2023 Will Be Better Than People Think

BY LARRY KANTOR AND BOB DIAMOND

Arecession hitting in 2023 is the consensus thought these days. That is no surprise, given that last year delivered the highest inflation rate, the most monetary tightening in four decades, and an inverted yield curve. However, if this slow-down is designated as a recession, it is already upon us and has been underway for many months. Moreover, it will likely end up as one of the mildest downturns on record. Recessions are typically generated by sharp declines in interest-ratesensitive sectors such as housing and manufactured goods, and we have been experiencing that for quite some time.

• Housing is clearly in a recession that began almost a year ago. Mortgage rates more than doubled, and home sales have declined for 11 consecutive months, amounting to a cumulative drop of nearly 40 percent. House prices and rents have been falling since last summer.

• Consumer spending on goods in real (inflation-adjusted) terms peaked in mid-2021 following a surge when many activities, such as travel and going out to restaurants were off-limits, and people were spending a lot more time at home. The decline accelerated toward the end of last year following consumers re-engaging in those services and a massive rise in interest rates. Retail sales in November and December plunged at a double-digit annual pace, forcing retailers to discount items to rid themselves of excess inventories, table expansion plans, and reduce their workforce.

That is what happens during recessions. The technology sector is also contracting following a COVID-induced boom in demand for tech services such as online buying and food delivery, streaming movies and shows, remote work, and video conferencing. Like in the retail industry, tech companies expanded their capacity to a level that turned out to be excessive. Typically, all of that would be enough to crash the economy, but the COVID experience delivered several unusual developments that have allowed the economy to hold up unusually well:

• A combination of factors—including early retirements, less immigration, people either sick or caring for someone who is, and a dearth of childcare services— produced a massive shortage of labor. Job openings peaked at a record 11.5 million, and there are currently 11 million openings compared with less than 6 million people unemployed. That has allowed the economy to continue generating job growth even as labor demand weakens. As a result, household income isn’t getting hit as hard as it usually does, thus mitigating the spread from the cyclical sectors to the rest of the economy.

• Household and business balance sheets have remained relatively healthy, supported by colossal income and wealth gains generated by unprecedented monetary and fiscal stimulus. Households were able to build up a vast stock of excess savings that they are still digging into to support spending. In addition, consumers and businesses did not take on excessive leverage and debt to the degree usually seen in the latter stages of economic recoveries.

• Energy and other commodity prices have fallen sharply, contrary to the experience during the significant inflation of the 1970s and early 80s. The decline in gasoline and natural gas prices has boosted household purchasing power, while sharp drops in lumber and steel prices have helped keep production costs under control.

The path of the economy going forward will be determined largely by the future path of inflation and how central banks respond to it. Fed tightening is working: the cyclical sectors are getting clobbered, and most asset prices—including stock and bond prices—have fallen significantly. Most important, inflation has decelerated at an extraordinarily rapid pace.

The oft-quoted year-on-year deceleration does not capture the true extent to which inflation has collapsed in recent months.

• While headline CPI decreased from over 9 percent in June to 6.5 percent in December, overall prices have been flat for the past two months (i.e., zero headline inflation).

• Much of the recent weakness in inflation is indeed due to the sharp drop in energy prices, which can’t be counted on to continue.

• That said, core (excluding food and energy) inflation—the Fed’s focus —has also decelerated impressively. Core CPI has been running at an annual rate of only 3.1 percent over the past three months, while the core PCE— a different measure of inflation that the Fed officially targets—was up 2.9 percent, already coming close to the Fed’s objective of 2 percent.

• Even more encouraging is that it is likely to slow even further. Shelter costs—which account for over 40 percent of core inflation—ran at an annual rate of over 9 percent during this same period but will almost surely decelerate significantly. Federal housing agencies, brokerage listing services, and other private data sources show that house prices and rents have fallen since last summer. This will be captured eventually in the official inflation data, which uses an average of rents over the previous six months to estimate monthly changes in shelter costs.

With that kind of progress on inflation already having occurred and more likely in the pipeline, the Fed hiking regime should be close to an end. Market pricing suggests that the Fed will complete this hiking cycle by the spring with a Fed funds rate of under 5 percent, which seems reasonable. But market expectations of rate cuts in the year’s second half will probably not be realized.

• The cyclical sectors of the economy are close to a bottom, making a significant further deterioration in the economy later this year unlikely.

• On the contrary, a bounce in the economy beginning in the spring or summer seems more probable than a more pronounced weakness. If the recent drops in mortgage rates and house prices are maintained, a pickup in sales sometime later this year would not be surprising. Meanwhile, excess inventories in the retail industry will probably be eliminated in a few months.

• While inflation is coming down to reasonable levels much more quickly than expected, the Fed will want to ensure that it stays that way and doesn’t pick up again.

All of this has implications for the financial markets. Current stock prices seem broadly consistent with a very mild economic downturn, as the cumulative decline since the beginning of last year is significant but less than the typical recession. The S&P fell almost 20 percent last year after a 27 percent surge in 2021. It’s up thus far this year for a net peakto-trough decline of around 15 percent. That compares with a mean drop in the S&P during recessions of 29 percent. That said, it seems too early to be overly bullish.

• Most valuation measures suggest that stocks are not cheap, and a robust economic rebound anytime soon seems unlikely.

• In addition, profit margins have peaked, and bond yields are likely to remain considerably higher than they were a few of years ago.

Bond yields are naturally trending higher than before the pandemic, which is consistent with the surge in inflation and higher Fed policy rates. The yield on 10-year U.S. Treasuries is currently at the bottom of the 3.5-4.25 percent range they’ve been in since the fall. While that is well above the 1.5-3 percent range that persisted for a decade before COVID, the change in economic fundamentals since the pandemic suggests that bond yields are likely to end up closer to the top end of that range or even a bit above it.

• The U.S. budget deficit is significantly larger, and the Fed will not resume buying bonds again for the foreseeable future.

• Zero policy rates are a thing of the past.

• While inflation is on a significant downtrend, structural changes suggest it will not settle as low as pre-pandemic when inflation was often below the Fed’s target of 2 percent. International trade is no longer trending up, and companies no longer use cost as the sole factor in deciding where to produce or buy inputs. Instead, they are diversifying their supply chains and placing more emphasis on reliability and safety.

The U.S. is not the only country where economic prospects outperform consensus forecasts.

• China’s sharp reversal of its zeroCOVID policy, setting the stage for a rebound from an unusually slow period of growth.

• The outlook for Europe has also brightened considerably, as energy shortages resulting from the war in Ukraine have been much less severe than had been feared. The weather has been warmer than anticipated, and countries have been able to build oil and gas stockpiles from non-Russian sources. As a result, natural gas prices have fallen back to below pre-Russian-invasion levels, a very positive surprise. The deep recession that many forecasters have been expecting for the Euro area no longer looks likely.

The bottom line is that 2023 doesn’t look nearly as bleak as consensus economic forecasts and recent financial news reports suggest. The inflation surge is evaporating quickly, Fed rate hikes are near an end, and a recession—if it ends up being designated as such—is already here and is much less painful than usual.