We’ve said (and reiterated) that the Fed would break something before it reached its 2% inflation goal. We saw a small break with the recent Silicon Valley Bank and Signature Bank failures. Now, we’re seeing those cracks widen with a lower-than-expected Q1 2023 GDP growth rate of 1.1%.
But the story isn’t all doom and gloom. Let’s dig into the details to see where the economy stands, why these trends might impact Fed policy in the future, and how we’re approaching the current environment in our equity and fixed income strategies.
Q1 2023 GDP Growth
First and foremost, it’s important to note that while GDP grew at a slower-than-expected pace, it’s still positive… and that’s positive.
Continued strength in consumption remains the largest contributor to positive GDP growth. In the first quarter, consumer spending (which is responsible for 70.9% of the Q1 GDP figure) grew 3.7%, an increase over the 1.0% growth seen in Q4 of 2022. Rising interest rates remain a headwind for consumers, but a tight labor market, rising wages, and residual financial padding from government subsidy checks have kept the average consumer in a relatively strong financial position.
In addition to consumer spending, increased government spending contributed to first quarter economic expansion, with particularly strong growth in the State/Local sector.
So on a positive note, the economic expansion seen in Q1 reduces the odds of a recession in calendar year 2023. However, there are factors at play (see below) that could further slow growth over the next few quarters.
Inflation, Rising Rates, And Impacts On Consumption
Though strong consumption remains a bastion for GDP growth, we must recognize the fact that headwinds remain.
We’re sure you’re aware of this, but inflation remains persistently high and interest rates are rising with it – both of which inhibit consumption and dampen business investment.
We’re beginning to see evidence that rising prices and rates are beginning to chip away at the resolve of consumers. Fixed Residential Investment continued to fall from previous quarters with a Q1 decline of 4.2%. Additionally, personal savings rates are rising notably. In the first quarter of 2023 personal savings came in at $946.2 billion, up from the $758.8 billion registered in the final quarter of 2022.
These serve as leading indicators that higher prices, a higher cost of servicing debt, and expectations of continued inflation are cause for concern among consumers, despite higher wages and strong employment.
Q1 2023 Earnings - A Similar Story
We are in the thick of first quarter earnings reports with 60% of market cap reporting by the end of the week (April 28th). On balance, more reports indicate revenues and earnings beating estimates than missing (this is not unusual as companies manage expectations ahead of reports). However, the bar for first quarter S&P 500 earnings is now 6.2% below the year-end 2022 expectations. Estimates for the balance of the year have also declined by 3.1% over the last three months. By the end of next week, we will have reports from 84% of the market cap within the S&P 500, and earnings projections for the rest of the year will be updated with the provided guidance.
Compared to last year, first quarter earnings will be down about 9%. If current estimates hold for the rest of the year, the next two quarters will sequentially post smaller year-over-year declines, leading to a 6% estimated gain in the 4th quarter.
Will the current earnings recession deepen, or will it be firmly behind us by year end? A lot can change over 12 months and we are tracking weekly changes carefully for indications.
A Silver Lining To Slowing GDP? (All Eyes On The Fed)
The Federal Reserve has remained steadfast in its fight against inflation. They’ve already indicated that a quarter-point rate hike is in store for May, which puts us “firmly in restrictive territory”. So, where’s the silver lining?
Despite not being anywhere near the Fed’s 2% target inflation (again, which we don’t think they can achieve – at least not in the near future), slowing economic expansion and earnings growth makes a much stronger case for May being the last rate hike…. There may be light at the end of the tunnel.
The Fed had pursued easy monetary policies since 2008. That’s fifteen years of liquidity being pumped into the system. It’s hard to see how the Fed could remove a large chunk of that liquidity in just one year’s time without breaking something. And while the Fed has communicated nothing but resolve in their inflation fight, we’re confident that they don’t actually want to break the system.
If the cracks widen further and consumer confidence waivers, we believe the Fed will likely soften its approach.
It all comes down to how long the Fed stays on their current path, and how long the consumer can overcome the challenges presented by higher prices and rates. Future consumption trends and Fed policy will be two trends to watch closely.
How Is Advanced Asset Management Advisors Approaching The Market Today?
We sound like a broken record, but there’s good reason for that. We manage portfolios fundamentally, through the black and white statistics of market pricing and sector valuation. And despite a lot of noise and volatility in the market, the fundamentals haven’t changed to a degree that would warrant a pivot from the positioning we established ahead of the pandemic.
Our equity portfolios remain focused on large cap companies, tilted toward more defensive sectors with an emphasis on earnings (Healthcare remains a standout). In our fixed income portfolios, we remain positioned in short-term and high-quality debt instruments to reduce the risk to principal in a rising rate environment.
Do you have questions about the economy, the market, or our fundamental investment process? If so, we invite you to submit a question at firstname.lastname@example.org. We’d be happy to speak with you.
Source: Bureau of Economic Analysis
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
Stay Up to Date
Want to stay up to date with fundamentally-driven market insight, economic analysis, and practice management advice?
Sign up to receive regular roundups of our content, delivered conveniently to your inbox.