"Q4 2023 - The Frog's Economy"

GROSS DOMESTIC PRODUCT

• In Q4 2023, The U.S. Economy grew at a seasonally-adjusted annual rate of 3.3%. Q4 2023 marks the sixth consecutive quarter where economic growth exceeded what many believe to the long-term trend growth of the economy at 2.0%. This quarter’s growth rate of 3.3% constitutes a deceleration from the abnormally high growth rate of 4.9% in Q3, while at the same time ranking as the 3^rd highest rate of quarterly growth over the past 2 years^1,2
  • Consumption
    • Personal Consumption Expenditures, by far the largest segment of the economy, grew at a pace of 2.8% (SAAR) in Q4. This quarter’s growth rate constitutes a very slight deceleration from last quarter’s growth rate of 3.1%; however, still remains in robustly positive territory. Consumer spending on Goods grew at a pace of 3.8% in Q4, which was shared relatively equally between Durable Goods and Non-Durable Goods, with each growing at respective rates of 4.6% and 3.4%. Within Durable Goods, Recreational Goods & Vehicles gained the top spot having grown at a rate of 11.0% in the quarter, marking the 3^rd consecutive quarter of double-digit growth in that sub-category. Additionally, Q4 witnessed the 3^rd consecutive quarter of contractions in the Motor Vehicles & Parts (Non-Recreation) subcategory as higher interest rates continue to collide with stubbornly high prices. Within the Non-Durable Goods category, all major subcategories experienced positive growth in Q4. The standout subcategory in Non-Durable Goods was Clothing & Footwear, having grown at a pace of 6.0% in Q4, directly in-line with the prior quarter’s reading of 6.2%. Consumer spending on the Services category has accelerated over the past 2 months, with Q4’s reading at 2.4%, up from 2.2% and 1.0% in the prior two months. Within Services, spending on Food Service & Accommodations continues to growth at a robust pace of 7.6%, the second highest quarterly reading in the past 2 years. Transportation Services also saw an elevated rate of growth in the quarter, coming in at 6.0%, which also constitutes the second highest quarterly reading in the past 2 years. Recreation Services is another sub-category where growth has been both robust and consistent with Q4’s reading of 5.1% marking an acceleration from the prior two readings of 2.3% and 1.5%^1,2
  • Investment
    • The Private Investment component of GDP grew at a pace of 2.1% in Q4 23’, a large deceleration from the prior quarter’s reading of 10.1%; however, this is largely due to the inherent volatility of Inventory Spending effects on this component, rather than this deceleration representing an outright deterioration of underlying fundamentals. The Non-Residential Investment category grew at a pace of 1.9% in Q4. This sub-category was bolstered by continued/large-scale investment growth in the Manufacturing Sector, which has consecutively grown by double-digit amounts every quarter for the past 2 years largely due to increased investment in domestic semiconductor manufacturing. Elsewhere within the Non-Residential Investment, Software spending continues to be one of the most consistent and highest growing areas of the economy, having grown by an average rate of 9.31% over the past 20 years. The Residential Investment category of Private Investment grew at a modest pace of 1.1% in Q4, with Single Family Housing experiencing its second consecutive quarter of double-digit growth, which was partially offset by contractions in Other Structure Investment of -6.1% (this line item typically includes Ancillary Residential Structures). Finally, businesses continued to add to existing inventories in Q4, adding an additional 82.7B worth of provisions, representing an increase from Q3 where businesses added 77.8B. The aggregate Change in Inventories line-item has been positive every quarter for the past 10 quarters^1,2
  • Net Exports
    • The U.S. Trade Deficit has continued its recent trend of contracting in Q4 (a beneficial development for domestic economic growth) and came in at a level of -908.2B. Q4 marks a material downtick in the Trade Deficit from Q3 where the metric came in at -930B, and is also a large improvement over the United States’ quarterly all-time high Trade Deficit of -1.116T in Q2 of 2022. Recent improvement in the U.S. Trade Deficit has been attributed to a stagnation in Imports, as well as outright growth in Exports over this time. A standout area of growth in Exports has come from Travel Services, which has grown by double-digits for 7 of the last 9 quarters.^1,2
  • Government
    • The Government Spending component of GDP has been an area of steady growth over the past 6 quarters. Q4’s aggregate growth reading for Government Spending came in at level of 3.3%, fairly in-line with the prior 5 quarters. Over the past 6 quarters, each sub-category (Federal/State/ Local Government Spending) has been positive. Federal Government spending grew at a pace of 2.5% in Q4, whereas State & Local Government spending grew at a pace of 3.7%. Each respective growth rate represents a slight deceleration from the prior quarter’s readings; however, both Q4 readings remain at moderately strong levels^1,2

 

EMPLOYMENT

• The Unemployment Rate for the U.S. Economy is currently at a level of 7%. This level of Unemployment is largely considered by the Federal Reserve as representing Maximum Employment levels for the Economy

• Over the past year, the Labor Force has seen a modest uptick. January’s Labor Force reading came in at a level of 167.3M, up from 166.3M one year ago^1,3
  • Higher levels of wage growth are an important factor driving growth in the Labor Force over the past year^1,3
  • Although the Labor Force has grown over the past year, the Labor Force Participation Rate remains below pre-pandemic levels, coming in at 62.5% compared to 63.3% in the pre-pandemic era.^1,3

• Over the past year the number of Employed Individuals has grown to a level of 161.2M, up from a level of 160.3M^1,3

• The number of Job Openings in the Labor Market have continued to moderate at a steady pace since reaching their all-time high at the start of 2022, a sign of normalizing labor supply/demand imbalances. There are currently 9.02M Job Openings ^1,3

• • There are currently 1.47 Job Openings available for every Unemployed Individual^1,3
  • The number of Unemployed Individual stands at 6.1M^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^1,3

• Average Weekly Earnings have continued to rise over the past year by about 3.01%, a continued 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, in tandem with consumer substitution effects, have been instrumental factors in allowing U.S. consumers to partially offset the effects of higher Inflation^1,3

 

INFLATION

• Headline PCE Inflation in the month of December was 2.0% (SAAR) and has averaged a level of 2.60% over the past 12 months.^1,4
  • Additionally, Core PCE Inflation’s December reading came in at a level not meaningfully different than Headline at 2.1%^1,4
  • Over the past year, substantial progress has been made in reducing the rate of inflation; however, the economy has not experienced widespread deflationary pressures. Many areas of the economy are still dealing with stubbornly high prices and continued inflation. Pricing pressures do appear to be more varied in recent history^1,4

 

• There has continued to be material differences between inflationary pressures across Goods and Services. Goods have generally been experiencing outright deflationary pressures, while Services have continued to experience upward pressure in prices^1,4
  • In the month of December, Goods experienced its third consecutive month of deflationary pressures, coming in at a level of -2.2%. The prior two reading were -8.3% and -3.6%^1,4
    • Durable Goods has been an area of varied deflationary pressures over the past quarter, with prices having contracted by -4.7%, -5.1%, and -3.3% over the past three months. Recreational Goods & Vehicles has been a standout area in the category with declines of -19.0%, -13.3%, -4.6% each month during the past quarter. Additionally, Furnishings & Household Equipment just cataloged its fourth consecutive month of price contractions, coming in at a level of -1.1%.^1,4
    • Non-Durable Goods have also experienced deflationary pressures over the past 3 months, logging readings of -0.70%, -10.1%, -3.8%. Food inflation has been stagnant over the past quarter with readings of 0.70%, -1.1%, 3.0%. Other standout areas of the Non-Durable Goods section include Clothing & Footwear, which has experienced 4 consecutive months of price contractions, as well as Gasoline & Other Energy Goods which have declined each of the past 3 months^1,4
  • Services Inflation has proven to be the most stubborn area of continued inflationary effects in the economy, having experienced abnormally high/positive inflation every single month since the start of 2021. The 15 year median for Services Inflation is about 2.40%, and this figure has been exceeded almost every single month since 2021, with December’s reading coming in at 4.16%^1,4
    • There have been many standout areas and trends within Services Inflation in recent history. Air Transportation has cataloged historically high levels of inflation in the past 4 months with readings of 21.8%, 38.0%, 17.7%, and 58.0%. Household Utilities prices have been abnormally high as well over the past 2 years, with the most recent readings coming in at 8.7%, 17.0%, and 4.9% (mostly from electricity and natural gas). Rent Inflation has also remained stubbornly high and has ranged from about 5.0-10.0% each month for the past 2 years.^1,4

 

• Market Expectations of future inflation levels have been extremely stable since the mid-point of 2022, a potentially welcome sign for the economy as expectations of future inflation have historically been closely correlated with actual inflation to come^5,6
  • Market Expectations for future Inflation on a 5yr forward looking basis are now at a level of about 2.25%, 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

Briefly indulge me for a moment and picture this – you’re enjoying your time in a nice warm, tropical habitat. You have sunshine, calm waters, a gentle breeze, and not a soul around to bother you. Your skin is perfectly moisturized, and you’ve never felt more limber ever before in your life. You start to feel an appetite coming on but notice there are no agreeable options within reaching distance. So, you assess your options, make a decision, get a quick stretch in, then you ……. jump from your lily pad in search of some tasty flies.

By now you have probably realized this is not the experience of an actual person, but of a frog instead.

As it turns out, although the differences between us humans and frogs are both obvious and numerous, nature has a funny way repeating itself, and we may actually be a lot more similar in behavior to our slippery green friends than initially imagined.

Humans, as well as frogs, are infinitely adaptive creatures and there is no better illustration at highlighting this remarkable ability than by looking at the state of the consumer in the U.S. Economy over the past 4 years. Of particular note has been seeing just how the consumer has responded to stubbornly high inflation across so many of the things we rely so heavily on. One of the most powerful weapons the consumer has had in combatting inflation has been the ever-increasingly important concept of Substitution. In the exact same way that a frog may substitute one lily pad for another in search of better food options, consumers have been successful in substituting out various products and services that have become prohibitively expensive for more agreeable options.

The direct effect of these consumer substitution is more straightforward in that this practice allows individuals to retain, reduce the decline of, or even grow disposable income in the face of abnormally high pricing pressures. The other effect of this consumer substitution is less straightforward in that it introduces intra-categorical volatility within the consumer-facing side of the economy (which is the lion’s share of the economy). GDP is a combination of 4 major categories (Consumer Spending, Private Investment, Government Spending, and Net Exports), with each of those categories being the culmination of many individual sub-categories. If you measure intra-category variability between those sub-categories each quarter, and then analyze how that variability has evolved over time – a unique insight can be found.

What we’re seeing is that although economic growth has generally been high during the post pandemic-era – so has the variability amongst where people spend money. One could point to this finding as the quantitative manifestation of Consumer Substitution effects. If that is the case, then what would that mean exactly for investors moving forward? Here are a few ideas…

To start, a rising tide may not lift all ships anymore. During the post global financial crisis era, ultra-low interest rates and job growth fueled rather indiscriminate consumer spending across pretty much every consumer facing industry. With the massive hindrance that is persistent inflation, consumers have exhibited a frog-like limberness, shifting their spending to more agreeable arrangements. Firms whose products and services can no longer be justified at their price level may experience a deterioration in business (by way of slower growth, or even outright contractions) as their market shares decline in favor of more agreeable products and services. Why would someone buy a fast-food burger if it costs pretty much the same as a filet mignon?

Additionally, as the rather dusty economics book taking up space in my closet would suggest, if we are in an environment where prices across many goods and services have gotten out of equilibrium (by way of overshooting) than we could be in store for isolated instances of supply surpluses. It seems like a counter-intuitive idea after having been recently plagued by ongoing inventory and labor shortages, but nevertheless this could very well be a viable outcome in specific instances (most likely not in an economy-wide manner). In theory, this could ultimately be a landing point for firms losing market share to more agreeable competitors.

Finally, isolated price wars. Many, but not all, firms have experienced at least some degree of margin expansion during the past few years. With the new backdrop of a more selective consumer, firms could attempt to take advantage of the ‘buffer’ these slightly higher margins afford and initiate a ‘race to the bottom’ in an effort to win consumer business. Price wars may also not be confined to business-to-consumer firms as well. Although not directly counted as Consumers, businesses do make for cost-cognizant shoppers as well, and as such could also be beneficiaries of pricing competition. Stated in amphibian terms, if two lily pads are pretty much the same size – I’m headed to the one with more flies.

So, much like our lily pad occupying counterparts, consumers are far from sedentary creatures. When faced with higher prices, or even lower wage growth positions, it has become more probabilistic now more than ever that we’ll follow the direction of our slippery green friends and ‘switch lily pads’. In essence, consumers adapt to the economy, and then the economy adapts to the consumer. Moving forward, we may be on the cusp of transitioning to the second link in that chain of events; as always, time will tell. In the meantime, keep in mind two things – this is a big pond, and there are a lot of lily pads in it.

 

[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”. February 1, 2024
2. Bureau of Economic Analysis. “Gross Domestic Product, 4^th Quarter and Year 2023 (Advance Estimate)”. February 1, 2024.
3. Bureau of Economic Analysis. “Labor Force Statistics from the Current Population Survey”. February 1, 2024.
4. Bureau of Economic Analysis. “Personal Income”. February 1, 2024.
5. FRED. “5-Year Breakeven Inflation Rate”. February 1, 2024.
6. FRED. “10-Year Breakeven Inflation Rate”. February 1, 2024.