A recession in the U.S. does not appear imminent, despite the most aggressive rate hikes since the 1980s over the past 15 months. The labor market remains strong, expectations for 2Q23 GDP growth are positive, consumer spending has exceeded expectations, and even housing has shown signs of life. Further good news comes from inflation, which has moderated, though largely due to falling energy prices.

We have also successfully weathered a couple of storms this year; regional bank worries have abated after the collapse of Signature Bank, Silicon Valley Bank, and First Republic, and the debt ceiling saga is behind us.

Investors are generally optimistic; stock indices registered strong 2Q gains and risk appetite was evident in bond markets. Consumer confidence has risen, and a recent small business survey from the U.S. Chamber of Commerce showed an increase in overall small business confidence in 2Q, especially regarding revenue and hiring. Just over 70% expected revenue to increase and 47% had plans to hire. (Not surprisingly, inflation remains the top challenge among small businesses, with more than 75% citing higher interest rates limiting their ability to raise capital.)

The Outlook for the Global Economy in 2Q23

On the good news front: 1Q23 GDP was a robust 2% (raised sharply from the most recent estimate of 1.3%) and the Atlanta Fed’s GDPNow estimate is for a repeat performance, roughly 2% in 2Q. Several metrics were revised upward: exports, consumer spending, government spending, and construction. Consumer spending rose 4.2% in 1Q, the strongest growth seen in nearly two years. 2Q releases have also surprised to the upside. Durable goods orders were up a lofty 1.7% in May, beating expectations and suggesting that companies are not in “retrenchment” mode.

Strength was widespread across sectors. In June, the Conference Board reported a sharp 7% monthly jump in its Consumer Confidence Index, bringing it to its highest level since January 2022. New home sales surged more than 12% in May (+20% year-over-year (YOY)) with gains broad-based geographically, according to data from the Census Bureau. Housing prices have risen in 2023 and are now just 2.4% off the June peak, according to the S&P Case-Shiller National Home Price Index. Results are mixed across cities, but low inventory has helped to boost prices even as mortgage rates approach 7%.

The labor market remained resilient. The Bureau of Labor Statistics reported April job openings, according to the Job Openings and Labor Turnover Survey (JOLTS), remained at just over 10 million with about 6 million unemployed. Unemployment remained low at 3.7% in May and average hourly earnings ($33.44) were up 4.3% over the past year, a bit higher than core inflation. Employers added a healthy 339,000 jobs in May, far outpacing expectations of 195,000.

But is this all too good to be true? The Fed has not abandoned its rate hike path and goal of 2% inflation and has suggested that further hikes are coming. Higher interest rates have a lagged effect but the impact can already be seen in some areas. In April, nearly 50% of U.S. banks reported tightening lending standards for loans to small businesses. Rising payments for credit card debt, auto loans, commercial mortgage payments, and corporate debt all have the potential to put the brakes on economic growth. While the default rate for corporations has not ticked up materially, a June report from S&P Global was a bit ominous: “…the tally of companies that have gone bankrupt so far in 2023 is higher than the first four months of any year since 2010.” Commercial real estate woes, especially office and retail, are also on the radar of the more pessimistic crowd. The resumption of student loan payments in August could also temper growth later this year. Americans owe roughly $1.8 trillion in federal and private student loan debt.

And there is mixed news: Headline CPI was up 4.0% over the past 12 months (as of May), the lowest since March 2021, with Core up 5.3% (down from a 6.6% cycle high in September). Headline CPI has benefited from falling energy prices (-12% YOY) while Core has not moderated as much and has the Fed’s attention. Within Core, shelter costs (+8% YOY) have been particularly sticky and comprise around 40% of the measure. The Fed’s favored inflation metric, the Personal Consumption Expenditures Index, showed progress with a +3.8% gain in May (YOY), down from 5.4% in January. As with CPI, the Core measure remains more stubborn and was up 4.6% in May (YOY), down only slightly from January’s 4.7%.

The Fed took a pause at its June meeting, leaving the Fed Funds target at 5.00% – 5.25%, citing uncertainty over the effects of tighter credit conditions and the lags with which monetary policy affects the economy and inflation.

However, more hikes are likely this year. The median projection from the Federal Reserve Board for Fed Funds is 5.6% at the end of 2023, up from the March projection of 5.1%. The Fed’s median prediction is 4.6% for the end of 2024, but the distribution reflects a wide range of views that range from 3.6% to 5.9%.

The Fed remains committed in its goal to tame inflation and it believes it will be successful. The median projection is for Core PCE inflation to be 2.6% in 2024 and 2.2% in 2025. Markets agree, at least over longer periods. The five-year breakeven spread (a market measure of expected inflation over the next five years) was 2.2% as of quarter-end.

Most of the globe continues to be in “tightening” mode (except for China and Japan) as inflation remains stubbornly high. The Bank of England raised rates 50 bps in June, above expectations, in response to May’s 7.1% (YOY) inflation print for core CPI, the highest since 1992. Central banks in Norway, Switzerland, and Turkey also raised rates in June. In the euro zone, inflation has moderated but remains high (6.1% YOY in May).

Further hikes from the ECB are also expected. However, the impact has already been felt as the euro zone is in a technical recession, as measured by two consecutive quarters of negative growth. GDP in the 20-nation euro zone fell 0.1% in 1Q23 and 4Q22, hurt by declines in household spending amid higher prices.

China’s recovery lost momentum after real GDP growth of 4.5% (YOY) in 1Q. The People’s Bank of China cut key interest rates In June after disappointing economic releases. China is grappling with multiple challenges including deteriorating exports, a high youth unemployment rate, a distressed property market, and languishing domestic demand. The Chinese yuan lost 5.4% versus the U.S. dollar in 2Q.

In Japan, core inflation was 3.2% (YOY) in May, higher than the Bank of Japan’s 2% target but lower than much of the world. The Bank of Japan has ultra-loose monetary policy, maintaining its -0.1% short-term interest rate target and 50 bps cap on its 10-year government bond yield at its June meeting. The bank first adopted a negative target in 2016 to fight deflation and a limping economy. The yen lost 8% versus the U.S. dollar in 2Q while the Nikkei 225 hit a 33-year high on optimism for the country. The Nikkei has risen nearly 30% in 2023, far outpacing other developed market countries.

The ultimate path of interest rates remains unknown, as does the eventual impact on inflation and the global economy. Economies are widely expected to slow and inflation to be conquered eventually, but there are disagreements around the timing and the depth of downturns. The World Bank estimates that global growth will be 2.1% in 2023, down from 3.1% in 2022. Its prediction for the U.S. is a muted 1.1% in 2023 and to decelerate to 0.8% in 2024.

Bond and stock markets present a perplexing picture. The U.S. Treasury yield curve is more inverted than it has been since the early 1980s. (Historically, an inversion has been a good predictor of a recession, though the curve has been inverted since April 2022.) Stock markets, conversely, do not appear to have priced in a significant slowdown.

While 2023 has thus far felt “too good to be true” for some of us, geopolitics continue to be a source of concern and storm clouds on the global economic horizon have mounted. With uncertainty ahead, Callan continues to recommend a disciplined investment process that includes a well-defined long-term asset-allocation policy.