Economic & Market Insights

For the week of November 28, 2022

2023 Economic Outlook

U.S. economy likely to slow further in ’23, enter mild recession

We expect the U.S. economy to expand around a muted 1% pace in 2023, as measured by real GDP, which incorporates our prediction for a mild recession beginning in late 2023. This would be a further deceleration in growth from approximately 2% in 2022, 6% in 2021, and the longer-term average annual growth rate of 1.8%.

Considering the major components of GDP, we expect real consumer spending to rise approximately 2% in 2023, which assumes wage growth of 4-5%, inflation moderating to 3-4%, and further drawdown of excess accumulated pandemic savings. Government spending, which makes up 17-18% of GDP, should be a neutral contributor in 2023, with increased spending related to infrastructure and the CHIPS and Science Act offset by reduced pandemic-related outlays. We see business investment up 3% in 2023, with solid spending on equipment and technology partly offset by lower spending on buildings, plants and structures. Weaker activity in residential investment—housing—is expected to persist in 2023 amid the higher interest rate environment. This represents about 5% of GDP and could be down 10-12% in 2023 after contracting roughly 10% in 2022. Net foreign trade is expected to be a 1% drag to 2023 GDP, as the stronger dollar likely hurts export demand. 

Fed’s hiking cycle nearing the endgame; terminal funds rate expected to reach 5%

The Fed is currently tightening monetary policy as rapidly as it has ever done, and we believe it will deliver another 100bp of hikes before going on hold next spring. This includes a forecast for a 50bp hike at the December meeting and two more 25bp hikes in February and March of 2023. Assuming we are correct, this would bring cumulative tightening to 475bp and put the terminal fed funds target range at 4.75-5.00%. 

We believe it’s most likely the funds rate is maintained at this restrictive level through 2023, or until there is conclusive evidence inflation is retreating to its targeted 2% level. It’s probable that some softening in the labor markets will be necessary for wage inflation to slow from the current 5% pace to a more comfortable 3.5%. Once this occurs, we think the Fed will ease policy rates to a more neutral level, likely in 2024. 

The Federal Reserve’s balance sheet reduction, or quantitative tightening, is also ongoing, and we expect the current runoff pace of $95 billion per month ($60 billion Treasuries, $35 billion mortgage-backed securities) to continue through 2023. This effectively reduces liquidity in the economy as private investors absorb assets rolling off the Fed’s balance sheet. 

While the rising interest rate environment has thus far been most obvious in the slowing housing sector and USD strength, we expect the cumulative effects of higher borrowing costs and tighter financial conditions to dampen demand more broadly across the economy in 2023. 

Consumers enter 2023 on solid financial footing, but with less cushion than in 2022  

Household balance sheets still look healthy by historical standards, though a meaningful portion of the excess savings and liquidity built up during 2020-21 has been depleted over the course of 2022. While employment gains and wage growth have helped support spending this year, it’s also clear consumers have dipped into savings accumulated during the pandemic and have bought more on credit cards. We estimate the $2 trillion-2.4 trillion of excess savings accumulated during the pandemic now stands at $1.2 trillion-1.8 trillion. Depending on the path of inflation and pace of consumer spending over the next several quarters, these excess savings could be fully depleted by the middle to end of 2023. 

Credit card balances have risen at a quick clip in the last six months and were up 15% year-over-year at the end of the third quarter, the largest rate of increase in more than 20 years. But even with the jump in balances, absolute levels have just returned to those of fourth-quarter 2019, and delinquency rates remain historically low. 

Looking at consumer borrowings—mortgages, auto loans, home equity, credit card and student loans—overall levels have risen $2.4 trillion from the end of 2019. Approximately 90% of this increase was mortgage debt, as low interest rates, internal migration patterns and other pandemic dynamics drove significant housing activity from mid-2020 through early 2022. Importantly, 65-70% of mortgages originated in the past two years have had a credit score of 760 or higher, and only 2% have had a credit score of below 620—far different than the years leading up to the subprime crisis in 2008. Higher auto and student loans make up the rest of the increase in consumer borrowings since 2019, with home equity loans still below pre-pandemic amounts. 

Despite consumer borrowings at all-time highs, aggregate delinquency rates have been stable for six straight quarters at 2.7%, near historic lows, after declining sharply early in the pandemic. And while debt costs have risen, overall debt servicing ratios are low relative to pre-pandemic standards and significantly down from levels in the years leading up to the 2008 financial crisis.

Manufacturing sector headwinds are building; services still benefitting from normalization

Overall, we think that real consumption increases 1-2% next year. Services spending likely will outpace goods spending, considering that goods spending is generally more sensitive to changes in interest rates and a stronger dollar. Plus, goods consumption still looks due for further reversion given its continued outperformance relative to pre-pandemic norms.

Consumers allocated a greater proportion of expenditures towards goods—especially durables—following the onset of the pandemic. Goods increased from 31% to 36% of the consumer spending mix during 2020-21, while services dropped from 69% to 64%. This has partially reverted in 2022, and we see further relative upside for services spending—like restaurants and travel—as supply and demand trends normalize.

We are no longer in a “rising tide lifts all boats” environment when it comes to retail sales. Growth in a few categories, including furniture and home furnishings, has slowed significantly in the past six months, and in fact turned negative in electronics and appliance stores as well as department stores as spending priorities have shifted. 

Auto sales have fared better recently, with improved inventory availability resulting in sales growth accelerating to 6% over the past three months compared to a decline of 1% in the three months prior. Lower new- and used-auto prices have likely helped entice buyers as well. We expect light vehicle sales could further recover in 2023 towards a seasonally adjusted annual pace of 16.5-17 million from an estimated 14 million pace in 2022. 

Restaurant spending continues to outpace overall retail sales, rising 14% year-over-year in October and 17.5% year-to-date. With regards to travel, TSA throughput indicates air travel has recovered to 95% of 2019 levels, even with reduced flight schedules and less business travel. A recent consumer sentiment survey found that a near-record 18% of respondents intend to take a foreign vacation in the next six months. 

Housing market activity likely to stay low with mortgage rates high

With the Federal Reserve on track to raise interest rates at a record pace this year, we have seen clear evidence of a slowdown in the housing market. As one of the most sensitive sectors in the economy to changes in interest rates, housing activity has weakened significantly in the last few quarters. 

The 30-year fixed-rate mortgage has more than doubled from 3.25% at the beginning of 2022 to roughly 7% in mid-November, and most measures of housing activity—affordability, builder sentiment, housing starts and turnover—have dropped sharply as a result. Demand for multifamily housing has held up amid tight single-family home supply and affordability challenges, with multifamily housing starts still close to the highs of the cycle. Still, overall real residential investment tumbled at a 16% seasonally adjusted annual rate across the first three quarters of 2022. 

Our past research indicates that total home sales decline by about 10% for each 100bp increase in mortgage rates. Given the roughly 400bp increase in mortgage rates this year, we could still see another 15-20% decline in home sales from here. Construction activity should follow suit, and we expect residential investment could be down 10-12% in 2023.

Meanwhile, median home values continued climbing through the first half of 2022, supported by low inventories and historically low vacancy rates. To return affordability back to historical norms, we think we could see a 10% peak-to-trough decline in house prices, with much of that decline occurring next year and risks skewed to the downside. 

Inflation set to fall quickly from peak, but remain above the Fed’s 2% target at end of 2023

While inflation is likely to remain somewhat elevated through the end of next year, we see signs that a moderation is already underway and that this cooling will become more prominent over time. We expect headline CPI inflation to ease from 7.7% year-over-year in October 2022 to 7.0% in December 2022 and to 3.4% by September 2023. For the core CPI, we forecast deceleration from 6.3% in September 2022 to 5.7% in December 2022 and 3.4% next September. The PCE price data, the Federal Reserve’s preferred inflation metric, should similarly moderate. 

A few forces are driving this expected moderation. First, pandemic-related distortions including supply chain bottlenecks have eased, and a surge in pent-up demand (initially for goods and more recently for services, such as travel) should fade. Energy prices are 20-30% off the summer highs, and new and used vehicle prices have been declining. Second, tighter monetary policy has caused significant U.S. dollar appreciation and higher mortgage rates. We expect higher interest rates will cause demand to soften into next year, and we expect the now-tight labor market to loosen, which should translate into lower wage growth. Labor market conditions will be an important driver of inflation both in the near term and further into the future.

Labor markets should start to loosen amid slower growth environment

With many pandemic-related distortions now clearly normalizing, the largest remaining imbalance is in the labor market, where demand continues to outpace supply. Payroll growth in recent months remains well above longer-term averages, though it has slowed from the earlier pandemic-recovery pace. October’s payroll gain of 261,000 was the slowest since late 2020, but handily above the monthly average of 180,000 for the decade leading up to the pandemic. All sectors except for leisure and hospitality have surpassed pre-pandemic employment levels. 

Other signs of strong labor demand include elevated job openings (10.7 million in September), an elevated “quit rate” of 2.9% and strong wage growth of 5-6%. Meanwhile, labor force participation continues to underwhelm and has held in a tight band year-to-date of 62.1-62.4%, below the 63.4% in February of 2020. While it’s unlikely older workers that retired early during the pandemic will reenter the workforce, we have seen growth in the foreign-born workforce recently resume after declines in 2020-21. Also, it’s possible the ending of student loan payment deferrals in January could encourage younger workers to reenter the labor force in 2023. 

The combination of solid hiring trends and stalling GDP means labor productivity continues to drop. Productivity in 3Q was 1.4% lower than the same time last year. The fact that businesses have kept hiring in a slowing demand environment appears to indicate that restaffing is a priority over margins. Numerous anecdotes also suggest that firms will be more reluctant than normal to lay off staff in a weaker economic backdrop. Even so, we expect a broad slowing of demand in 2023 to ultimately moderate demand for workers and reduce hiring activity. This could result in the U.S. economy shedding 1 million jobs and cause the unemployment rate to move up from 3.6% at the end of 3Q to 4.3% by the end of next year. 

Stronger dollar has mixed implications for the economic outlook

On a real, trade-weighted basis, the U.S. dollar is up about 15% since the beginning of the year to 20-plus year highs. Different than prior cycles, much of the dollar gains this year have been against other developed market currencies including the euro (9% year to date), sterling (11%), and yen (22%). In 2023, we expect the dollar’s strength to extend slightly, but with more of the gains coming from emerging market currencies.

A strong dollar has mixed implications for the U.S. economy and businesses. It makes our imports cheaper and lowers prices across a range of U.S. dollar-denominated globally traded commodities like oil, metals and agricultural products. 

On the flip side, a strong dollar is a headwind to U.S. exports. A strong dollar also hurts revenues and profits generated in international markets for U.S.-based companies. We already started to see this play out in third quarter earnings season, as approximately half of S&P 500 companies generate at least one third of revenues outside the U.S. 

It should be noted that the effect of dollar appreciation usually takes rather long to play itself out. For 2023, we expect that the strong dollar and slowing global growth means that net foreign trade will subtract about 1 percentage point from GDP growth in 2023, and that this trade drag will continue into 2024.

Supply chains get getting back to (new) normal

In the area of supply chains, there have been signs that constraints are easing, even if not completely back to pre-pandemic normal. For example, Shanghai-to-Los Angeles ocean freight rates are down 80% from the beginning of the year and 83% from the peak in 2Q21, but still 25% above the 2010-19 average. At the same time, several manufacturing surveys point to significantly improved delivery times. While this could be partly explained by slower order activity—that is, lower demand—we think loosening of pandemic-related restrictions in most markets is improving the flow of goods as well. An exception is China’s zero-tolerance COVID-19 policy that continues to cause uncertainty for businesses reliant on Chinese manufacturing.   

Challenges with semiconductor chip availability since mid-2021 have constrained production for a wide range of electronic and automotive products. While not yet fully recovered, production levels have been gradually improving as semiconductor availability and supply chain constraints slowly ease. Of note, the $52 billion in the CHIPS and Science Act dedicated to semiconductor production capacity is only 10% of what would be needed for complete U.S. semiconductor self-sufficiency. 

Expect improved credit market conditions in 2023, but also higher spreads and defaults 

We believe a more challenging fundamental backdrop for corporate issuers will translate into increased spread dispersion among sectors, ratings decompression and wider high yield bond and loan spreads in 2023. We see high yield bond spreads widening 75bp to 575bp (versus a non-recession average of 520bp, recession average 970bp) and loan spreads widening 30bp to 600bp (non-recession average 470bp, recession average 805bp) by year end 2023. A portion of the expected widening year-over-year is due to our belief that an additional premium will need to be reflected in spreads as growth stalls, rates remain restrictive, the cycle matures and uncertainty around 2024’s landscape builds. 

Given the tepid growth outlook for U.S. GDP, we believe leveraged credit markets will become more vulnerable to increased defaults with the passage of time amid sustained higher rates, constrained capital markets, and as tight financial conditions weigh on fundamentals with a lag. We expect leveraged credit default rates to trend higher over the next two years and hover around the long-term average of 3.2%.

We expect an increase in capital market activity for HY bonds and loans in 2023 amid a clearer backdrop for growth and inflation, slower pace of Fed tightening, and less rate and yield volatility. That said, 2023 should be another light year for bond and loan issuance versus the past decade’s standards. For context, 2022 produced the lightest new issue volume for bonds (about $115 billion) and loans (about $250 billion) since 2008 and 2010, respectively. We forecast 2023 HY bond gross new issuance of $200 billion, which would represent a 90% year-over-year increase. Despite our view that capital market conditions should improve, these volumes reside roughly 40% below the past decade’s norm. For institutional loans, we forecast gross new issue volumes in 2023 of $300 billion, a roughly 30% year-over-year increase. Still, these anticipated loan volumes reside 46% below the past decade’s average.