Andrew Pyle
January 26, 2024
Is the American economy really this bullet proof?
There are three more trading sessions before we close the books on January – a month that started off shaky for both equities and bonds; yet a renewed sense of optimism has taken grip in the past week or so. Whether that optimism holds during these next three days will depend on whether market participants can latch on to a different motive that has not yet been put in question. On this week’s conference call (playback details can be found at the end of the newsletter), I discussed the shift in focus from a monetary policy pivot, as the driver behind improved valuations, to economic resilience. Evidence to the latter is certainly out there, but corporate earnings reports are telling a slightly different story, leaving us with the question of whether the North American economy is impervious to traditional headwinds.
One of the common tenets of economics is that models will always change. It’s not necessarily because underlying theories change, but because behaviour is stochastic and often irrational. When outcomes deviate from a model’s prediction, we go back in and evaluate why, making adjustments where needed. Most often, these adjustments are relatively minor. The pandemic, and what transpired after, required significant modifications to existing macro models and, in some cases, a wholesale re-write. Coming into 2023, however, most believed pre-pandemic models regarding the impact of tighter monetary policy would hold true. Economic growth would cool or stall, unemployment would rise and stock markets would probably not be stellar.
That is why forecasts for U.S. real GDP growth in 2023 deteriorated in the face of a 4.25% increase in the fed funds rate from March to December 2022. There would be then an additional 1% rise by the summer of 2023. Forecasts made at the start of 2023 pointed to a stall out and significant probability of recession. Well, as the above chart shows, there was no recession and there was no stall-out. More importantly, U.S. real GDP growth (quarterly on a seasonally adjusted annualized basis, or SAAR) accelerated in the second of half of last year. On Thursday, it was reported that GDP grew by 3.3%. This was down from 4.9% in the third quarter, but well above the 2% growth that economists had predicted.
Keep in mind that this is what we call the advance report. There are actually three reports for U.S. GDP – the advance estimates, the second estimates and the final estimates. In these subsequent reports, the estimate could get revised lower or higher. What probably won’t get revised by any significant degree is the overall growth for 2023, which now stands at 3.1%. That contrasts to only 1% in 2022. This was definitely not the output from models a year ago. But it gets better.
In addition to real growth staying well above what economists would suggest is trend, we also got a smaller than expected increase in prices as measured by the GDP deflator, or price index. This measure was supposed to cool from a 3.3% pace in the third quarter to around 2.2%. Instead, we got a 1.5% print. This isn’t the only price metric that the Fed watches, but 1.5% is the slowest pace of increase in the price index since the end of 2019 (ignoring the actual deflation at the start of the pandemic). Did someone say “Goldilocks”?
Again, traditional models would say that if there were underlying price pressures still present in the economy, above-trend growth in GDP would not allow for such an orderly return to what is essentially the central bank’s desired inflation level. Indeed, if we could repeat whatever happened to prices in the fourth quarter, the annualized rate of change in prices by the end of 2025 would be only 1.4%. The problem is that models would only predict this if there was significant slack in the economy, which does not appear to be the case at this point in time. That’s not to say it can’t happen. It’s just that there are a number of factors at play that could still trip up what the traditional models would say about the coming quarters. In the most recent set of Fed forecasts, released in December, expectations were for core PCE deflator inflation to arrive at 2% by the end of 2026. Yes, I said 2026. In other words, the Fed does not see a straight line drop, because of the resilience in the economy and certain areas where inflation is sticky.
For one, even if annualized inflation numbers come down they are falling from extremely elevated levels. If cost pressures on households were a problem coming into 2023, they won’t disappear just because the pace of increase has relaxed. For example, between the end of the great financial crisis and just before the pandemic, the U.S. GDP deflator advanced at an average annualized clip of 1.6%. The pace since the pandemic has been north of 4%. Even if we maintain a steady low-pace increase in the index, we will still have an average annual gain of 3% or more by the end of 2027 according to my estimates. In other words, if household budgets are feeling constrained by higher costs, we will need income gains to exceed 3% on an annualized basis to maintain a buoyant consumer.
That’s just one demand-side element that models today need to recalibrate for, but let’s come back to prices for a moment. Whenever we have supply constraints we usually end up with higher costs, that can be passed along through the chain to the end user. We saw this in the pandemic and then again when Russia invaded Ukraine. We are watching it again unfold as Middle East hostilities continue. Before the Hamas attacks on Israel, the number of crossings by ships through the Suez Canal (south to north) were running at more than 60 on a 7-day rolling basis. That was actually an improvement over 2022. That number has now dropped to between 10-15 – very close to the near shutdown levels of the pandemic.
If this situation persists, and I would argue that we are already past what many economists believe would be the end date of the conflict, then the supply constraints from sending 500 ships around the southern tip of Africa will likely show up in higher prices for goods again. I wouldn’t say this will be a repeat of what we saw in the last three years, because savings from government stimulus have declined. That said, any meaningful increase in goods prices will work against the Goldilocks decline in inflation. It could even cause growth to be weaker as consumers and businesses become defensive again.
Models can’t predict pandemics, government reactions to pandemics, or geopolitical events; but they can provide guidance as to what to expect from such things. Changes in data and outcomes that deviate from predictions lead to modifications of those models, and those models help direct investor positioning. Our view today is that some recalibration is required to both growth, inflation and the path of eventual monetary policy easing. Market participants are also going to have to adjust their thinking on the pace of monetary easing or the strength of the economy. That doesn’t mean there has to be a major adjustment, but considering the mixed bag of company earnings this week there is a suggestion that the U.S. economy may not be as pristine as what is being priced in.
On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.
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