As investors prepare for the May Federal Open Market Committee (FOMC) meeting next week, recent economic data have revealed the toll of the Federal Reserve’s (Fed) aggressive rate-hiking cycle, tightening lending conditions and the softening labor market on economic growth.

The first estimate of 1Q23 real GDP showed the economy grew at a 1.1% annualized rate, below the consensus expectation for 1.9% growth. The downside surprise was largely due to a huge downward swing in inventory-building, which has been a particularly volatile component of GDP over the last few quarters. Meanwhile, final demand rose at a very strong 3.4% annual rate, reflecting a 3.7% surge in consumption. However, we wouldn’t put much emphasis on this strength as consumption was likely flattered by warmer-than-usual weather and the 8.7% cost-of-living adjustment to social security payments that hit in January. These boosts to spending are now fading, and the consumer is facing a series of headwinds that could undermine spending in the remainder of the year.

In particular, the labor market is showing signs of weakness with rising layoff announcements and slower hiring, which may be incentivizing consumers to save more. The personal savings rate has risen to 5% of disposable income from 4.4% at the end of 2022. Still, compared to pre-pandemic savings levels, consumers are saving much less than average, and this has brought the aggregate stock of excess savings that was accumulated during the pandemic down to just USD 0.6 trillion from its peak of USD 2.1 trillion. 

Elsewhere, the outlook for business spending is especially precarious. Business capital expenditures rose at a mere 0.7% annualized rate in the first quarter and survey measures of capital spending intentions have nosedived, as shown in the chart. The regional banking crisis has made credit harder to find and the Fed’s rate hikes have increased the cost of financing new spending, pointing towards a meaningful slowdown in business spending ahead.

In sum, the economy may have squeaked out modest growth in the first quarter, but the tailwinds that supported this growth have now faded and the odds of the economy entering recession by the end of the year have increased. For the Fed, this outlook combined with a sustained downtrend in inflation argues for an end to monetary tightening. Whether we like it or not, we still expect they will raise rates by 0.25% next week, but this hike should be their last. For investors, while we still expect this next recession will be mild, a precarious growth outlook and the heightened risk of a debt ceiling stalemate this summer suggest that an emphasis on quality, diversification and a somewhat defensive mix of asset classes may help investors weather choppier waters.

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