FLAHERTY & CRUMRINE TOTAL RETURN FUND INC. TEST
Fourth-Quarter U.S. Economic Update
February 2023
Summary of Recent Economic and Market Developments
Real GDP grew at a solid pace in the fourth quarter of 2022, but the composition of growth was again weak, with net exports and inventories contributing most of the quarter's 2.9% growth. Hiring and wage growth slowed modestly but remained resilient in the face of tighter monetary policy. Real personal consumption expenditures rose 2.1%, down slightly from Q3, and consumers continued to shift spending toward services. Home sales continued to fall, and real residential investment plunged by more than 26% for the second consecutive quarter. Manufacturing surveys declined further and industrial output fell, signaling that a recession in manufacturing should begin soon. Real business investment growth slowed to just 0.7%. Other sectors-trade (+0.6%), inventories (+1.5%), and government consumption (+0.6%)-together contributed 2.7% to real GDP. That left core real GDP growth, private domestic final sales, up only 0.2%. As consumer spending slows in the second half of 2023, we expect the U.S. economy to slip into a mild recession.
Inflation slowed in the fourth quarter as energy prices fell significantly and goods prices fell modestly. However, services inflation remained high. Year-over-year CPI rose 7.1% in Q4, and the PCE deflator rose 5.5% YoY in Q4-about 1% lower than in Q3. Core inflation (excluding volatile food and energy prices) showed more limited improvement. Core CPI rose 6.0% YoY in Q4 (down 0.3% from Q3), while the core PCE deflator rose 4.7% YoY (down0.2% from Q3). As supply chains normalize, goods inflation should continue to slow. Services inflation, however, has remained stubbornly high. Slower wage growth and stronger productivity eventually should push down services inflation too, although tighter monetary policy may be needed to deliver it. Slower money supply growth should reinforce disinflationary trends.
The Federal Reserve continued to hike the fed funds rate rapidly in the fourth quarter, with hikes of 75 bp in November and 50 bp in December. The Fed downshifted to a 25 bp hike in February, putting the fed funds target range at 4.50-4.75%currently-up 450 bp from a year ago. Market forward rates show the fed funds rate peaking at about 5.2% by mid-2023, with a 25 bp cut in late 2023 and more cuts in 2024. Yields on intermediate-term Treasuries rose modestly in Q4 and remain near those levels as of the date of this Update, but they have traded in a wide range. Credit spreads narrowed as markets eyed the end of monetary policy tightening, despite recession risk later this year.
Although we anticipate a mild recession in the second half of 2023, fundamental credit quality remains healthy. We think financial companies, which are the largest issuers in the preferred market, should benefit from higher interest rates and have the capital, earnings, and reserves to manage strains that a recession could bring. We believe today's higher yields on preferred and contingent capital securities offer a foundation for potentially better returns ahead.
Fourth-Quarter U.S. Economic Update | Page 1 | February 13, 2023 |
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Economic Outlook
Figure 1: U.S. Gross Domestic Product
Sector
Gross Domestic Product (GDP)
Personal Consumption Expenditures
PCE: Goods
PCE: Services
Fixed Investment
Business Investment
Structures
Equipment
Intellectual Property
Residential Investment
Government Consumption
Federal
State & Local
Domestic Final Sales
Private Domestic Final Sales
Real GDP (QoQ%, AR; *Q4/Q4) | |||
2022:4 | 2022:3 | 2022* | 2021* |
2.9% | 3.2% | 1.0% | 5.7% |
2.1% | 2.3% | 1.9% | 7.2% |
1.1% | -0.4% | -0.5% | 7.1% |
2.6% | 3.7% | 3.2% | 7.2% |
-6.7% | -3.5% | -2.7% | 3.7% |
0.7% | 6.2% | 3.7% | 5.0% |
0.4% | -3.6% | -5.2% | -5.2% |
-3.7% | 10.6% | 3.8% | 4.7% |
5.3% | 6.8% | 7.9% | 10.8% |
-26.7% | -27.1% | -19.3% | -0.3% |
3.7% | 3.7% | 0.9% | 0.5% |
6.2% | 3.7% | 0.2% | 0.4% |
2.3% | 3.7% | 1.3% | 0.6% |
0.8% | 1.5% | 1.0% | 5.4% |
0.2% | 1.1% | 1.0% | 6.4% |
Nominal GDP (QoQ%, AR; *Q4/Q4) | |||
2022:4 | 2022:3 | 2022* | 2021* |
6.5% | 7.7% | 7.3% | 12.2% |
5.3% | 6.7% | 7.6% | 13.2% |
-0.4% | 2.4% | 5.5% | 15.6% |
8.3% | 9.0% | 8.7% | 12.0% |
-2.5% | 4.0% | 5.2% | 9.8% |
4.2% | 14.2% | 10.5% | 8.5% |
7.1% | 15.8% | 9.2% | 4.7% |
2.3% | 17.1% | 11.3% | 7.2% |
4.7% | 10.8% | 10.3% | 11.6% |
-21.1% | -21.2% | -9.2% | 13.6% |
6.8% | 7.5% | 7.6% | 7.3% |
9.2% | 8.7% | 5.0% | 4.6% |
5.5% | 6.7% | 9.1% | 9.0% |
4.2% | 6.3% | 7.2% | 11.6% |
3.7% | 6.1% | 7.1% | 12.5% |
Implicit Deflator (AR; *Q4/Q4) | |||
2022:4 | 2022:3 | 2022* | 2021* |
3.5% | 4.4% | 6.3% | 6.1% |
3.2% | 4.3% | 5.5% | 5.7% |
-1.5% | 2.7% | 6.0% | 7.9% |
5.6% | 5.2% | 5.3% | 4.5% |
4.5% | 7.7% | 8.1% | 5.9% |
3.5% | 7.6% | 6.6% | 3.3% |
6.7% | 20.1% | 15.1% | 10.4% |
6.2% | 5.9% | 7.2% | 2.4% |
-0.5% | 3.7% | 2.2% | 0.7% |
7.7% | 8.1% | 12.4% | 13.9% |
3.0% | 3.6% | 6.7% | 6.7% |
2.9% | 4.8% | 4.8% | 4.3% |
3.1% | 2.9% | 7.8% | 8.3% |
3.4% | 4.8% | 6.2% | 5.9% |
3.4% | 5.0% | 6.1% | 5.7% |
Legend for all Figures: AR = Annual Rate; SA = Seasonally Adjusted; MA = Moving Average; C.O.P. = Change over Period Data source for all tables is Macrobond, unless noted otherwise. Green (red) shading denotes improving (worsening) values.
U.S. economic growth was stronger than expected in the fourth quarter, although the composition of growth was weak. Gross domestic product after inflation (real GDP) rose by 2.9% in the quarter and 1.0% in 2022 (Figure 1). A narrower trade deficit and faster inventory accumulation-neither of which are likely to last-together added 2.0% to 4Q GDP. Although not quite as bad as in Q3, real residential investment once again was extremely weak, leaving it down more than 19% in 2022. More worryingly, growth in business investment slowed to just 0.7% in Q4 after averaging 4.7% over the first three quarters of 2022. Real personal consumption expenditure grew modestly as spending on goods rebounded slightly while services slowed a bit. Real government consumption rose moderately on a 6.2% jump in federal government spending. Modest consumer spending, plunging residential investment, and slower business investment added up to sluggish domestic final sales, which rose just 0.2% in Q4-although it was up 1.0% in 2022, matching overall GDP growth. While inflation remained too high at 6.1% for 2022, the implicit deflator slowed in almost all major sectors of the economy in the fourth quarter, with the notable exception of PCE services inflation.
Looking ahead, economists expect a slowdown around the middle of 2023 but not a recession. The most recent Survey of Professional Forecasters shows a median forecast for U.S. real GDP growth of 0.6% in Q1 and 1.0% in Q2, slight contraction in Q3 (-0.1%), and a return to modest growth in Q4 (1.2%), which implies no net change (Q4/Q4) in 2023.1 They forecast annual growth of 1.4% in 2024, as inflation approaches the Federal Reserve's 2% target and monetary policy gradually loosens. The core PCE deflator is forecast to slow from 3.9% in the fourth quarter to 3.6% in 1Q2023, 2.5% in 4Q2023, and 2.3% in 2024.
Our economic outlook has not changed significantly since our last Update.2 We continue to think nominal GDP growth will slow over 2023 as consumers deplete savings from the
- Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters, February 10, 2023.
- Flaherty & CrumrineThird-QuarterU.S. Economic Update,November 20, 2022.
Fourth-Quarter U.S. Economic Update | Page 2 | February 13, 2023 |
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pandemic and reduce spending, but resilient employment and falling inflation should allow real GDP to expand modestly in the first half of the year. Eventually, however, we think tight monetary policy will push up unemployment, and consumer spending will stall. Residential investment, which has been hit hard by higher interest rates, is likely to continue to contract, albeit at a slowing pace throughout the year, and it should be poised to rebound as monetary policy eases in 2024. Business investment looks soft to start the year, but we expect only a mild pullback as businesses seek higher labor productivity and additional capacity to prepare for renewed economic growth in 2024. By the second half of 2023, we think the economy will be in a mild recession.
As we expected, services inflation (excluding energy) remains sticky while goods inflation has slowed rapidly. As the economy slows and unemployment rises, wage growth should moderate and drive down services inflation. That process may take time, however. Although the Fed is likely within 50 bp of its "terminal" rate for this cycle, it may leave rates at that peak longer than markets currently expect to bring inflation down. With the path of inflation highly uncertain, expect interest rate volatility to remain elevated. Nonetheless, we think risks around growth and inflation will diminish in the second half, and with yields up sharply from a year ago, fixed income investors do not need a rally in rates to earn good returns.
Because our views have not changed much from last quarter, we will keep most of our comments brief in the review of the major sectors of the economy and preferred market conditions that follows.
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Employment, Income and Spending | |||||||||
Figure 2: Employment Overview | |||||||||
Employment | MoMΔ (Level for Rates) | QoQ Change | YoY% Change | Chg vs. | |||||
(Thousands except percents) | Jan-23Dec-22Nov-22 | 2022:4 | 2022:3 | 2022:2 | Jan-23Dec-22Feb-20 | ||||
Nonfarm Payrolls | 517 | 260 | 290 | 874 | 1,270 | 988 | 3.3% | 3.2% | 2,702 |
Private | 443 | 269 | 228 | 796 | 1,143 | 951 | 3.6% | 3.6% | 3,184 |
Household Employment | 894 | 717 | (66) | 394 | 793 | (271) | 2.0% | 2.0% | 1,389 |
Labor Participation Rate % | 62.4% | 62.3% | 62.2% | 0.0% | 0.1% | -0.2% | 0.2% | 0.3% | -0.9% |
Unemployment Rate | 3.4% | 3.5% | 3.6% | 0.0% | -0.1% | 0.0% | -0.6% | -0.4% | -0.1% |
MoM% Change | QoQ% Change, AR | YoY% Change | |||||||
Average Hourly Earnings | Jan-23Dec-22Nov-22 | 2022:4 | 2022:3 | 2022:2 | Jan-23Dec-22Feb-20 | ||||
Average Hourly Earnings, All | 0.30% | 0.40% | 0.43% | 5.0% | 4.4% | 4.5% | 4.3% | 4.9% | 3.7% |
QoQ% Chg (not annualized) | YoY% Change | ||||||||
Employment Cost Index | 2022:4 | 2022:3 | 2022:2 | 2022:1 | 2022:4 | 2022:3 | 2022:2 | 2022:1 | 2019:4 |
Employment Cost, Total, Civilian | 1.0% | 1.2% | 1.3% | 1.4% | 5.1% | 5.0% | 5.1% | 4.5% | 2.7% |
Job growth slowed a bit in the fourth quarter but soared in January, and revisions to prior data show even stronger job gains in 2022 than previously reported. The unemployment rate hit a 54-year low in January and the labor participation rate rose, highlighting the resilience of the U.S. labor market (Figure 2). However, wage growth and employment cost inflation slowed despite that resilience (Figure 3). Job openings data sent mixed signals. The ratio of job openings to unemployed persons remained very high in 2022, implying high labor demand and upward pressure on wages. In contrast, the percentage of employees who quit jobs each month fell, suggesting less opportunity to boost wages by changing employers, which is consistent with slowing wage growth (Figure 4). Normally, these move together, and it is unclear which is correctly signaling wage trends. For now, the Fed is more worried about high job openings than encouraged by fewer quits, but time will tell.
Figure 3: Wages Slowing, but Labor Tight | Figure 4: Job Openings & Quit Rate Diverge |
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Figure 5: Personal Income and Spending | ||||||||||||
Personal Income and | ||||||||||||
MoM Change | QoQ Change (AR) | YoY Change | ||||||||||
Consumption | Dec-22Nov-22Oct-22 | 2022:4 | 2022:3 | 2022:2 | 2022:4 | 2022:3 | 2021:4 | |||||
Personal Income | 0.22% | 0.26% | 0.80% | 5.8% | 5.4% | 4.9% | 4.8% | 4.1% | 6.9% | |||
Wages & Salaries | 0.25% | 0.32% | 0.41% | 5.0% | 7.0% | 4.9% | 5.9% | 7.9% | 9.9% | |||
Real Disposable Pers. Inc. | 0.21% | 0.22% | 0.54% | 3.3% | 1.0% | -2.3% | -2.3%-4.3%-0.4% | |||||
ex Transfer Payments | 0.21% | 0.17% | 0.13% | 1.8% | 1.9% | -1.5% | 0.0% | 0.2% | 1.8% | |||
Nominal PCE | -0.23% | -0.11% | 0.80% | 5.3% | 6.7% | 9.5% | 7.6% | 8.6% | 13.2% | |||
excl. Food & Energy | -0.09% | -0.05% | 0.72% | 6.0% | 8.0% | 8.2% | 7.5% | 8.2% | 12.5% | |||
Goods | -1.59% | -1.32% | 1.22% | -0.4% | 2.4% | 7.8% | 5.5% | 8.5% | 15.6% | |||
Services | 0.45% | 0.52% | 0.58% | 8.3% | 9.0% | 10.4% | 8.7% | 8.7% | 12.0% | |||
Real PCE | -0.29% | -0.20% | 0.42% | 2.1% | 2.3% | 2.0% | 1.9% | 2.2% | 7.2% |
Both nominal and real disposable personal income accelerated in Q4 but slowed as the quarter progressed (Figure 5). Solid hiring and good wage gains were partially offset by lower hours worked, which dampened wage and salary income in Q4. Income growth slowed modestly during 2022 (Figure 6), although this data does not yet reflect the upward revisions to employment that we noted earlier. While income growth has moderated a bit, real income is looking better as inflation slows, which is why we think decent personal spending growth should continue in the first half.
Figure 6: Spending Steady, Income Slowing | Figure 7: Leading Indicators Flash Recession |
Nominal personal consumption expenditure (PCE) slowed again in the fourth quarter (Figure 5). Goods spending fell. Services spending growth slowed slightly but remained high, leaving real PCE up 2.1%, near Q3's pace. Income modestly outpaced spending, which boosted the personal saving rate from its recent record low. We expect real PCE growth to remain near its current level in Q1 before stalling in the second half as unemployment rises.
Last quarter, we observed that the index of leading economic indicators (LEI) slipped below the level that has historically signaled a recession in about six months (Figure 7). It crossed
Fourth-Quarter U.S. Economic Update | Page 5 | February 13, 2023 |
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Flaherty & Crumrine Total Return Fund Inc. published this content on 14 February 2023 and is solely responsible for the information contained therein. Distributed by Public, unedited and unaltered, on 15 February 2023 00:34:05 UTC.
