"Q1 2023 - The Economy Throws a 'Smoke Screen'"

GROSS DOMESTIC PRODUCT

• GDP growth in Q1 2023 was 1.1%, a deceleration from the prior two quarters’ readings of 2.6% and 3.2%. Important to note, Aggregate GDP growth in Q1 2023 was largely obfuscated by mathematical effects of Private Inventory stagnation, and therefore may significantly understate the actual strength of the economy over the quarter. This marks the third consecutive quarter of positive GDP growth, with growth averaging-out at a pace of 2.3% over the past three quarters. Average GDP growth over this period of time is in-line with estimates of the long-run average growth rate of the U.S. Economy^1,2
  • Consumption
    • The Consumption component of GDP, which is the largest component within US GDP, grew at a very robust pace in Q1 2023, coming in at a level of 3.7%. This is the highest rate of growth in the Consumption component since Q2 2021 when the US Economy was pivoting out of COVID lockdowns. Additionally, the 3.7% rate of growth experienced in the quarter is far above the longer-term median rate of growth for the Consumption component, which is roughly 2.65%. Consumers accelerate spending for both Goods & Services in the quarter, with each category growing at a pace of 6.5% and 2.3% respectively. Within the Goods category, Durable Goods spending was robust, growing at a pace of 16.9%, which was primarily bolstered by a large increase in spending on Automobiles, which increased by 45.3% in the quarter. Elsewhere in the Goods category, spending on Groceries contracted for the 5^th time in the last 7 readings, a sign that consumer substitution effects are continuing to take place in response to higher food inflation realized over the past year. Within the Services category, spending on Recreation Services accelerated to a level of 5.9% from 4.6% in the prior quarter. Additionally, spending of Food Services & Accommodations accelerated to a pace of 4.8% from a level of 2.3% in the previous quarter.^1,2
  • Investment
    • The Private Investment component of GDP contracted at a pace of -12.5% in Q1 2023, due primarily to stagnation in Inventory additions during the quarter. The Non-Residential Investment category grew at a modest pace of 0.7%, which was mostly driven by continued robust spending on Manufacturing Structures, growing by 40.1%. Residential Investment continues to be a weak spot in the Investment component, having contracted by -4.5% in Q1 2023. This is the 8^th consecutive quarter where Residential Investment contracted. Contraction is the Residential Investment category was mostly due to continued weakness in Single-Family Home Construction, which contracted at a rate of -20.7% in the quarter. Q2 2023 represented the 6^th of the last 7 quarters where Single-Family Construction contracted, as the effects of higher interest rates and higher home prices have stifled affordability. Inventory Level Growth stagnated in Q1 2023 which produced an outsized/ negative effect to overall GDP growth. However, is important to note that Inventories have been steadily augmented every quarter for the last 5 quarters, therefore stagnation in Inventory Growth may be attributed to already sufficient Inventory Levels. Additionally, not all sectors experienced Inventory Growth stagnation uniformly, as some sectors did cumulatively add to overall provisions during the quarter^1,2
  • Net Exports
    • The U.S. Trade Deficit was largely unchanged over the past quarter, coming in at a level of $1.23T. Although the aggregate Trade Deficit was unchanged over the quarter, the U.S. did experience offsetting changes in Exports and Imports. Exports in Q1 2023 grew at a pace of 1.1%, while Imports correspondingly grew at a rate of 0.7%. Currently, the U.S. Trade Deficit has receded from its previous quarterly all-time high level of $1.49T from back in Q1 2022.^1,2
  • Government
    • The Government spending component of GDP accelerated to a pace of 4.7% in Q1 2023, up from the prior two months’ levels of 3.8% & 3.7% respectively. Acceleration in growth was shared across Federal, State, and Local Governments alike. Federal Government spending increased at a pace of 7.8%, which was bolstered greatly by Non-Defense Structure spending which grew at a pace of 18.8%. State & Local Government spending came in at a level of 2.9%, which was largely augmented by a 17.9% growth in Equipment investment^1,2

 

EMPLOYMENT

• The Unemployment Rate for the U.S. Economy is currently at a level of 3.4%. This level of Unemployment is largely considered by the Federal Reserve as representing Maximum Employment levels for the Economy
  • The Unemployment Rate is currently at a multi-decade low point, indicating an abnormally strong Labor Market^1,3
• The U.S. Labor Force has rebounded moderately over the past few months. The Labor Force now stands at a level of 166.7M, up from 164.3M a year ago^1,3
  • Upwards pressure on Wage Growth has been a key factor in driving more people to re-enter the Labor Market^1,3
  • However, the Labor Force Participation Ratio is largely unchanged from the start of 2022 at a level of 62.6%^1,3
• The number of Employed Individuals has risen over that past year to a level of 161M, up from 158.3M a year ago^1,3
• The number of Job Openings in the Labor Market continues to be historically high, although has moderated from the previous all-time high, now at a level of roughly 9.59M^1,3
  • There is now 1.68 Job Openings available for every currently Unemployed Individual^1,3
  • The number of Unemployed Individuals currently stands at 5.7M^1,3
  • Moderation in the number of Job Openings has been a key factor referenced by the Federal Reserve as a potential sign to begin Monetary Policy normalization via ceasing Rate Hikes, and potentially beginning a Rate Cut Cycle.
• Average Weekly Earnings have continued to rise over the past year by about 3.45%, a sign of a strong Labor Market^1,3
  • Over the past year, Average Weekly Earnings increases have been entirely attributed to increases in Wage Growth as opposed to Hours Worked^1,3
  • Elevated Wage Growth has been an instrumental factor in allowing U.S. consumers to partially offset the effects of higher Inflation^1,3
  • Consumer Substitution effects have allowed consumers to benefit from higher Wage Growth, while partially insulating them from the full effects of Inflation^1,3

 

INFLATION

• Headline PCE Inflation in the month of April decelerated greatly from the prior month, coming in at a level of just 0.9%, down from 3.7% in March. This marks the second consecutive month of deceleration in Headline Inflation^1,4
  • Core Inflation has also experienced a deceleration over the prior two months, dropping from a level of 6.9% in February, to a level of 3.6% in April. ^1,4
  • Larger contractions in Energy & Food related costs in recent months have produced the wider than average divergence between Headline and Core Inflation levels^1,4
• Material differences continue to exist between inflationary pressures related to Goods versus Services^1,4
  • Goods Inflation contracted in the month of April, deflating at a rate of -2.6%, which is a considerable decrease from January’s inflationary reading of 7.1%^1,4
    • Within the Goods category, both Durable & Non-Durable goods experienced deflationary pressures in March. Durable Goods deflated at a rate of -1.0%, and Non-Durable Goods deflated at a pace of -3.6%^1,4
    • Standout sub-categories within Goods were Gasoline & Energy Costs which deflated at a pace of -43.1%, as well as Food & Beverage which deflated at a pace of -2.3% in March. This was the first deflationary month in Food & Beverage costs since November 2020, a sign that lower upstream costs to food production are starting to show up in consumer facing prices^1,4
  • Services Inflation was 2.8% in April, marking the second consecutive month of decelerating pricing pressures. Services Inflation was previously 7.7% in January^1,4
    • Within the Services category, standout areas of interest included Health Care, which inflated at an accelerated pace of 5.7%, and Accommodations, which inflated at an elevated pace of 33.4%^1,4
    • Some degree of disinflationary pressures were present in Rent Prices, which came in at a decelerated pace of 6.0%. This was the lowest inflation reading for Rent Prices since April 2022^1,4
• Market Expectations for future inflation have continued to moderate over the past year, and are now roughly consistent with historically normal levels^5,6
  • Market Expectations for future Inflation on a 5yr forward looking basis are now at a level of about 2.3%, declining consistently from the previous high of 3.5% in March 2022^5,6
  • Market Expectations for future Inflation on a 10yr forward looking basis are now also at a level of about 2.3%, which have also declined from the previous highs achieved in March 2022^5,6

 

FORWARD LOOKING ASSESSMENT

A smoke screen. That is what the U.S. Economy so graciously provided to us in Q1 2023. In fact, if you were tasked with creating a set of economic data points that would achieve the goal of creating an illusion of rapidly slowing growth (a smoke screen) then it would be rather difficult to do a better job than what the Economy organically generated in Q1. Looking at our top-line GDP growth figure of 1.1% in Q1 and comparing that to the previous two quarters’ growth rates of 2.6% and 3.2% one might come to the conclusion that the U.S. Economy is in the midst of a large slowdown; however, that is far from the underlying reality, and the outlook may not necessarily be as ‘smokey’ as one might expect.

Getting into the numbers, it seems rather strange and counterintuitive that the U.S. Economy could be slowing down over the past 3 quarters when the largest, and third largest, components of GDP have accelerated over those 3 quarters (Consumer Spending & Government Spending). Keep in mind that the U.S. Trade Deficit also improved over this period of time as well, making the slowdown all the more puzzling. The culprit for this ‘smoke screen’ slowdown we have seen over the past few quarters is one that usually finds itself at the center of economic confusion (a repeat offender if you will) … Private Inventories.

Private Inventories are a notoriously common culprit for providing a ‘smoke screen’ effect over economic data due to the way in which it is measured. Essentially, the data point measures the change in the change of Inventory Levels (Ex: Adding 5 after adding 10 means a -50% decrease, even though overall levels were raised). And no, business inventories did not plummet as businesses decided a ‘storm’ was coming and froze purchasing across the whole economy; rather, Private Inventories have been steadily augmented since the start of 2021 and therefore were probably at a sufficient to meet demand, but not so high as to burden companies with undue costs. This ‘goldilocks’ level of inventories is much more likely to be an explanation for the Private Inventories effect in Q1, and not a structural degradation in business expectations.

Taking a step back from the Inventory data, let us look forward to what may be to come throughout the 2^nd half of 2023, and into 2024. It is the consensus expectation that the Federal Reserve is done hiking rates, and will likely pivot to a more normal Monetary Policy stance by way of Rate Cuts before the end of 2023. After a long time of hearing about how interest rates are going higher and higher it may seem odd to start thinking about how that rhetoric is expected to shift in the opposite direction before the year is over, but that is precisely where we are. Lower rates have traditionally been a positive driver of economic growth and market performance as well.

Additionally, it is the expectation that the Labor Market will remain historically tight even if a gentle cooling-off were to occur. This would posit that Wage Growth may very well continue to be a factor in Consumers being able to steadily increase incomes to further combat the effects of Inflation, which has significantly waned over the past quarter. From the Consumer’s perspective, this backdrop may provide for a future that holds a unique combination of gainful employment, wage growth, and normalized prices across major spending categories.

It is my own belief, as well as the belief of many others, that a constellation of lower interest rates, a wealthier consumer, and waning inflationary pressures could provide a very beneficial path forward for the U.S. Economy and investment markets alike. There are bound to be bumps, bruises, and smoke screens along the way, but with the benefit of extremely solid footing and a bright outlook, we can successfully look through the ‘smoke screens’ and into an exciting economic future.

 

[See Below for Disclosures & Annotations]

DISCLOSURES

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

The companies presented here are for illustrative purposes only and are not to be viewed as an investment recommendation.

Tax laws and regulations are complex and subject to change, which can materially impact investment results. LPL Financial does not provide tax advice. Clients should consult with their personal tax advisors regarding the tax consequences of investing.

 

ANNOTATIONS

1. FactSet. “Economics – Country/Region – United States”. May 4, 2023.
2. Bureau of Economic Analysis. “Gross Domestic Product, 1st Quarter and Year 2023 (Advance Estimate)”. May 4, 2023.
3. Bureau of Economic Analysis. “Labor Force Statistics from the Current Population Survey”. May 4, 2023.
4. Bureau of Economic Analysis. “Personal Income”. May 4, 2023.
5. FRED. “5-Year Breakeven Inflation Rate”. May 4, 2023.
6. FRED. “10-Year Breakeven Inflation Rate”. May 4, 2023.