I have never been blessed with any skill in golf.  However, I do have some imagination and so I can imagine a situation in which I am lining up a long and difficult putt.  With well-justified humility, I wince as I strike the ball, knowing it will miss.  However, even two or three seconds after sending it on its way, I realize that, surprisingly, I’m still not sure how it will miss – I can’t quite tell if it’s going to miss to the right or to the left.  And so, of course, the ball trundles its zig-zaggy way up to the lip of the hole, pauses, and then topples in.

Last week’s GDP report ignited angst on both sides.  Some worried that the economy was slowing too much, with recession in the offing.  Others saw too much inflation, requiring an even more aggressive Fed campaign to squash it before it begins to reaccelerate in a serious way.

However, even in this age of pessimism, there should be a limit to the number of fears we are willing to indulge at the same time.  The details of the GDP report suggest that there is no immediate reason to worry about a sharp slowdown.  The April jobs report, due out at the end of this week should reinforce this message.

Moreover, while the declining trend in inflation appears to have stalled out for now, a closer examination of the numbers suggests that it will slowly reemerge in the months ahead.  More importantly, with core PCE inflation at 2.8% year-over-year, it is far below its 5.6% peak, set back in February of 2022, and it’s within one percentage point of the Fed’s 2% target.

When the Fed meets this week, they will very likely worry out loud about the tightness of the labor market and the lack of further progress on inflation.  These worries could further dash hopes of meaningful monetary easing in 2024 and could put some downward pressure on both bonds and stocks.  However, the truth is the data show an economy that is largely on track to both enhance the living standards of American households and to support rising asset prices.  In this environment, investors should still focus on making sure they have the right asset mix among long-term investments rather than hiding in cash and waiting for the economy to fall of the rails. 

The Growth Track

Looking first at economic growth, following surprisingly strong readings of 4.9% in the third quarter of last year and 3.4% in the fourth, real GDP grew by just 1.6% annualized in the first quarter of this year.  This was well below consensus expectations for a 2.5% gain.  However, the shortfall was entirely due to weakness in inventory growth and trade, which are notoriously the most volatile components of real GDP.  Real domestic final sales grew by 2.8%, following 3.5% gains in each of the prior two quarters, far more indicative of the true track of economic growth in early 2024.

Looking at the details, consumer spending posted a healthy 2.5% annualized gain for the first three months of the year.  Moreover, with strong real spending gains of 0.5% in both February and March and solid industry reports on April activity, consumer spending could rise at a 3.0% annual pace in the second quarter.  Thereafter, consumer spending should grow more slowly.  However, with strong year-over-year gains in both real wages and employment and with sharp increases in household wealth, courtesy of a rising stock market, consumer spending should continue to drive economic expansion for the rest of the year and into 2025.

Investment spending should also grow at a steady pace, at least in the near term.  While a glut of low-end office buildings and retail space is acting as a drag on construction and interest rates are much higher than over most of the past 15 years, there are some important positives also.  Federal government incentives are promoting the construction of domestic manufacturing facilities and green transition spending.  The promise of AI-fueled productivity gains is spurring technology spending.  And finally, American business is just generating a lot of cash for investment purposes, with corporate profits sustaining recent gains after soaring in the wake of the pandemic. 

Following a first-quarter surge, homebuilding should grow more slowly going forward while the U.S. trade deficit could widen.  Conversely, government spending should grow steadily and inventory growth should add slightly to GDP gains in the year ahead.  We still expect real GDP growth to slow from 3.1% year-over-year in the fourth quarter of last year to a little over 2% by the fourth quarter of this year.  But for those worried about recession, there is nothing on the demand side of the economy that suggests this is imminent.    

The Jobs Track

This Friday’s April jobs report should give us some further insight on the supply side.  Strong GDP growth in recent quarters should translate into significant gains in payroll employment and we are looking for a roughly 240,000 job gain following a greater than 300,000 increase in March.  Moreover, with unemployment claims remaining a very low levels, the U.S. unemployment rate could remain at 3.8% - the 29th consecutive month with unemployment at or below 4%.

Since the unemployment rate dipped below 4.0% in December 2021, the U.S. economy has added a remarkable 8.4 million jobs, despite projections of very sluggish growth in the working age population.  This has been achieved partly due to a rise in the labor force participation rate for people of working age and partly because of a migration surge.  The increase in labor force participation rate is likely to fade from here.  However, the lagged effect of the migration surge should continue to supply workers to meet still-rising demand.  This could keep the unemployment rate from drifting significantly lower.

In addition, there is still little sign of a surge in wage pressures.  We expect the employment cost index, due out on Tuesday, to show a further small decline in year-over-year compensation growth, possibly to below 4%.  Meanwhile, Friday’s reading on average hourly earnings for all workers in April could also show a slight drift down in wage inflation. 

Despite a labor market that is universally acknowledged to be tight, workers are generally not receiving huge nominal wage increases.  This may, to some extent, just reflect a greater determination on the part of business to limit wage increases than on the part of workers to demand them.  It is notable that there have only been four major strikes so far this year, that is strikes involving more than 1,000 workers, and only one which has lasted more than a few days.  The number of workers quitting each month has also now fallen below pre-pandemic levels, with a new reading on this statistic due out in the JOLTs report on Tuesday.

So while the strength of the labor market could, in theory, ignite wage inflation, so far it has not done so in a serious way.

The Inflation Track

The U.S. economy is producing solid economic growth, strong job gains, low unemployment and, so far, moderate wage gains.  However, it must be admitted that inflation, while far below its peak levels, has stopped falling in recent months.

In particular, the personal consumption deflator rose by 2.7% year-over-year in March – its fastest pace since last October.  The core consumption deflator, which excludes food and energy, rose 2.8% year-over year, the same as in February and not significantly lower than 2.9% year-over-year gains seen in January and December.

Looking at the details, goods inflation has essentially fallen to zero over the past year.  There are some areas of genuinely sticky inflation within services, most notably in measures of rent and owners’ equivalent rent, insurance, restaurants, leisure and hospitality and day care.  However, we believe that the rental inflation measures will continue to fade (as they have done over the past year) in a lagged reflection of actual new leases being signed.  Auto insurance inflation  should also fade as both new and used vehicle prices are down year-over-year.  Meanwhile, an influx of migrant labor should eventually reduce inflation in the restaurant, leisure and hospitality and day care industries. 

While inflation may be slow to fully descend to the Fed’s 2% target, a 2.7% year-over-year number, with the prospect of further moderation, is hardly a reason for alarm.

The Fed’s Track and Investment Implications

As the Fed’s Federal Open Market Committee gathers in Washington this week, market hopes for near-term easing have evaporated.  Futures markets are currently pricing the probability of a June rate cut at just 14% and have only one rate cut for 2024 fully priced in, with a 44% shot of a second.  This stands in sharp contrast to the start of the year when futures markets were predicting six rate cuts or more in 2024. 

While the Fed’s own messaging has not swung as wildly as the futures market, Fed officials have sounded increasingly hawkish in recent weeks and this will likely be reflected in their communications on Wednesday.  In particular, they are likely to note that progress towards lower inflation has stalled in recent months and that they will now need to wait for some more time to gain confidence that inflation is on a downward track.

This messaging, if they leave it at that, might not undermine financial markets.  However, markets would likely react badly if they ramped up hawkish messaging, opening the door to no rate cuts at all in 2024 or further tightening. 

However, for long-term investors, there is little reason for angst either about the track of the economy or the Fed’s reaction to it.  Long-term interest rates are higher than they have been on average since the Great Financial Crisis.  However, it is worth noting that, in the 50 years before the GFC, 10-year Treasury yields averaged 2.7% above core CPI inflation.  If that inflation measure, along with other inflation gauges, is indeed headed back to 2%, today’s 10-year yield of 4.62% seems about right – low enough to help good businesses prosper while high enough to gradually weed out unprofitable enterprises and unreasonably lofty valuations.

In truth, the economy appears to be on the right track in terms of economic growth, job growth, real wages, inflation and interest rates.  It is a track that should allow for positive long-term returns for financial assets.  However, with relative valuations still distorted following the pandemic and the economic turmoil it triggered, investors should focus not on whether to invest but rather on how to invest in today’s extended soft-landing economy.