Jim Solloway and Vivian Estadt discuss the 2023 third quarter economic outlook.
Video: Third quarter economic outlook
- Hello, I'm Vivian Estadt, client service director at SEI. I'm here with chief market strategist and Senior Portfolio Manager Jim Solloway, who will present SEI's economic outlook. Jim, the last time we spoke, there was ongoing debate in financial circles about whether or not 2023 would see a downturn in economic activity. Now that we are entering the final months of the year, it seems that forecast for recession are in the minority as the US economy has displayed surprising resiliency. What's your perspective on the prospect of a recession?
- Thanks, Vivian. It's been our view since the start of the year that the US economy would display a fair degree of resiliency led by robust consumer spending. Certainly among advanced economies, the US stands out with respect to withstanding the economic pressure of high inflation, sharply rising interest rates and lagging inflation-adjusted incomes. The chart plots the Citigroup's economic surprise index for the US versus the rest of the developed world. In the box to the right, we see a big jump for the US since May. While other countries have registered an uptick in positive data surprises too, they have not been nearly as significant. Strong retail sales, service consumption, industrial production, and housing demand all contributed to last quarter's surprising results.
- Last quarter, you mentioned early signs of recession. Are you saying that those failed to pan out?
- Not exactly. Even if the US shows continued signs of economic buoyancy relative to other countries and regions, the extent of the surprises are likely to ebb. They could even turn negative as we approach the end of the year. To be clear, we still expect economic growth to decelerate and a mild recession to take hold in 2024. Although economists have mostly shifted away from their recession calls, we remain skeptical that the US Federal Reserve can raise interest rates just enough to reduce inflation without causing a recession. Over the past two years, we have consistently warned that inflation and interest rates would be higher for longer than generally anticipated. In fact, inflation is proving to be tougher to tame than the central bankers assumed, resulting in a cycle of interest rate hikes across the globe. The chart tracks central bank policy rates across the major economies. On the far right of the screen, you can see that most central banks did not begin to raise interest rates in earnest until 2022. Since then, the consensus underestimated the magnitude of tightening that would occur in the face of an inflation problem that proved far less transitory than expected. At this point, the cycle of rising interest rates appears to be finally drawing to a close. While financial markets reflect the possibility of one or two more rate hikes across major economies, these increases may or may not materialize depending upon the fragility of certain economies and how quickly economic growth weakens. The latest Fed projections for the US federal funds rate clearly indicate an intention to keep the policy rate higher for longer. We're in alignment with this view. We don't see the central bank cutting rates until the second half of 2024.
- Inflation has moderated somewhat in recent months, and the US Federal Reserve maintains that core inflation will ease to 2% by 2026. Jim, it sounds like you're not so sure. What are you seeing that gives you pause?
- It's true that inflation pressures have eased somewhat, despite that we are of the view that there has been a regime change when it comes to long-term sustained inflation. We think US inflation will run at a consistently higher rate than the Fed's 2% target for a number of reasons. Labor markets are likely to remain tight as Baby Boomers age out and retire. We are seeing efforts worldwide to diversify supply chains in an effort to reduce dependency on China. This in itself will lead to lower productivity and higher manufacturing costs. Sharply higher borrowing rates, the prospect of higher corporate taxes and efforts to transition to a carbon neutral world will all weigh on corporate profit margins, and companies are likely to respond by passing those higher costs onto consumers. There are hopes that productivity growth will accelerate and help offset these pressures. Generative artificial intelligence and policies incentivizing semiconductor manufacturing could usher in a productivity surge much like the turn of the millennium with the expansion of the internet. As much as we'd like to believe that, productivity data suggests otherwise, at least in the years immediately ahead. The chart plots the five-year annual percentage change in US hourly output per hour versus the capital stock, often referred to as property, plant and equipment. The light blue line representing the change in the capital stock is trending downwards, indicating the seller rating corporate investments in productive capacity. While the black line representing the change in US hourly output isn't showing a sharp decline. Neither trend is indicative of a near term boom as illustrated at the turn of the century seen in the middle of the chart.
- So what do you think this means for investors, Jim? Should they brace for an economic crash landing?
- No, it's certainly not all doom and gloom. The US economy has exhibited surprising strength. It is less interest rate sensitive thanks to all the refinancing of mortgage and business debt that occurred when rates were at historically low levels. We just don't believe that the current resiliency is sustainable in the face of a prolonged high interest rate regime. A mild recession in 2024 still seems to be a reasonable probability at this juncture, even though consensus has swung away from that view.
- Thanks, Jim, we always appreciate your insights. SEI is focused on the major issues that are of interest to our clients. We incorporate these discussions into our advisory process as the impact varies based on each client's goals. For more of SEI's insights,, read our latest economic outlook available on our website.