The Soft Landing Scenario

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As the calendar flips to August this week, consumers, workers, investors and the Federal Reserve all have reason to be pleased with recent data.?Stock market returns have been strong all year, economic growth has been surprisingly resilient, unemployment remains very low and, despite all of this, inflation has fallen sharply.?The Fed continues to tighten in a manner that appears aggressive given the balance of risks.?However, so far, this does not appear to have inflicted too much damage on the overall economy or markets.?So where do we go from here??One approach to this question is just to review an economic checklist of Growth, Jobs, Inflation, Profits and Rates.

Growth: On economic growth, last week’s GDP report was very encouraging.?Second-quarter economic growth of 2.4%, annualized, significantly outpaced expectations for a 1.8% gain and was the fourth consecutive quarter of growth at 2% or better.?In addition, the composition of growth was promising, with solid gains in consumer spending and fixed investment and only mild inventory accumulation.?

Going forward, GDP growth should still slow as job gains diminish, reflecting a lack of available workers and cautious corporations cutting back on capital spending.?However, many of the forces that were expected to drag on the U.S. economy in 2023 are fading.?Housing appears to be stabilizing, even with much higher mortgage rates, as a chronic lack of supply keeps prices high and encourages new homebuilding.?Global growth, while not booming, appears sufficient to allow for moderate growth in exports while hiring by state and local governments is partly offsetting federal fiscal drag.?After a mini-crisis in March and April, regional banks appear?more stable and, despite a very hot summer and international tensions, the economy has, so far, avoided the kind of environmental or geopolitical events that have tipped us into recession in the past.

While a full-employment economy is always vulnerable to these kinds of shocks, as of today, it seems probable that the economy will avoid recession in 2023 and possible that it will avoid it throughout 2024 also.

Jobs: On jobs, data due out this week should show a steadily normalizing labor market.

Job openings peaked in March of last year at 12.0 million, 4.4 million higher than the highest number ever recorded before the pandemic.?Since then, this extraordinary excess demand for labor has eased, with job openings falling to 9.8 million in May of this year.?We expect Tuesday’s JOLTS report to show another decline in June, although it could take until the second half of next year for job openings to fall below their pre-pandemic peak.?That being said, job openings data may overstate the current strength of the labor market, as both quit rates and layoff rates have almost returned to pre-pandemic levels.?

Friday’s employment report could show payroll job gains in excess of 200,000 for the 31st consecutive month, potentially pushing the unemployment rate back down to 3.5%.?However, a modest pickup in both labor force participation and legal migration over the past year has allowed for strong hiring without further sharp reductions in the unemployment rate and we expect unemployment to remain in a range of 3% to 4% for as long as the economic expansion continues.?

Crucially, this very tight labor market has not led to an explosion in wages.?In fact, average hourly earnings for production and non-supervisory workers, which rose by 7.0% in the year ended in March of 2022, only rose by 4.7% year-over-year this June.?We expect this statistic to moderate further going forward, falling to roughly 4% by the end of 2024.

While Fed officials may see current wage gains as a potential cause of future inflation, workers likely regard them as partial compensation for prior inflation.?As workers become more aware of falling consumer inflation and businesses continue to talk about potential layoffs, wage demands may well ease.?Moreover, it is important to recognize that wages are supposed to rise by more than consumer inflation.?In equilibrium, the growth in hourly compensation should equal the growth in output prices plus the growth in productivity.?Data due out on Thursday should provide good news on this front, with output per hour in the non-farm business sector likely rising by 3.8% annualized, its strongest gain in almost three years.?Going forward, solid economic growth, in a very labor-constrained economy, could lead to further productivity gains.

Inflation: Inflation data have also been positive lately with last week’s consumption deflator readings for June generally coming in a little softer than expectations.?The headline PCE deflator showed month-over-month inflation of 0.2% and a year-over-year gain of 3.0%, far below the 7.0% year-over-year gain 12 months earlier.?

A recent surge in gasoline prices and tougher comps could cause the year-over-year inflation rate to rise slightly in July.?However, over the rest of the year and into 2024, inflation should resume a gradual decline and could well fall below the Federal Reserve’s 2% target by the middle of next year.

Profits: This week marks the peak of the second-quarter earnings season with 170 of the S&P500 companies set to report.?Through last Friday, with 58% of S&P500 market cap reporting, 73% of firms have beaten earnings expectations – the highest number in seven quarters.?By contrast, only 51% of firms have beaten revenue expectations, the lowest number in over three years.?This suggests that companies are succeeding in maintaining margins even in the face of fast-decelerating revenue growth.?

While this penny-pinching bodes well for shareholders in the long run, it does impart a deflationary impulse on the economy overall.?However, to the extent that this diminishes the risk of economic over-heating, it may well help extend, rather than curtail, the current economic expansion.?

Rates: Finally, on interest rates, the Fed raised the federal funds rate by 25 basis points last week, as was widely expected.?The FOMC statement could be described as hawkish, since it made no reference to fast-falling inflation and repeated language from the prior statement about how the Fed would determine “the extent of additional policy firming”.?

However, the opening statement in Chairman Powell’s press conference did not imply multiple likely future rate hikes, in contrast to the statement at his June press conference.?Moreover, in the back and forth with reporters, he did acknowledge that the June CPI report came in a bit better than expectations.?He also, perhaps inadvertently, revealed a good deal about the Fed’s thinking on monetary easing, noting that as he saw it, the Fed would have “to start cutting before you got to 2 percent inflation”.?

He also implied that it was possible for the Fed to continue with quantitative tightening even as it brought rates down from restrictive levels as part of policy “normalization”.?In an extended soft landing, this is a plausible scenario. At its current pace of quantitative tightening, that is up to $95 billion per month, the Fed would still hold $6.6 trillion in assets by the end of 2024, down from a peak of $8.9 trillion in March of last year but still far higher than the $4.1 trillion the Fed held before the onset of the pandemic.

Consequently, provided inflation continues to ease and for as long as the economy avoids recession, the Fed may keep rates on hold for the rest of this year and cut by 25 basis points every second meeting starting in January of 2024, while maintaining the current pace of quantitative tightening.?This would also allow for a slow drift down in long-term interest rates, providing support to both the bond and stock markets.

Investment Implications:?It should be stressed that this extended soft-landing represents a best-case scenario for the economy and markets.?There is some possibility that inflation will prove to be more sticky, tempting the Fed into further rate hikes.?It is even more possible that some shock to the real economy could tip us into recession.?In this scenario, Fed rate cuts would be in reaction to economic weakness, rather than falling inflation, and would likely come faster and be accompanied by a suspension of quantitative tightening.

And investors should still pay close attention to this recession possibility.?Soft landings are rare and, even if we collectively pull it off for a while, every landing eventually turns hard.?Every expansion eventually ends in recession.?That is not a reason to avoid investing.?We believe that a recession, when it eventually arrives, should be relatively mild and should leave a low-inflation, low-interest rate environment in its wake.?However, the market volatility that normally precedes a recession could inflict disproportionate damage on the most over-valued assets today.?Consequently, while the outlook for the short term has improved, long-term investors should still remain well diversified and pay close attention to valuations that have climbed on the back of rising soft-landing hopes.

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