1/27/23 – The Devil is in the Details

Fourth quarter GDP registered 2.9% annualized growth, beating the 2.6% expectation, but as is often the case with economic data, the devil is in the details.  The growth was driven by rising inventories, government spending, and softening imports.  The weakness in imports is mostly due to the Chinese covid quarantine and the resultant slowdown in production.  With the Chinese factories humming again, we expect that net imports will revert to being a drain on GDP in the first quarter.  Similarly, inventories added nicely to the headline number but that is also likely to flatten this winter.  The biggest disappointment in the release was private final domestic demand.  The measure of how much Americans wanted to consume fell from 1.1% in Q3 to 0.3% in Q4.  That’s a significant slippage in demand, which jibes with the disappointing retail sales registered in the last two months of 2022.

Similarly, Durable Good sales for December surged to a better than expected 5.6% following a decline of 1.75 in November, and more than doubling the forecast of 2.5%.  But the headline number was dominated by a large aircraft purchase of Boeing aircraft by United Airlines.  Durable Goods, ex-transportation, a better measure of broad durable activity contracted by -0.1 in the month, further evidence that manufacturing is softening.

Finally, on Friday morning the University of Michigan survey showed that consumers expect inflation in the coming 12 months to register 3.9%.  That measure touched a high of 5.4% last March and has been steadily falling since then.  We interpret that as a welcome indication that consumers are assuming that inflation is not going to become entrenched.

Investors looked past the headline GDP and Durable Goods numbers and are focused instead on the slowdown in consumption.  With the peak yield in Treasury Bills at 4.45% and the 2-year note yielding 4.21%, investors are implying that the Federal Reserve will not be able to push Fed Funds up to their stated 5%-plus target.  With the FOMC meeting next week, the consensus estimate is that the Fed will hike rates another 25 basis points.  Given the widely telegraphed message that another rate hike is coming, we’re not going to argue otherwise.  But we think they should pause in March and evaluate what they’ve done to date.  Conventional wisdom holds that monetary policy affects the economy with about a 14-month lag.  Given that the Fed first hiked the overnight rate less than one year ago, a pause is certainly warranted.