Economy defies inflation and rate hikes - What gives?

DEWITT, Mich. - Feb. 21, 2023 - PRLog -- Key Takeaways:

• The economy started the year on a solid footing. But January's unexpected consumer strength, tight labor market, and persistent inflation challenge the Fed to keep interest rates higher for longer.
• Our view remains that a mild economic downturn, or a growth slowdown combined with a modest rise in unemployment, is likely in the coming quarters.
• We think the trajectory of inflation is lower and the direction for markets is higher, but the path for both will likely be bumpy in the coming months.
• The potential for a more forceful Fed could be a catalyst for renewed volatility, which warrants a somewhat defensive stance with a focus on quality.

Economic data and market signals have made an about-face from last year. The jump in retail sales, together with January's blowout jobs report and a rebound in homebuilder sentiment, paints the picture of a strong economy with positive momentum. Before last week, equity valuations were once again expanding, while tech and other growth investments sensitive to changes in interest rates have been leading the gains.

This backdrop is hardly what one would expect from an economy that is still navigating inflationary pressures and the most aggressive Fed tightening cycle in four decades. Which begs the question: Does the Fed need to do more? The bond market appears to think so, but equities have remained largely unfazed. Given what we learned last week, here are our thoughts on how the narrative might evolve and how some of the existing market tensions might be resolved.

2023 is off to a strong start for consumer spending

• The highlight last week was the release of U.S. retail sales, which soared the most in almost two years. Sales for January rose 3% from the prior month, well ahead of expectations for a 2% increase, and more than offsetting December's decline¹. The advance was led by a rise in auto sales, along with strong spending at restaurants and furniture outlets. But gains were broad across different categories, suggesting that consumers played catch-up and were willing to spend after pulling back in the fourth quarter of last year.
• There were likely a couple of temporary factors that helped boost spending, like unseasonably mild weather and a hefty raise in Social Security benefits that came into effect in January (the cost-of-living adjustment impacts approximately 70 million consumers, according to the Department for Social Security). Nevertheless, we think the strength in spending is underpinned by a tight labor market with historically low unemployment and solid wage gains.

Sources: 1. FactSet