. But apparently the holiday spirit had taken hold, and the markets would not be swayed: bond yields drifted lower, stocks rallied into year-end, and Fed funds futures traders maintained their optimism.
In fact, Powell actually stated that the Fed will continue to tighten: the central bank plans to continue Quantitative Tightening – selling long-term bonds – at the current pace of $95 billion a month. That has the effect of increasing yields at the long end of the curve. Thus, we may see a correction in the ten-year yield as reality takes hold. (Powell did say that if rate cuts become necessary to stimulate a weakening economy, the Fed would discontinue Quantitative Tightening.)
The futures market has priced in the greatest probability for the first rate cut of 2024 to occur at the March FOMC meeting. If that cut doesn’t materialize, we can expect a sharp reaction from the bond market. We believe that the market has overshot the Fed’s intent, and that a correction in yields may be forthcoming.
Housing Market Trends
As of October – the latest available data – only one of the 20 markets in the S&P/Case-Shiller Composite Home Price Index was negative on a year-over-year basis (Portland). For the month of October, home prices in all but two markets – Portland and Dallas – increased. (Note that the index cited is seasonally adjusted.) The strongest market on a year-over-year basis was Detroit, up 8.1%; the overall index was up 4.9%.
The steady increase in home prices throughout 2023 has been driven by a lack of supply of existing homes, as homeowners are reluctant to sell in the current mortgage rate environment. As a result, new home sales have accounted for the lion’s share of activity.
Those trends are continuing even as rates have begun to fall in response to lower bond yields. Single-family housing starts rose 18% in November, reaching the highest level in more than 18 months. At the same time, November pending home sales were unchanged from October, and down more than 5% year-over-year, in spite of a decline in mortgage rates. One economist noted that “American housing demand is permanently higher than before the pandemic since people are spending more time at home.” While we’re reluctant to use the term “permanent” – everything cycles, after all – the increase in remote work arrangements is influencing housing trends, and that will require increased supply from builders to augment the resumption of trade-up activity as mortgage rates fall further.
A study conducted by U.S. News in September found that more than 80% of homeowners who took out a mortgage in the last year expect to be able to refinance in the near future. Nearly half of those surveyed would need rates to fall to between 5.5% and 6.0% in order to be able to refinance. The average 30-year fixed mortgage rate is currently about 50-100 bp higher than that, and aggressive easing by the Fed has already been priced into those rates.
So if the Fed does not ease as aggressively as the market anticipates – and we’ve already noted that they haven’t indicated that they will – those homeowners might not be able to refinance. And more troubling is the fact that nearly 15% of the survey respondents said that they won’t be able to continue making their mortgage payments if they’re unable to refinance.
We expect mortgage rates to trend in the 6% range in 2024, and housing inventories to remain tight. That will keep pressure on home prices as builders struggle to add sufficient inventory to meet demand. Expect affordability to decline further, and the possibility of increased delinquencies among recent-vintage mortgages.
Auto Sales and Manufacturing
Sales of cars and light trucks drifted lower from mid-year through November, the latest data available as of this writing. In general, vehicle sales have been range-bound throughout 2023. Automakers have dusted off incentives, offering 0% financing and deferred first payments on many popular models. Sales remain below pre-pandemic levels. Increasing reports of reliability problems with EVs are preventing significant growth in that segment.
Overall, the factory sector is the Goldilocks of the economy: not too hot, not too cold. It’s difficult to say that it’s just right, as manufacturing isn’t doing much to carry output growth. But capacity utilization is at a level that doesn’t indicate weakness (though it doesn’t indicate strength, either); the Industrial Production index year-over-year isn’t signaling an imminent downturn; and durable goods orders are up more than 9% year-over-year.
Labor Market
The theme we’ve consistently reinforced for more than a year now remains true: job growth (or more accurately, job replacement) has yet to reach equilibrium after the covid shutdown eliminated more than two million jobs. Nonfarm payrolls fully recovered those two million jobs in June of 2022. However, had the economy not been shut down, the pre-pandemic pace of payroll growth would put total payrolls about 4.3 million above where they are today.
Moreover, that gap is widening as the pace of job growth is slowing. Payrolls grew by 262,000 in September, 150,000 in October, and 199,000 in November. To maintain the pre-pandemic pace of payroll growth, we need to be adding 200,000 jobs per month, a mark that payroll gains have failed to hit in four of the last six months. Not coincidentally, job openings have fallen by about 3.3 million since March of 2021.
A couple of other potential early warning signs in the labor market are the unemployment rate and continuing jobless claims. The unemployment rate moved a couple of ticks lower in November, to 3.7%. But the October reading of 3.9% was the highest since January 2022, when we were arguably still coming out of the pandemic. And the jobless rate has drifted steadily higher over the course of 2023, having started the year a half-point lower than the October level.
As for continuing claims, they too have drifted higher of late. Interestingly, initial claims have been steady throughout the year; the latest reading was roughly the same as a year earlier at 218,000, and the range has been fairly tight, from a low of 194,000 in January to a high of 265,000 in June (claims are often higher in the summer as automakers shut down plants temporarily to re-tool for the new model year). But continuing claims have risen from about 1.66 million in September to 1.88 million in mid-December.
We expect further softening of the labor market in 2024. Widespread layoffs are unlikely (other than perhaps in retail, but some of that is seasonal), but hiring will likely slow, which will also reduce gains in earnings.
GDP Growth and Inflation
GDP grew at an unexpectedly strong 4.9% in Q3, driven by strong consumer activity, which has bolstered economic growth all year. We believe the Q4 reading will also be strong, again driven by robust consumer spending during the bellwether holiday season. However, there are troubling signs embedded in that consumer activity.
Spending is largely being driven by record credit card use, and serious credit card delinquencies are at historically high levels. Another very concerning trend is the sharp increase in 401(k) hardship withdrawals. We suspect that not all of those withdrawals represent true hardships, but are merely being used to facilitate additional spending. And while student loan borrowers were required to resume repayments in October, an estimated 40% of those borrowers failed to make the required payment that month.
Compounding the potential credit issues – and perhaps contributing to the increased spending – is the fact that inflation remains an issue for most households. While it’s true that the headline inflation rate has fallen from an annual rate of 8.9% in June of 2022 to 3.1% in November, the latest reading is still more than a point above the Fed’s target. But most importantly, the declining rate belies the compound effect of inflation.
Remember, that 3.1% inflation rate is on top of the 8.9% inflation rate of a year and a half ago. In other words, as prices continue to rise, albeit at a lower rate, those price increases are compounding. As a result, prices are 10% higher than they were two years ago, and 18% higher than they were three years ago. By contrast, average hourly earnings are up 9% vs. two years ago and 15% vs. three years ago. Small wonder that American households continue to feel stressed over inflation.
We expect output growth to slow in 2024, with a possibility of recession ensuing in the second half. The inflation rate should continue to come down slowly, unless Washington starts playing fast and loose with stimulus spending in an election year in an effort to buy votes.