Consumers Feel Constrained
A pivot from spending on goods to services is expected to keep spending going over the summer. Travel and tourism are strong, but the big area to watch is health care. Many are still scrambling to catch up on routine exams and elective surgeries delayed by the pandemic. This is in addition to the surge in long COVID cases, which will further stress the health care system. (I am still trying to get my arms around monkeypox and how that will play out for the labor market and distort demand for services.)
A rapid drawdown in the savings amassed during quarantines, high inflation, rising interest rates and an eventual increase in unemployment suggest that consumer spending will further weaken as we move into 2023.
Separately, there is the unwinding of spending on goods we saw as the pandemic took hold and home buying soared. We have already bought much of the stuff needed to work from home and to ease the monotony of quarantines. Now we will see a downdraft in demand for home remodeling and big-ticket household goods; that includes spending on vehicles.
We were already skating on thin ice in the second quarter of the year, with consumer spending growing at an anemic 1% annualized pace after adjusting for inflation. That is about as close to zero as one can get without completely stalling out. A couple of negative quarters can’t be ruled out.
Home buying and building are the most interest-rate sensitive of sectors and have already plummeted. A 20% drop in pending home sales and an 11% drop in single-family permits in June suggest that the worst is still ahead of us.
Even investors, who were paying cash and snapping up homes sight-unseen to flip, are pulling back. Those shifts and a surge in cancelations for homes to be built are eating into backlogs.
Making matters worse for the Fed are housing shortages. That has buoyed prices and increased the demand for rentals, which remain in short supply. Investors are still buying houses to rent. The result has been an acceleration in shelter costs.
Problems in the tech sector mean that some of the hottest relocation markets in recent years will be hit hardest; Austin, Boise and Charlotte are in that mix. That is not enough to derail the upward pressure on ownership costs in the pipeline. It takes a year or longer for the initial rise in home values to show up in inflation measurements; home values were still accelerating in the first quarter of this year.
The silver lining is improvements in underwriting, which have left homeowners and lenders with a larger cushion in equity than we saw when the bubble of the early 2000s burst. Properties that slip into default should still be able to be sold at a premium. That is the opposite of the surge in underwater mortgages in the wake of the subprime crisis.
Businesses Pull Back
Business investment is poised to pick up a bit after pausing in the second quarter. Many of the supply chain problems triggered by lockdowns in China have begun to be resolved. That opens the door for some catch-up in economic activity in the second half of 2022.
Prospects for 2023 are not as good. Additional rate hikes, a strong dollar and weakness abroad are expected to take a larger toll on investment in 2023.
Large banks are already tightening credit standards to avoid big losses, while deals that made sense when rates were zero are now being abandoned. Even venture capitalists and private equity investors are growing more cautious. Unicorns are seeing much of their funding disappear.
The silver lining has been investment in intellectual property. That includes business and nonprofit investment in R&D, software and entertainment, literary, and artistic originals. It represents the backbone of innovation. Even there, we could see some weakness given the drop in streaming so many relied upon to weather the storm of lockdowns.
Inventories fell in the second quarter after ballooning in late 2021. The problem is that the overhang is still high relative to demand, especially in the retail sector. Manufacturing inventories look more balanced. The former has prompted discounting by big-box retailers. This is known as the bullwhip effect and should alleviate some of the upward pressure on goods prices.
The overhang of inventories is likely to challenge the shift from just-in-time to just-in-case inventory systems. Storing inventories is costly. Big-box retailers are already attempting to leverage their market power and shift more of those costs onto their suppliers.
Government Spending Rises
Federal government spending is poised to continue to shrink in 2022 as the effects of pandemic aid play out. We have not included any additions for the scaled-back, Schumer/Manchin compromise; the annual spending is a rounding error on the federal budget and partially offset with some tax increases.
Much like the infrastructure bill, much of the bill will take time to ramp up. The full effects of the infrastructure bill are not expected to show up in government spending until the mid 2020s.
State and local government spending, which represents the lion’s share of government spending, is expected to have more impact. State and local governments have yet to spend the windfall gains in tax revenues they received as employment surged and spending on goods and homes soared.
That is in addition to the savings school districts accrued as they pivoted to online from in-person and the transfers to states in the last round of pandemic aid in 2021. Some of those gains are being banked in rainy day funds. Others are being held up due to constraints on how aid can be spent. Many states are still trying to figure out how they can stay within the framework laid out by the federal government when using those funds.
Any state that can is cutting or temporarily eliminating taxes on food, energy and even things like school supplies. They are also issuing tax refunds to blunt the blow of inflation. That makes for good politics but further complicates the Fed’s goal to cool inflation via weaker demand.
Trade Deficit Waffles
After widening sharply in the first quarter, the trade deficit narrowed in the second quarter. The question is whether it can stay there. A strong dollar and a more resilient economy in the U.S. than abroad suggest the trade deficit will widen in the second half of 2022.
A sharper slowdown in the U.S. in 2023 could reverse those trends and allow the trade deficit to narrow a bit. Imports are expected to weaken more than exports next year.
The wildcard is China. Increased tensions with the U.S. and Taiwan have upped China’s military exercises in the Taiwan Strait, which is disrupting global trade flows. There is the potential it could be more consequential.
Risks are stacking up to the downside. The bulk of the slowdown triggered by recent rate hikes by the Fed are still ahead of us. The Fed is still raising rates and will not know it has gone too far until it has. This is in addition to the speed of rate hikes, which in-and-of themselves are destabilizing, and reductions in the Fed’s bloated balance sheet. The latter do not hit their stride until after Labor Day.
Chart 2 provides the outlook for overall and core (excluding food and energy) Personal Consumption Expenditures (PCE) index over the next year and a half. It will take some time for inflation to return to the Fed’s 2% target:
- The recent drop in prices at the gas pump will take some of the steam out of month-to-month increases in overall inflation. However, the rise in gas prices relative to a year ago remains high. This will put a floor under how rapidly overall inflation cools.
- Discounting by big-box retailers and the slowdown in housing will help alleviate the upward pressure on goods prices.
- A surge in the value of the U.S. dollar should exacerbate the slowdown/drop in import prices.
- The sticking point is service sector prices. Shelter costs still have room to run. Home values have only begun to slow but it takes at least a year for those shifts to show up in home ownership costs, while rents are still skyrocketing.
- Medical costs have begun to rise. COVID was costly and upped the risk of consolidation in the health care sector; staffing shortages remain acute and backlogs on more profitable and inflationary elective surgeries remain large.
This is at the same time uncertainty is high regarding additional supply shocks. My friends in the intelligence community have not ruled out more aggressive moves by President Vladimir Putin to weaponize oil exports, while military exercises in the Taiwan Strait underscore the breadth of geopolitical risks we are facing.
Separately, the frequency of extreme weather events is accelerating due to climate change. That is further disrupting supply chains and exerting upward pressure on prices. The recent flooding, damage to property and disruption to businesses in Appalachia and fires and drought in the West are only a few examples.