When it comes to economic data in 2023, upside surprises have been the name of the game. Last Friday, we saw the number of jobs added to the economy in September double the forecast (336k VS 170k estimated). In August, monthly retail sales exceeded expectations (growing +0.56% VS +0.2% estimated). Meanwhile, overall economic activity, as measured by GDP for Q1 and Q2, showed annualized growth rates above 2%, which was well ahead of most predictions. Even now, the Atlanta Fed estimate for Q3 GDP, based on current data, is indicating that the economy grew at 5.1%, much higher than most forecasts we had seen coming into the quarter. So, what gives?
Conventional wisdom suggests the unprecedented pace of interest rate hikes over the past 18 months would have dampened economic activity by now. While we have seen inflation decline this year, we have not gotten the expected decline in economic activity many would have anticipated. There are many possible explanations for what we have seen. One simple explanation for this is the oft-quoted refrain from Nobel Prize-winning economist Milton Friedman that “monetary policy (in this case rate hikes) operates with a long and variable lag,” meaning that we simply have not yet seen the impact of all the rate hikes hitting the economy. Another possible explanation is that the after-effects of forced savings and transfer payments (stimulus checks) during the COVID period have provided consumers with enough spending money to shield the impact of increased rates and higher inflation. Other explanations include the idea that after years of asset price inflation (market returns), consumers who have been invested have assets they can monetize (sell) to continue their consumption or that the markets most acutely impacted by higher rates (housing, auto purchases) have structural factors that are keeping them from transmitting the impact of higher rates to the economy as a whole. It is possible that some or all of these factors play a role in the surprising economic strength we have continued to see this year.
One area we have thankfully not seen upside surprises is inflation, as it has continued to decline from multi-decade highs last year. There is a possibility that the next move in inflation we see is slightly higher due to technical factors, but we do not anticipate a break in the downward trend taking hold over the next several months. The key to this outlook will be whether or not we continue to get upside surprises in the other data that is released. Throughout most of this elevated inflationary period, companies have been able to pass along higher prices. Although wages have crept up to keep pace with some of the price hikes, we have not seen the 1970s-1980s wage-price spiral, where wages and prices keep going up one after the other. As long as the upside economic surprises do not result in a wage-price spiral, we anticipate inflation will remain under control and trend toward the Fed’s 2% target.
As mentioned in John’s commentary, our view is that an economic slowdown is still the most likely outcome, as higher rates will impact the consumer and businesses. This likely means that the surprises we have seen recently are not indicative of the future levels of economic activity. We will continue to closely monitor economic activity for signs of any pending slowdown and adjust portfolios accordingly.
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