The economy is unwell, and it could get worse before it gets better
The economy is unwell. It’s not the flu, but it is a throat ache. And it’s unlikely to get better in the coming months
The combination of persistently elevated prices, high interest rates and now tightening credit conditions will weigh on business investment, consumer spending and the transactions markets in the coming months. As I’ve stressed before, even though we do not see evidence of broad-based economic imbalances, recessions are often nonlinear psychological events. We continue to see signs of a midyear recession.
All interest-rate-sensitive sectors have experienced a notable pull back, with housing suffering the brunt of the correction
With homes sales plunging 30% over the past year and construction activity following the downfall with a lag, the housing sector is likely to remain under significant pressure in the coming months. And while the recent decline in interest rates and easing home prices (especially in some of the hottest regional markets) could provide some support to potential home-buying activity, we should recall that housing affordability remains near its all-time low. Fortunately, the historically rapid housing correction occurred at a time when household leverage was near a 20-year low. As such, the current correction is not a repeat of 2008 when excess leverage and elevated credit risks combined into a broader financial crisis. With 80% of homeowners having locked in mortgages rates below 4%, the biggest concern for housing going forward is less of a credit risk than a lack of housing mobility and an elevated barrier to entry.
At the same time, business investment activity is softening
The latest Institute for Supply Chain Management (ISM) manufacturing survey pointed to the lowest levels of activity since May 2020 with news orders, employment and backlogs all contracting. Business sentiment appears to be shifting with demand continually slowing and no clear evidence of positive spillovers from China’s reopening. Durable goods orders and shipment trends are also deteriorating rapidly, indicating much slower equipment investment momentum in the first quarter of this year than at the end of 2022. With spending on structures under pressure from a higher cost of capital, it is increasingly likely that we’ll see a business investment contraction in Q2 and potentially Q3.
In this environment of softening final demand, inventory management has become a central concern for business executives
After spending the majority of 2021 and 2022 rebuilding inventories at break-neck speed, this year will likely be a year of inventory recalibration. This means that we may very well see an amplification of the capex business cycle to the downside as business leaders look to rightsize stocks considering slower future demand, an important risk to monitor for the US economy.
The backbone of the economy remains the US consumer, but even there we’re observing a significant cooling of spending at the end of Q1
Whereas the spending jolt in January gave the false impression of an extremely resilient consumer, we cautioned that elevated prices, high interest rates and slowly deteriorating credit conditions indicated slower spending in the months ahead.
Spending momentum cooled notably in February, and we anticipate further weakness in March
Yet, given the strong start to the year, real consumer spending growth is on track to grow around 4% annualized on average in Q1. The strong performance — which will be featured in the upcoming Q1 GDP report on April 27 — will be subject to misleading interpretations of underlying consumer strength. However, a situation where personal income remains well below its pre-COVID-19 trend and significantly lower than consumer spending is not sustainable. Consumers may have been able to manage the burden of elevated prices thanks to their savings and increased use of credit, but that simply cannot replace organic income growth in the medium term.
That is not to say that the rebound in real personal income over the last eight months is not a positive development — it is
But it won’t be enough to offset the growing headwinds facing consumers, especially lower- to median-income families who have come under increasing pressure from persistent inflation, slower income growth, reduced access to credit and depleted savings.
And while families in the top two income deciles have been driving a slightly larger share of spending than the historical norm, their ability to continue fueling growth is diminishing
Two key factors are likely to weigh on their spending capacity in the coming months. First, services costs have continued to rise at a rapid clip. And while inflation is moderating, higher price levels are undoubtedly going to curb consumers’ enthusiasm over the summer. Second, credit conditions are tightening, and the recent banking sector stress will only further exacerbate the impact, leading to slower spending on big-ticket items and services. Against this backdrop, we anticipate real consumer spending will likely contract around 1% (annualized) in both Q2 and Q3.
Can the labor market save the economy? As we have stressed previously, this ain’t your father’s labor market
Post-pandemic conditions are unique. Labor market tightness will remain a feature of this business cycle given business executives’ reluctance to let go of valuable and prized talent pools, but we continue to anticipate reduced hiring, strategic resizing decisions and wage growth compression. The latest Job Openings and Labor Turnover (JOLTS) report — while it must be read with caution given the extremely low response rates — showed a notable downward trend in job openings and hirings. Similarly, quit rates have declined visibly, especially in white-collar occupations.
Recent labor market evidence along with our conversations with business executives indicate that hiring efforts have been scaled back notably across numerous sectors.
This could favor a nonfarm payroll print below the 240,000-consensus estimate in March. And, with seasonal factors weighing on the data, the payroll gain could fall below 150,000.
Additionally, our attention will be focused on average weekly hours worked in the private sector, which fell 0.3% in February. While the recent decline in hours worked indicates a normalization to pre-pandemic levels, a further deterioration would point to a more concerning labor market slowdown.
Wage growth will also garner a lot of attention. After a modest 0.2% month over month (m/m) in February, we expect wages will grow 0.3% m/m in March. This should lead to a moderation in wage growth from 4.6% year over year (y/y) to 4.3% y/y, and represent a notable 1.6 percentage-point decline from the March 2022 peak of 5.9% y/y.
Credit tightening hits you where it hurts the most
While it’s impossible to determine with any degree of precision how the banking sector situation will evolve, we anticipate a notable tightening of credit conditions in the coming months. The fragmentation of the US banking system, with thousands of small banks providing financial intermediation for consumers, small and medium-sized businesses, and real estate, means that tighter credit conditions will likely slow the economy through various channels.
To put things into perspective, small domestically chartered commercial banks (outside of the top 25 banks by asset size) contribute to between a third and half of the consumer loans, commercial and industrial loans, and residential loans in the US. And they contribute about 80% of all commercial real estate loans. With a net 50% of banks tightening credit standards on commercial and industrial loans and around 25%–40% tightening standard for auto loans, credit cards and mortgage loans prior to the banking sector stress episode, the tightening will only get worse.
As we have previously noted, we anticipate tightening credit conditions will represent a drag on the US economy worth around 0.5% of GDP over the next 18 months
As a result, we now anticipate real GDP growth will be closer to 0.8% in 2023 and around 1.5% in 2024.
With the Fed adopting a dual-track approach distinguishing monetary policy tools from macro-prudential tools, we anticipate a final 25 basis points rate hike in May
This would bring the terminal fed funds rate range to 5.00%–5.25% in line with the Federal Open Market Committee statement that “some additional policy firming may be appropriate.”
While the Fed will maintain its posture of “not thinking about thinking” about rate cuts in the coming months, we don’t discount the possibility of a pivot around the late-summer Jackson Hole meeting
By that time, we anticipate the economy will be in a recession with slower private sector activity, job losses and potential adverse financial market ramifications. We maintain our view that rate cuts are a strong possibility before the end of the year. These will likely initially come as a recalibration exercise, but once there is ampler evidence of inflation having sustainably declined toward the Fed’s target, rate cuts may become larger and more rapid.
The views expressed by the author are his own and not necessarily those of Ernst & Young LLP or other members of the global EY organization.