2023: American Consumer 1, Economists 0

If there was one word to describe the economy in 2023, it was resilient.

The labor market remained strong, inflation at first continued its stubborn ways but then began to retreat, stocks did well, and the economy grew more than predicted.

As for the much-expected recession?

“This time last year, Chair Powell said the Fed would ‘stay the course’ with rate hikes ‘until the job [was] done,’” Madison Faller, global investment strategist at J.P. Morgan Private Bank, wrote in the firm’s year-end review. “While inflation was slowing, it was still elevated, and the labor market was way out of balance. Amid what felt like a tremendous amount of uncertainty, a record number of CEOs said they expected a U.S. recession. Following that came bank stress, the debt ceiling and government shutdown drama, and geopolitical turmoil.”

“Today, inflation across the developed world has since more than halved, all while growth has remained resilient,” she added. “That strong pace stands to fade, but the recession many of us fretted over never happened.”

Looking back, it is clear that the one-word description fails to fully capture the effects of the COVID-19 pandemic and the recovery that followed it, causing the economy to behave in a way that defied the conventional wisdom of most of the economics profession and political class.

And it would be trite just to explain it all away by saying that flooding the economy with money, whether in the form of congressionally approved stimulus or a Federal Reserve that pivoted from excessive monetary ease to record tightening in the space of a little more than a year – though that does explain some of what happened.

In the end though, the American consumer proved too strong for the doomsayers.

The Inflation Rollercoaster

After being pummeled for saying inflation was “transitory” as prices soared in late 2021 and early 2022, Powell did an about-face in March 2022 and began rapidly raising interest rates. But while inflation did come down from its peak of 9.1% in July 2022, it still ended the year at 6.5%. The Fed continued raising rates by another 1% until pausing in July, as the economy cooled and inflation subsided somewhat. However, despite predictions of a recession, the economy – and particularly the labor market – remained strong throughout the year, defying economic theory that says unemployment will rise if interest rates do.

Behind the scenes, though, improvements in supply chains and pressure on borrowing costs from higher interest rates began to bring inflation down. The housing market, especially, weakened as mortgage rates hit 8% for a 30-year fixed rate loan. Now, the consumer price index is running at 3.1%.

Consumers, though, continue to cite inflation as their top concern and that has weighed on the approval rating of President Joe Biden.

As inflation gathered steam in late 2021 and into 2022, a political debate ensued with many blaming Biden’s $1.9 trillion American Rescue Plan for stoking the fires of inflation. Traditional economists believed that there was too much money floating around the economy, encouraging spending that would continue to drive up prices. Meanwhile, gasoline prices – the most obvious sign of inflation, along with high prices, for most consumers – touched $5 a gallon in June of 2022.

Some economists thought that inflation was being driven not so much by too much demand for goods and services but rather a lack of supply, whether it be of semiconductors or household items. As supply chains became unstuck and as energy prices began to recede, even as key suppliers like Saudi Arabia and Russia enacted production cuts, inflation started to recede, although prices remained high.

Now, inflation is on track to come back down close to the 2% Fed’s annual goal. But it could be 2025 before that level is reached. A recent consumer sentiment survey from the University of Michigan shows that Americans reduced their expectations for inflation over the next 12 months sharply in November, to 3.1% from 4.5% a month earlier.

“Inflation cycles are still being driven heavily by pandemic-related supply distortions,” Neil Shearing, group chief economist at Capital Economics, wrote in the firm’s 2024 outlook. “This is one reason why we have argued that the post-COVID inflation scare is more analogous to the inflation shock that followed World War Two than the inflationary surges of the 1970s.”

Shearing does not see a return to the deflationary period and near-zero interest rate regime that preceded the pandemic.

“But 2024 is likely to be the year where core inflation finally moves back towards central banks’ comfort zone of around 2%.”

Growth Proves Stronger Than Forecast

Remarkably, economic growth proved stronger than almost anyone predicted in 2023, even as interest rates hit levels not seen since the early 2000s and inflation kept its vise on consumer wallets. A major reason for this was that Americans had a reservoir of savings and jobs stayed plentiful. Wages, too, grew at a rate that, while initially below inflation, became positive in real terms as inflation waned in the second half of the year.

The nation’s gross domestic product grew by 2.2% in the first quarter, then dipped slightly to 2.1% before roaring back to 4.9% growth in the third quarter. The Fed recently updated its full-year forecast to 2.6%. That would be the best performance in four years, excluding the pandemic recovery year of 2021.

Richard de Chazal, macro analyst at William Blair, characterizes 2023 as “a year that can be better described by what didn’t happen to what did.” This includes:

– “There was no recession.”

– “Energy prices did not shoot to the moon.”

– “We did not have another deadly pandemic.”

– “The collapse of several regional banks, including the 16th largest bank in the country, did not result in a financial market meltdown.”

– “There was no government shutdown, and the debt ceiling standoff ended with a whimper not a bang.”

– “China to date has managed to keep the ball rolling, as it continues massive debt leveraging.”

– “The current conflicts in Ukraine and Gaza have so far not turned into wider regional conflicts or World War III.”

The Job Market Just Kept on Going

In 2023, everyone who wanted a job could find one. In January, there were 10.7 million open jobs, the number rising to 11.2 million in February. Even as the number began to go down as supply and demand of workers came into better balance, by the year’s end there were still 8.7 million open jobs.

Wages, meanwhile, have steadily risen. The average hourly earnings of all private sector workers was up by 4% as of November from a year earlier. Lower-income workers have made out better as a lot of the job growth in 2023 came in industries such as leisure and hospitality, where wages tend to start out lower.

The labor market is slowing down as the year ends, but November’s job growth of 199,000 is double what it takes to keep the economy in an expansive mode. Overall, monthly job growth averaged 233,000 in 2023.

LinkedIn’s monthly report on the labor market for November saw “pockets of improvement” in hiring after a stall earlier in the year and says “the job market has remained surprisingly resilient and stronger than expected.”

One bright spot was a rebound in tech hiring, a sector that had bulked up in the post-pandemic period but then announced large layoffs in early 2023, sparking concerns of a wider dropoff in employment.

“In November, hiring in tech experienced its third lowest monthly decline of 2023, and its hiring pace is actually up 2.6% since July (versus overall hiring which is down 3.1% since July),” LinkedIn said.

The unemployment rate ends the year at 3.7% after starting it at 3.4%. Both are very low by historical standards. Economists generally expect the unemployment rate could hit 4% or so in 2024, again a number that is considered fairly strong.

The Federal Reserve Pivots – and Then Again

The Fed “pivot” is something Wall Street loves, as it often signals a good time for the markets when the central bank decides to lower interest rates. When rates are high and hurting the economy and corporate balance sheets, a sign that rates may be about to come down often sets off a strong rally as has happened in the past few weeks.

Markets now believe the Fed is all in on lowering rates and bringing the plane in for a “soft landing” in 2024.

“I think there’s a lot of hopefulness around the numbers right now,” says George Calhoun, director of the Quantitative Finance Program at Stevens Institute of Technology.

Soft landings are few and far between, as the Fed often overshoots the runway. While it puts the odds of a soft landing at 70%, Ned Davis Research does outline a scenario that could upset that forecast.

“Given that our projection is for below-trend growth in 2024, slipping into recession territory could be relatively easy,” Veneta Dimitrova, senior research economist at Ned Davis Research, wrote recently. “The historical record also warrants caution, as most Fed tightening cycles have ended in recession an average of 24 months after the first rate hike.” That would put it right about March of next year.

There’s one aspect that could play into the soft landing scenario that is different this time. Increasing interest rates appears to have had less of an effect during this cycle. There are many plausible reasons for this, most of which came into play in 2023.

Company and household balance sheets entered this period much healthier than they did in the run-up to the 2007-2009 financial crisis and recession. Demographics favor the labor market remaining tight by historical standards, which could lead to fewer layoffs if the economy stumbles. The shift of the U.S. economy away from a dependence on manufacturing toward services has changed the dynamics of which companies prosper. The large tech giants, for example, create ample amounts of free cash and, therefore, are not heavy borrowers.

“The interest-rate sensitivity of the economy is so much less now than it was at the beginning of the great financial crisis” in 2007, says Cindy Beaulieu, chief investment officer at Conning North America.

Housing Learns to Live With Higher Rates

Even the housing market, the sector of the economy most vulnerable to interest rates, has changed. More than half today’s mortgages have interest rates below 4%. As a result, existing homeowners have been unwilling to sell and trade a low mortgage for a higher one that might come with a new house. That has left the market with limited inventory of homes for sale. The median price of a home in the third quarter of this year was $431,000, 31% higher than at the beginning of 2020.

“There’s a supply-demand imbalance,” says David O’ Reilly, CEO of the Howard Hughes Corp., a major developer of planned communities.

Even the 8% mortgage rates that briefly hit in October are having less effect than would have been thought in years past. New home sales have been strong as builders often provide below-market mortgages to lure buyers.

Also, Americans are getting married later, delaying having children and otherwise changing the historic patterns that have underpinned the housing market.

“I think there’s a group driving supply and a group driving demand. People are staying in their houses, baby boomers in particular, longer than previous generations. The average length has gone from seven to 13 years.”

Government Dysfunction Becomes the Norm But Does Not Derail the Economy

In Aesop’s fable “The Boy Who Cried Wolf,” a shepherd boy repeatedly warns villagers that a wolf will attack their sheep but the warnings are false. Then, when a wolf does appear, the villagers don’t believe the boy and their sheep are eaten. That has not happened yet on Capitol Hill. But in 2023, the threats of a government shutdown over a failure to pass a debt ceiling increase happened twice. Both times, Congress agreed to a short-term solution at the last minute to keep the government funded, now at least until January.

The first budget showdown cost former Speaker Kevin McCarthy his job when a group of hard-right Republicans declined to support the California Republican after he agreed to a compromise deal with Democrats to keep the government running. But current Speaker Mike Johnson, also a Republican, governs with a thin majority. And who knows whether he will be able to navigate the next budget deadline?

Many economists believe there is a cost in terms of credibility for the U.S. government and higher interest rates on federal debt. So far, though, politicians do not seem to have changed their behavior, and it remains to be seen how the markets may react in 2024.

Oil Prices Do the Opposite of What the Experts Predict

Shortly after Russia invaded Ukraine in late February 2022, analysts predicted that Europe would lose access to oil from its eastern neighbor upon whom it depended for a lot of its energy. The price of a barrel of oil quickly rose by $20 to $117 before topping out at $123. In October, when Hamas militants staged a surprise attack on Israel, there were fears again of oil supplies being affected and the price reached $92. Today, oil is selling on world markets for $78 a barrel after a recent spike due to repeated drone attacks on vessels in the Red Sea. Meanwhile, Russia and Saudi Arabia have cut production levels this year to maintain prices.

But there is no shortage of oil and, in fact, America has become a key player in keeping oil prices low. As economist Joseph Politano has documented in his blog Apricitas Economics, “the U.S. is producing more energy than ever before, and that growing surplus is being sent abroad – net U.S. energy exports have reached $70 billion over the last 12 months despite falling oil and gas prices,” Politano notes.

Liquefied natural gas exports to Europe from the U.S. are filling the gap caused by the loss of Russian gas.

“In Q3 of this year, American LNG made up 19% of total EU natural gas imports compared to 15% for all Russian sources.”

America’s role in the world’s energy markets is little understood even as Republicans blame President Biden for what they bemoan as the country’s lack of “energy independence.” Yet, the U.S. is currently producing the most oil and gas in its history.

Overall, 2023 turned out to be the opposite of what most people predicted. Whether 2024 continues this trend or is a return to normal, whatever that is these days, be in the cards.