Resilience, revisions & risks… Weathering political dysfunction & war

Housing retraces its steps. New home construction got a boost over the summer, as builders moved downscale to build smaller, less expensive homes and offered discounts to buoy first-time buyer demand. That shift means that housing activity added to the overall economy for the first time in nine quarters over the summer.

Those gains will be short-lived. The surge in rates, which has been amplified by the bump in bond yields, is making it harder for builders to offering deals to keep first-time buyers.

Pending home sales continued to lose ground in August as housing affordability plummets. Mortgage applications for existing home purchases dropped to their lowest levels since 1995 in recent weeks.

Prices are the sticking point. Supply remains well below demand as millennials age into their prime home buying years. Prospects for the single-family market improve again in late Spring and Summer 2024, after mortgage rates start to come down but winter will be chilly for the housing market.

Higher rates, tighter lending standards, escalating insurance costs and cooling rents are taking a toll on the multifamily market. Backlogs have ballooned, which will keep supply coming on line. The key is to keep those projects financed. Many developers are turning to private investors – home offices and private equity — to get the funding they need. That is expensive.

Business investment weakens. Business investment has been bolstered by government incentives to build chip and electric vehicle plants and the spillover effects associated with the ramping up of infrastructure investment. Those gains will dissipate after the initial surge. 

Higher rates are the largest drag on investment in 2024. Corporate debt that was locked in at low rates earlier in the recovery is due to reset in 2024. Higher interest expenses and elevated wage gains are expected to put a crimp on corporate cash flow.

This is in addition to tighter bank lending standards, which have already moved into recession territory. The resetting of office leases has yet to show up as a drag on bank balance sheets. Small and mid-sized firms are much more reliant on that credit than larger firms.

Inventories are particularly expensive to finance, given the rise in rates and increase in insurance costs. This is one of many reasons retailers have been reluctant to stock up as much as usual for the holiday season. You may want to take advantage of October promotions.

The outliers are investments in cyber security and generative AI (GenAI). The KPMG U.S. CEO Outlook survey revealed that CEOs were eager to leverage the new technology to boost productivity growth and contain costs. They also express concern and the need to guard themselves more aggressively from cyber-attacks and the theft of intellectual property enabled by GenAI.

Government spending becomes a drag on growth. Much of the stimulus passed during the pandemic has been spent. The boost to Social Security payments, which was the largest single contributor to federal spending in 2023, is expected to moderate on cooler inflation figures in January. The increase in spending associated with wars and the border pales when compared to outlays for Social Security and Medicare. Much of the rise in the federal deficit in 2023 was due to a shortfall in tax revenues; capital gains taxes plummeted in 2022 relative to 2021, which curbed government revenues in fiscal 2023.

State and local government receipts have slowed, with the exception of real estate and sales tax revenues. That accounts for the lion’s share of government spending and will exacerbate the moderation in growth in 2024.

The trade deficit widens. Exports are expected to grow slower than imports, as a strong dollar and weaker growth abroad work their way through to trade. The International Monetary Fund (IMF) lowered its forecast for global growth in early October; it tends to be more optimistic than private forecasters. Synchronous rate hikes and the spillover effects of higher rates in the U.S. on currencies abroad were cited as reasons. Depreciating currencies abroad stoke inflation, add to deficits and weaken growth. They require central banks to raise rates and to head off the price increases that accompany a weakening currency.

Indeed, the IMF issued a warning with its most recent reports. It fears that central banks are becoming too complacent on inflation by declaring a peak in rates too soon. They may need to raise rates much more than previously expected to fully derail inflation.

The Fed moves to the sidelines. The leadership of the Fed has made clear that the threshold to raise rates again is higher than the threshold to stay where it is, given the recent surge in bond yields. We would need to see a very large drop in yields to make the Fed raise rates in November.

That said, stronger growth and concerns that the economy could be more prone to bouts of inflation post-pandemic have delayed the timing and magnitude of rate cuts in 2024. We now expect the Fed to cut rates in July instead of May and only cut by a quarter instead of a half of one percent at that meeting.

Central banks around the world are worried that the post-pandemic economy will be more susceptible to bouts of inflation than the world we left. Escalating geopolitical tensions, climate change and a rethinking of supply chains are all adding to frictions in the flow of goods and services across borders, which makes the global economy more vulnerable to supply shocks.

Those shifts are appearing in an upward creep in the Fed’s estimate of the neutral or non-inflationary Fed funds rate. That is a long way of saying that we do not expect to return to the ultralow rates we saw pre-pandemic, even after the Fed completes its easing cycle in late 2025 and early 2026.

The economy has proven remarkably resilient, with accelerating growth, in spite of the most aggressive credit tightening cycle by the Fed since the 1980s. Recent revisions to the data only shore up that narrative; they suggest that households have much more savings than we previously thought to weather the storm of tighter credit conditions.

The sand in the gears is a government shutdown. That would exacerbate weakness in the fourth quarter and could have more of a lingering effect on growth than it did in the past. Every time I think the bar for political discourse can’t go any lower, it does. I would like to be surprised on the upside for a change. I say this in the most positive of ways. Congress, make my day.