Expectations for Soft Landing Growing – But Headwinds Remain
Key Takeaways:
- Investors increasing calls for “soft-landing” scenario.
- Inflation still not at Fed’s 2% target.
- Consumers may not be able to keep up with higher prices for much longer.
- Higher interest rates for longer mean higher interest payments.
- Resilient labor market creates problem for the Fed.
Investors have recently increased their expectations for a “soft-landing” scenario as economic data continues to suggest an easing of inflationary pressures. The term “soft-landing” suggests the Federal Reserve has accomplished their goal of returning inflation to their 2.0% target without tipping the economy into a recession. We are still skeptical that this will occur and see a recession in the next 12 months as the most likely outcome of the most aggressive rate tightening cycle since the 1970s/1980s.
The labor market which has been keeping the economy afloat has started seeing the impact from the higher rate environment. The most recent data showed the economy added jobs at a robust pace in November and the unemployment rate actually fell from October. However, JOLTS data showed that job openings have decreased for the past two months, pulling the number of job openings to the lowest level since March 2021.
In this weekly we wanted to lay out the headwinds we see to the optimistic view that the economy will avert a recession.
- Inflation is improving, but still work to be done: Inflation has improved drastically from 9.1% (YoY) high we saw in mid-2022. However, the year-over-year change in CPI inflation is still not at the Fed’s 2.0% target level. In addition, the Fed’s preferred inflation gauge, PCE Core, shows inflation is running at a 3.5% year-over-year pace. Therefore, it is too early to say rate cuts are on the horizon. Instead, the Fed will have to keep rates higher for longer.
- Consumers may be running out of steam: Consumers remained resilient to the majority of the Fed’s aggressive rate hiking cycle and have weathered the inflation storm well. However, according to the most recent retail sales data (for October) consumers have pulled back their spending, albeit slightly, constrained by higher prices. We have also heard a cautious tone from many retailers surrounding the health of the consumer. Additionally, covid-era stimulus savings have been depleted, which could force consumers to be more cautious with their spending, especially into 2024.
- Consumer credit is a major headwind: A higher federal funds rate means consumers have been paying higher interest rates for credit cards. In our November 13, 2023, Weekly Insights, we mentioned the most recent New York Fed Survey indicated Americans owe ~$1.08 trillion on credit cards and delinquency rates have been rising across all income levels. As we expect a higher fed funds rate for longer, consumers will continue to be strained by higher credit card rates.
The Bottom Line:
While inflation data has shown signs of easing, the resiliency of the labor market makes it difficult for the Fed to cut rates as the economy weakens. We believe that investors are too optimistic on this view and are not prepared for a higher for longer interest rate environment. In addition, manufacturing is deeply in contraction territory, banks continue to tighten lending conditions, bankruptcies and delinquencies are rising and leading indicators suggest a recession may be unavoidable.