The economy has been stronger than most economists projected this year. Many had expected a recession, but we have seen the opposite, with Gross Domestic Product (GDP) expected to grow 2% in the 3rd quarter. The growth has been due to resilient consumer spending, which makes up 2/3rd of GDP. However, consumer spending may wane as the summer spending spree on concerts and travel comes to an end. There are numerous economic land mines which may finally trip the economy into a recession (2 consecutive quarters of declining GDP).
There are five economic factors of concern; three are minor, while two are of greater macro concern. The recent discretionary budget stalemate, resumption of student loan payments and the United Auto Workers (“UAW”) strike pose minor economic challenges. Hopefully these events do not expand into larger issues. However, the UAW strike has longer-term implications. The auto industry has experienced a new threshold as the barriers to entry have been broken by the electric vehicles (EV) manufacturers. The legacy manufacturers will be at significant disadvantage if they do not have the flexibility to change, which often occurs in mature bureaucratic organizations. Also, the new budget funding challenge poses a creditability issue with credit agencies and raises the possibility of another credit downgrade.
Now, considering the longer-term challenges. First, the price of oil has risen over 30% based on West Texas Intermediate (WTI) benchmark since June that poses an economic challenge. The increase is due mostly to Saudi Arabia’s decision to cut oil production to increase oil revenues. Remember many oil producing countries are “not our friends” as has been shown many times throughout history. Although the U.S. produces nearly all our country’s oil production needs, the global price of oil influences the domestic price. However, WTI trades about 4% cheaper than Brent crude.
With about 50% of oil being used in numerous applications besides transportation, product cost increase materially. Further, will the Federal Reserve increase interest rates to counter the Saudi Arabia production cut? This is a key factor in the rise of interest rates and stock market weakness since the July highs.
The second and most important longer-term economic challenge is the increase in interest rates. Higher interest rates are damping economic activity and shifting investors’ asset allocations from growth investing to holding cash. Higher interest rates may be driving inflation higher. A few examples relate to home ownership and energy. Higher interest rates have dramatically slowed the home construction industry with 30-year mortgages now at 7.7%, making the housing supply shortage worse and increasing rental rates. Further, the residential solar installations have plummeted as the financing costs outweigh the energy cost savings; These are a few examples of how the Federal Reserve’s high interest rate strategy may be acerbating inflation, not reducing it.
Looking back since the financial crises (2007-2009), we have been in an era of low interest rates. Low interest rates have been a significant tail wind for innovations that bring many new products and services to advance society. In addition, it allowed the issuance of Federal debt that is never a problem, until it is a problem. With the debt rating agency, Moody’s, threatening to strip the U.S of its last AAA credit rating due to poor governance over fiscal affairs, that day may be approaching.
To sum up the economic outlook, strong consumer spending has carried on better than expected, creating GDP growth in 2023. Looking forward, the tightening credit conditions from higher interest rates, higher oil prices, and other external events suggest a slower growth or economic recession is looking more likely. Reduced economic activity could cap the increase in interest rates, thus creating a more favorable environment for the bond and stock markets.