There is a slowdown lurking. It is currently hiding so well, in the long grass of statistical anomaly, that many observers, including the Federal Reserve, don’t seem to notice it at all. However, investors need to recognize it and have a clear view on the outlook for economic growth, jobs, inflation and profits, how the Federal Reserve may react to a slowdown, and what this could mean for investment returns over the next few years.

On Growth
Real GDP grew at a very healthy 2.9% annualized rate in the fourth quarter of 2022. However, this likely overstates momentum in the economy and, more importantly, deflects attention from potentially weaker growth over the next few quarters. In particular:

• Fourth quarter growth was boosted by surging inventories. Excluding inventory accumulation, real final sales grew by just 1.4%. The January ISM surveys of purchasing managers show that, on average, businesses regard current stockpiles as being roughly appropriate, implying that inventory growth could fall back to average levels relative to final sales over the next few quarters. This could, on its own, reduce real GDP growth by 0.5% over the next year.

• The trade deficit narrowed in the fourth quarter, contributing a further 0.5% to real GDP growth. Given relatively slow global growth and the lagged effect of a high dollar, we expect trade to subtract from real GDP growth going forward.

• Outside of trade and inventories, we expect real consumer spending to grow only very slowly in the year ahead. The personal saving rate in the fourth quarter was 2.9% compared to 7.3% a year earlier, as consumers increased borrowing to try to maintain pandemic-era spending levels. However, this is likely not sustainable and slower credit growth, along with slower job growth, should imply less spending growth in the year ahead.

• Home-building will likely continue to fall, at least in the first half of 2023, reflecting the lagged impact of higher mortgage rates. Elsewhere state and local government spending should rise steadily, although hampered by an inability to attract qualified workers. Business fixed investment could also rise steadily as companies try to substitute technology for expensive labor.

Adding it up, we estimate that real GDP may well register a decline for the first quarter and will likely see just 0.6% real growth on a year-over-year basis by the fourth quarter of 2023 – roughly in line with the Fed’s 0.5% growth projection.

On The Job Market
The January job’s report was clearly much stronger than expected with the economy adding 517,000 jobs in January, compared to a consensus expectation of just 185,000, and revisions adding 71,000 to the gain over the prior two months. This was accompanied by a decline in the unemployment rate to 3.4% for the first time since May 1969 and followed a surprise rebound in job openings at the end of December to over 11 million positions.

That being said, job gains are likely to fall sharply over the next few months. On the demand side, while real GDP rose by just 1% in the year that ended in the fourth quarter of 2022, payroll employment increased by 3.4% over the same period, giving back many of the productivity gains achieved over the pandemic. Going forward, with demand growing very slowly, many employers may be reluctant to boost wages or hire unqualified workers just because they have unfilled positions.

In addition, there may be a seasonal reason for the strong January jobs report. Traditionally, January is the weakest month of the year for employment. Indeed, in the five years before the pandemic, payrolls fell by an average of 2.938 million jobs, not seasonally adjusted, between December and January. In January 2023, the not-seasonally-adjusted decline was 2.505 million jobs, contributing to a seasonally adjusted gain of 517,000.

However, it may be that in today’s very tight labor market, employers were simply reluctant to engage in the traditional layoff of seasonal workers, or that the pandemic has smoothed some seasonal hiring and firing patterns. If either of these explanations has some validity, payroll gains should be much slower over the next five months when the average monthly pre-pandemic not-seasonally-adjusted job gain was 835,000. 

Overall, we expect average payroll job growth of roughly 150,000 per month over the rest of the year. Despite this downshift, continued weak growth in the labor force suggests that this may only marginally boost the unemployment rate from today’s 3.4% to 3.6% in the fourth-quarter, well below the Fed’s 4.6% projection.

On Inflation
Despite a sharp slowdown in the growth of output and employment, a still super-low unemployment rate may cause the Federal Reserve to worry about achieving their inflation goals. They really shouldn’t.

While the extent of the inflation surge took many, including myself, by surprise, the reality is that year-over-year CPI inflation peaked at 9.0% last June, fell to 6.4% by December and is very likely to fall further in the months ahead, possibly dropping to 3.0% by this June. More importantly, most of the factors driving the inflation surge have now moved into reverse. 

• Pandemic related supply-chain issues have largely been resolved, with the percentage of global purchasing managers claiming slow deliveries returning to pre-pandemic levels.

• Excess demand from government pandemic support has also evaporated, with no further government stimulus checks and the end of most other programs.

• The spike in global food and energy prices due to the Ukraine war has also subsided. Crude oil and natural gas prices have retreated to near-pre-pandemic levels while the World Bank’s global food price index in January was down 18% from its peak of last March.

Inflation expectations also remain well under control, with Treasury markets and surveys of consumers and economists all forecasting CPI inflation of between 2.0% and 3.0% over the next 5 years.

Indeed, the only two remaining areas of concern are shelter costs, which are acknowledged to lag reality, and wage growth which some allege is inflationary.

On this last issue, it is really hard to see the point of the inflation pessimists. In January, the average hourly earnings of all workers were up 4.4% year-over-year in a month when we estimate CPI inflation was 6.3% year-over-year. This will mark the 22ndconsecutive month in which wage growth has failed to keep pace with consumer inflation. And this, despite the fact that both employees and employers know that this is the tightest labor market in over 50 years.

As a matter of economic theory, in equilibrium, wages can rise by the sum of output prices and productivity growth. Over the past 20 years, productivity growth in the non-farm business sector, that is the increase in output per hour worked, has averaged 1.7% per year. So, in very rough terms, if you want to sustain a CPI inflation rate of 6.3% year-over-year, wages could grow by 8.0% per year. Anything more, and inflation should rise. Anything less, and it should fall.

The reality of the U.S. labor market is that, despite an excess demand for workers, businesses are unwilling to overpay for labor and workers, largely without the representation of unions and fearing an imminent recession, are willing to accept wage increases below the measured rate of inflation. If this is the case, then as CPI inflation drifts down in a slow economy, so will wage gains.

Consequently, while we expect year-over-year CPI inflation to fall to 3.0% by the middle of this year (after a 0.5% month-to-month bump in January), it could meander up slowly for the rest of the year before resuming its descent in 2024. However, an inflation rate of 3.0% which is taking its time descending to 2.0% is hardly an economic crisis and does not warrant the Federal Reserve tipping the economy into recession in order to hurry its progress towards its inflation goals.  

On Profits
Finally, on the issue of slowdowns, there is clearly a slowdown under way in profit growth. Through last Thursday, with 70% of the S&P500 market cap reporting, S&P500 fourth-quarter operating earnings per share are on track to fall by 11% year-over-year.

We expect this to be indicative of the year ahead, even if the U.S. economy narrowly avoids outright recession. Companies are facing higher interest costs, increased wages, a still-high dollar, declining demand growth and, for roughly 150 large companies, increased taxes due to provisions in the Inflation Reduction Act. After a tough 2023, earnings could stabilize and resume growth in 2024. However, the hit to earnings will likely induce some further corporate caution in hiring and capital spending decisions, adding some drag to the economy.

On The Fed
Given all of this, it would be wise for the Federal Reserve to avoid any further rate increases. By the summer, inflation will be down to manageable levels and there is no particular risk in letting inflation drift sideways or down from there. The U.S. economy is not a fundamentally inflation-prone economy today, any more than it was a decade ago, and it is simply not sensible to trigger a recession to achieve an inflation goal a little faster than would have occurred anyway.

However, investors would do well to take the Fed at its word when it forecast further rate increases in its statement last week or in Chairman Powell’s assertion at his press conference that it would not be appropriate to cut rates this year. While futures’ markets are still pricing in a more dovish outcome, the Fed may now feel its credibility is on the line if it doesn’t maintain this track.

If the Fed does push the funds rate to a range of 5.00%-5.25% at its May 3rd meeting and holds it there through the end of the year, the risk of rising unemployment or an outright recession grows in late 2023 and into 2024. With no further fiscal help likely and with small initial rate cuts undermining, rather than bolstering, business confidence, the Fed’s hard line this year may result in a much softer line in 2024 and beyond. When they do begin to cut rates, they may find they have to cut them a lot.

This is not a great outcome for the economy as a whole and particularly for those families disrupted by job losses. However, it could ultimately be quite good for financial markets if, due to overtight policy in 2023, 2024 turns into a year of further modest declines in inflation and a sharp reduction in interest rates.

In summary, despite recent strong numbers on GDP and jobs, there is a slowdown lurking, which should, belatedly, cause the Fed to reverse course. The policy whiplash won’t do the economy any good, but it could benefit investors who are willing to position themselves today for an eventual return to a slow-growth, low-inflation and low-interest rate economy.

David Kelly is chief global strategist at JPMorgan Funds.