Notes on the Economy – Q2 2023 Summary

SKATING ON THIN ICE

The U.S. economy avoided entering a recession in the first quarter of 2023. Growth was considerably weaker than in the two preceding quarters, which recorded annualized gains in real GDP of 3.2% and 2.6% in the third and fourth quarters of 2022, respectively. Still, real GDP advanced an annualized 1.1% in the first quarter. Furthermore, growth in demand for goods and services was quite robust, and conditions in labor markets continued to be indicative of an overall shortage. Real final sales exceeded production with an annualized increase of 3.4%, as what would have been inventory investment was diverted to meet the strong demand for products. The unemployment rate flatlined near a 50-year low. It was 3.4% in April, and as of March there were more than 1.6 job openings for every unemployed person willing to work.

Even so, one cannot say that the economy is in tip-top shape. Inflation remains uncomfortably elevated. Interest rates are high and credit conditions have tightened, while investment in capital items is weakening. Over the last twelve months the Consumer Price Index for All Urban Consumers (CPI) increased 4.9%. Core CPI inflation (CPI inflation less its volatile food and energy components) was 5.5%. The Federal Reserve (Fed) has raised the target range for the federal funds rate to 5.0%-5.5%, and surveys show banks are generally becoming more selective in extending credit. Investment in capital equipment, inventories, and housing all showed declining activity in the first quarter of 2023.

HEADLINES – WHAT’S IMPORTANT

1. The Decline in Inflation Has Been Sluggish – Monthly core CPI inflation has been stagnant for five months. It will probably fall during the rest of 2023 but will likely remain well above the Fed’s 2.0% target at year-end.
2. Interest Rates Are at or Near a Peak – Fed policymakers increased the federal funds target by 25 basis points in early May but now suggest that a pause in rate increases is in order.
3. Investors Should Close In on Their Desired Maximum Bond Portfolio Duration – Historical precedent indicates that investors should complete duration adjustments within about four months of a peak in the federal funds rate.
4. The Bear Is Not Yet Hibernating – Conditions for initiating the next bull market have not yet been fulfilled; investors had best use caution in acquiring high-beta equities.

LOOKING AHEAD

Recent data and Fed policy point toward continuing subpar growth in output. The federal funds rate is well above any reasonable estimate of a neutral level. Also, in addition to the weak investment picture noted above, first-quarter consumer spending was supported by a blow-out increase in spending, 16.9%, on durable goods (mostly passenger vehicles). Such blow-out spending on high-ticket items is typically followed by consumer caution.

Growth is likely to be nearly flat over the next few quarters. AMG projects slight contractions in the second and third quarters. This would likely still not constitute a recession, due to the resilience of the U.S. labor market. The resilience, if maintained, would seem to preclude the National Bureau of Economic Research (the private nonprofit organization generally recognized as the arbiter about the occurrence of recessions) from declaring such an isolated minor dip in production alone to be a recession.

However, the economy is skating on thin ice. It would not take much—e.g., a policy error, stickier-than-anticipated inflation, a few more bank failures, an adverse foreign event, etc.—to shake domestic confidence enough to turn a minor dip into a downturn serious enough to warrant the recession label.

At first glance, the global economy appears well positioned to continue its recovery from the abysmal 2020. Supply-chain disruptions are unwinding and the dislocations to energy and agricultural markets caused by the war in Ukraine are receding. However, the recent bout of banking instability demonstrated how fragile the recovery is under the surface. The International Monetary Fund (IMF) now expects that after last year’s estimated growth of 3.4%, the global economy will grow only 2.8% in 2023 before accelerating slightly, to 3.0%, in 2024. This expected growth remains well short of the historical (2000–2019) average of 3.8%.

* The information contained within this edition of the Notes on the Economy Executive Summary is based on data released as of May 19, 2023.

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