Investors in the week ahead will likely be most focused on the aftermath of the terrible attacks in Israel over the weekend. The consequences of this violence are, of course, first and foremost a human tragedy for all the families affected and they are in our prayers at this time. However, an initial rise in the dollar and oil prices in response to these attacks serves as a reminder of the potential for conflict in the Middle East to impact the global economy and investors will need to keep a close eye both on the evolution of the conflict and its economic implications.
The situation in Israel only adds to the complexity of a very confusing backdrop for markets. Throughout this year, the U.S. economy has been navigating a narrow channel between sticky inflation on one side and a slide into recession on the other, even as Federal Reserve policy has grown into an ever stronger headwind to growth. Meanwhile, over the last few weeks, a storm of data and events have made it very difficult to assess both where the economy is and where it is headed.
Even before the attack on Israel, investors were assessing the impacts of the ongoing UAW strike, the resumption of student loan payments, a narrowly-averted government shutdown followed by the ouster of the Speaker of the House, revisions to national income and product account data going back 10 years, a surge in long-term interest rates to their highest levels since 2007, a selloff in the stock market that has eroded a good chunk of this year’s gains and finally, on Friday, an employment report showing double the expected gain in non-farm payrolls.
Given all of this, it seems like an appropriate time to reassess where the economy is in terms of growth, jobs, profits, inflation, interest rates, risks and opportunities.
Growth
On economic growth, recent data continue to point to very strong gains in the third quarter, with real GDP growth potentially topping 4% annualized. Most notably, real consumer spending, which accounts for more than two-thirds of GDP, appears to have grown by 4% annualized. This gain should be supplemented by strong gains in net exports and government spending, while investment spending, for now, appears remarkably resilient in the face of higher interest rates.
All of this being said, consumers will face greater pressures in the fourth quarter and in 2024. The resumption of student loan payments will act as a drag on spending for younger households while higher mortgage rates and auto-loan rates should help suppress home and vehicle sales. The UAW strike, if extended and expanded, could represent a major hit to output while fiscal policy is likely to grow tighter as the result of any eventual deal on the fiscal 2024 budget. Meanwhile, the recent back up in long-term interest rates, combined with the earlier effects of Fed tightening on short-term interest rates, will also continue to tighten bank lending standards and impact business activity, with many less profitable firms being forced to retrench. Finally, global PMI data for September showed very mediocre overseas growth which, combined with a still-high dollar, should limit any further improvement in net exports. In sum, after a strong third quarter, we expect economic growth to slip to a roughly 2% pace in the fourth quarter and in 2024.
Jobs
Of course, it should be noted that this pace of economic growth is actually above the long-run Federal Reserve expectation of 1.8% and would likely, if realized, prevent any further meaningful increase in the unemployment rate.
The 336,000 gain seen in non-farm payrolls in September was well above market expectations and we expect to see smaller gains going forward. That being said, excess demand in the labor market continues to generate stronger job growth than would be suggested by economic growth alone. Last week’s job openings report for the end of August provided fresh evidence of this, with the number of vacancies rising by almost 700,000 to 9.6 million—still far above the pre-pandemic peak of 7.6 million set in November 2018. Investors will be watching unemployment claims data, due out on Thursday, for further evidence of a tight labor market.
However, even more remarkable than the number of job openings today, is the willingness of workers to settle for moderate wage gains. Average hourly earnings rose by just 0.2% for the second consecutive month in September and are now up just 4.2% year-over-year. Year-over-year wage growth has steadily decelerated since peaking in March 2022 at 5.9% despite the unemployment rate being below 4% since December 2021 and a widespread perceived need for workers to get some addition compensation to offset the last two years of strong CPI inflation.
Profits
That being said, at 4.2% per year, wage growth is still a challenge to companies since we estimate that real GDP per worker, a simple measure of productivity, rose by just 1.0% in the year ended in the third quarter. This should continue to put some pressure on profits with pro-forma S&P500 earnings per share and adjusted after-tax profits from the national income and product accounts likely to show close to unchanged year-over-year readings in the third quarter. In many ways, however, this should be taken as a win by investors as firms have been battling decelerating revenue growth, higher compensation costs and higher interest rates all year. The ability of companies to maintain profit margins in this environment bodes well for earnings gains when interest rate and wage pressures ease. Investors will get a better view of this this week as 12 S&P500 companies are set to report at the start of the third quarter earnings season.
Inflation
And then there is the issue of inflation. On Thursday, the Bureau of Labor Statistics will release its estimates for consumer prices for September. We expect a benign report, with headline inflation rising just 0.3% and 3.6% year-over-year (compared to 3.7% year-over-year in August) and core CPI climbing 0.2% and 4.0% year-over-year (compared to 4.4% year-over-year in August). Moreover, wholesale gasoline prices have fallen quite sharply in recent weeks due to falling crude prices and narrower refiner margins. While fallout from the attack on Israel could reverse this trend, if it doesn’t, then energy prices should subtract from inflation in the months ahead. It is still the case that, despite resilient economic growth, both headline CPI and headline consumption deflator inflation appear to be headed to 2% year-over-year or lower by the fourth quarter of 2024.
Interest Rates
Given all of this, and the restrictive effect of the rise in long-term interest rates since the start of the summer, we expect that the Fed will put off any decision on a final rate hike at their meeting on November 1. It is still possible that they will raise rates at their last meeting of the year on December 13. However, if they do so, that will very likely be it. While the economy has proven resilient so far, the risk of over-tightening in an environment of so much uncertainty exceeds the danger of not tightening enough.
For investors, despite all these uncertainties, recent data suggest that the economy is not only looking stronger for longer but also that it is achieving this momentum without the inflationary penalty that many, including members of the Federal Reserve, thought was inevitable. However, risks abound from domestic politics, geopolitics, industrial action and the danger of a policy mistake.
This being the case, it still makes sense to look for opportunities in long-term investments in equities, fixed income and alternatives but to do so with a keen eye to valuations and a disciplined approach to diversification in a very complex financial environment.
David Kelly is chief global strategist at J.P. Morgan Asset Management.