By Veronica Fulton, Research Analyst
The Federal Reserve will continue its efforts to crush inflation, as they hike again for the 6th time this year, raising the target Federal Funds rate range to 4.25-4.50% . This time last year, it would have been difficult to envision that the U.S. economy would be able to withstand monetary tightening to this degree. It seemed highly likely that increasingly higher interest payments on massive amounts of debt, which function as the structural underpinnings of the economy, would be destabilizing to our financial ecosystem. Yet, we are 425 basis points into one of the most aggressive tightening cycles in U.S. history, and the economy is, in aggregate, okay. Consensus seems to believe that an imminent recession is a foregone conclusion as yields on longer dated treasuries have come down, and the yield curve remains deeply inverted. However, we believe the strength of the U.S. consumer is undervalued in this environment. Excess savings brought on by stimulus and low unemployment rates could support consumer demand that is stronger for longer, buoying the economy.
Consumer demand is up and so are credit card balances. However, these debt levels in this environment are peculiar as they may not indicate strain. Consumers, especially those in the higher income cohorts, are still flush with savings. All things considered, the consumer appears to be relatively secure. In terms of cushions to the credit side of the consumer balance sheet, gas prices have come down from over $5 to now around $3 – this provides a boost to disposable income, particularly for those in the lower income cohort. Moreover, consumers in some states are receiving transfer payments from state governments in the form of rebates and expanded tax credits to help combat inflation. Government aid from the Inflation Reduction Act, Infrastructure Law and pension adjustments should continue to support consumers and businesses even with tighter financial conditions. In the current economic environment, fiscal policy is loose, while monetary policy is tight – the outcome of which is indeterminable but could lead to consumer spending remaining robust for longer.
Another considerable tailwind to the consumer can be found in job security. November unemployment came in unchanged and remains at some of the lowest levels historically. Some companies, particularly those that benefitted from the COVID stay-at-home bubble, have announced layoffs. These layoffs, in our opinion, originated from over-zealous companies who over-hired, over-ordered, and over-expanded because of a transitory boom in demand and fears of shortages. Now many of these companies, although still profitable, must cut costs to maintain margins in an environment where growth is slowing, valuations are contracting, and the Fed is hiking interest rates.
As consumers get back out post-COVID, they appear to prefer experiences over goods. Consumers are allocating more of their spending to the service and travel related sectors. As a result, there is a disconnect in the labor market, as sectors that benefitted from COVID are laying off workers, while travel & leisure companies are looking to hire. This phenomenon may reflect more of a secular change in consumer preferences, in our view, as opposed to a cyclical moderation in demand. U.S. real GDP is on track to grow at 4% quarter-over-quarter, led by consumer spending – in aggregate, demand is healthy.
As long as the labor market and consumer demand remain strong, the odds of persistent wage inflation remain elevated. Although wage growth came down slightly in November, avoiding a wage-price spiral remains a top concern for the Fed. Some economists believe in order for the Fed to do so, they will have to drive up the unemployment rate, sending the economy into a recession in 2023. But with lower energy prices, China potentially reducing zero-COVID policy restrictions, delivery times decreasing, and supply chains improving, we believe the supply/demand imbalance could return to more normal levels, thus taking some more pressure off pricing. Only time will reveal the true ramifications of both unprecedented monetary and fiscal policy actions. We continue to believe many economic indicators signal the economy being tepid for longer as opposed to coming to a screeching halt. There’s a widely accepted notion that once the Fed embarks on a tightening path they don’t stop when inflation comes down in real time (because its only realized in the rearview mirror), but only when something in the economy breaks. As a result, keeping a gauge on the health of the U.S. consumer is an important consideration in understanding when the Fed pivots or equivalently, when a recession truly becomes imminent.
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