Resilient, Turbulent 2022

Real GDP rose 2.9% in the fourth quarter, a modest slowdown from the 3.2% pace of the third quarter. That contrasts with two consecutive quarters of decline in the first half of the year. Real GDP growth grew at 2.1% annual rate in 2022 after hitting a stunning 5.9% pace in 2021. The change in growth on a fourth-quarter-to-fourth-quarter basis, which better tracks momentum in the economy, fell to 1.0% in 2022 from 5.7% in 2021. 

Solid Year-End

Consumer spending slowed but did not collapse in the fourth quarter. Spending on services – travel, tourism and medical care – outpaced gains on goods. Heavy discounting helped buoy spending on big-ticket items at the end of the year. 

The recession in housing deepened, with home buying and construction activity falling at a 26.7% annual rate in the fourth quarter, almost the same as the third quarter. That makes for three consecutive, double-digit quarterly losses in a row. Housing activity is expected to get worse before it improves. Mortgage applications were still more than 30% below 2022 levels in January of this year. Remodeling activity held up better. Backlogs for materials and appliances have eased, which has opened the door for those with low rates and a lot of equity in their homes to finally move forward with repairs and upgrades delayed during the peak of the buying and building frenzy. 

Business investment expanded 0.7%; declines in spending on equipment offset a rise in intellectual property. Nonresidential structures were close to flat after declining for six consecutive quarters. Recent orders data suggest that business investment will contract in the first quarter. The backlog of orders due to supply chain disruptions has largely been met while new orders, except for aircraft, are now falling. 

On the structures side, the outlook remains dim. Cap rates on commercial office space spiked in the fourth quarter as the work from home genie is not returning to its bottle. Those who did return to offices continued to look for higher quality office space, which left lower quality space empty. The outliers are construction of computer chip and electric vehicle plants. 

Inventories were rebuilt in the fourth quarter after draining in the third quarter. Those increases alone accounted for more than half of overall growth in the fourth quarter and will need to be liquidated as we move into the first and second quarters of 2023. The contraction in manufacturing activity, which slipped below year-ago levels in December of 2022, will accelerate.

Government was the biggest surprise. Nondefense federal spending surged at a double-digit pace after adjusting for inflation as some infrastructure projects got started. That was despite the continuing resolution, which held government spending in check while Congress scrambled to pass a budget for the 2023 fiscal year. The new fiscal year started on October 1, 2022. State and local government spending slowed but also surprised to the upside, as coffers were drained to hand out tax rebates and blunt the soaring prices at the gas pump at the start of the quarter.  

We expect federal spending to remain strong in the first quarter as an 8.7% surge in Social Security payments takes effect in January. That is the largest cost of living adjustment (COLA) for Social Security recipients in decades. The gains in federal spending will dissipate as we get into the second quarter. The question mark is how much infrastructure spending from the fiscal 2021 budget ramps up.

The trade deficit narrowed in the fourth quarter for the wrong reasons. Imports fell more rapidly than exports. Imports softened as retailers braced for weaker demand and more discounting on goods, while exports weakened in response to a strong dollar and weaker growth abroad. Services exports, which includes international travel, picked up.   

Separately, the overall GDP deflator, an aggregate measure of inflation, slowed to a 3.5% annual rate in the fourth quarter from a 4.4% annual rate in the third quarter. The Federal Reserve’s favored index, the personal consumption expenditures (PCE) index, cooled to a 3.2% annual rate. That is still 1.2% above the Fed’s desired target. The fourth-quarter-to- fourth quarter rise in the PCE was 5.6%, more than double what the Fed predicted in December 2021 for year-end 2022.

Bottom Line

The resilience we saw in the fourth quarter is both a blessing and a curse. It showed how well the economy could hold up against rate hikes and inflation. Inflation remains too hot for the Federal Reserve. Hence, its commitment to continue to raise rates. Momentum has already begun to slow in response to rate hikes but the bulk of the slowdown is yet to come. A ramp up in infrastructure spending could add a new wrinkle as it could buoy inflation and growth at a time when the Fed is looking to cool the economy. The Fed’s goal is to let growth stall out in 2023. Whether what we experience is deemed a full recession may become little more than semantics.