Slower growth and sticky inflation

Bottom Line

The U.S. Commerce Department revised its flash report for first-quarter GDP down from 1.6% to 1.3% yesterday. This was largely due to a reduced contribution from personal consumption—which accounts for 70% of GDP—whose growth rate was revised down from 2.5% to a slimmer gain of 2.0%. That exacerbates the trend of slowing GDP growth over the past three quarters. The rate was 4.9% in the third quarter of 2023 and 3.4% in the fourth.

Commerce revised corporate capex, housing and government spending higher in the first quarter of this year, but adjusted net trade and inventory liquidation slightly lower. So, on balance, private domestic final sales growth were modestly lower in the first quarter to 2.8% from the initial report of 3.1%, down from 3.3% and 3.0%, respectively, in last year’s fourth and third quarters. That’s consistent with our soft-landing forecast for the U.S. economy here at Federated Hermes.

Consumer spending slowing The labor market, retail sales and housing have slowed in recent months, the ISM non-manufacturing index dropped below the contraction level of 50 for the first time in 16 months in April and the ISM business activity index hit a 4-year low last month.

Household employment has lost jobs in three of the past five months, and the unemployment rate has risen from 3.4% to 3.9% over the past year, triggering renewed focus on the Sahm Rule. Former Fed economist Claudia Sahm's assertion is that if unemployment rises 0.5% or more on a rolling 3-month basis over a year’s time, the economy typically slows, perhaps into recession. Although March retail sales were strong due to the early Easter, control sales have been breakeven or negative in three of the past four months. The combination of elevated mortgage rates and high home prices have cooled what was a solid spring selling season. The Housing Market Index declined sharply from 51 in April to 45 in May.

Business and consumer confidence weak The small business optimism index is just off an 11-year low in March, Michigan sentiment plunged to a six-month low in May, and the Conference Board’s consumer confidence index fell to 2-year low in April, before surprisingly bouncing in May. The leading economic indicators index (LEI) has been negative in 26 of the last 28 months, hitting a 4-year low in April.

Manufacturing soft The six regional Federal Reserve indices that we monitor have been weak across the board for the past three years, with many of them posting negative results. Aside from March, the ISM manufacturing index has been below the critical 50 contraction level in 17 of the past 18 months.

Inflation persistent This morning, we learned that the core Personal Consumption Expenditures (PCE) Index—the Fed’s preferred measure of inflation—rose an in-line 2.8% year-over-year (y/y) in April for the third consecutive month. True, it’s down from 5.6% in February 2022, but the Fed is projecting that it won’t hit its 2% target until year-end 2026. The headline Consumer Price Index (CPI) plunged from 9.1% in June 2022 to 3.1% in January 2024. But over the past three months, this inflation metric has risen to 3.4% y/y, as lower base effects have rolled off, replaced by rising prices of electricity, gasoline, food, housing and wages. It’s hard to imagine the Fed easing anytime soon. We’re continuing to project one or two rate cuts after the election.

Are financial markets reflecting this macro picture? We’ve been expecting a barbell-shaped year for stocks in 2024. After a strong start to the year—the S&P 500 rallied nearly 12% to recent highs—we envision a choppy second quarter due to inflation- and Fed-related uncertainty. That could be followed by a volatile third quarter, as investors begin to price in their election-related concerns. Finally, we continue to expect a powerful post-election, sigh-of-relief rally to finish the year in record territory.

We still expect a cleansing rotation in which this equity-market rally broadens out, with the underperforming domestic large-cap value, small cap growth and international stocks playing catch-up, while the growth and technology stocks trim some of their dramatic outperformance from the past 18 months.

Tweaking our GDP and inflation estimates The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met Wednesday to discuss the combination of slower economic growth across the board and persistent inflation:

• Commerce revised first quarter 2024 GDP down from 1.6% to 1.3%, largely due to a sharp decline in personal consumption, compared with GDP gains of 3.4% and 4.9% in last year’s fourth and third quarters, respectively.
• We inched up our estimate for second quarter 2024 GDP from 2.0% to 2.1%. The Blue-Chip consensus raised its estimate from 1.6% to 2.1% (within a range of 1.2% to 2.9%), while the Atlanta Fed’s GDPNow lowered its estimate from 4.2% to 3.5%.
• We raised our projection for third quarter 2024 GDP from 1.7% to 1.9%. The Blue-Chip consensus increased its from 1.4% to 1.6% (within a range of 0.7% to 2.4%).
• We expect the Fed to begin to cut interest rates after the election. So, we tweaked our estimate higher for fourth quarter 2024 GDP from 1.6% to 1.7%. The Blue-Chip consensus raised its from 1.4% to 1.5% (within a range of 0.6% to 2.4%).
• As a result of the first-quarter’s downward revision, we reduced our full-year 2024 GDP projection from 2.6% to 2.4%. The Blue-Chip consensus left its estimate unchanged at 2.4% (within a range of 2.1% to 2.7%).
• We left our year-end 2024 forecast for core CPI inflation unchanged at 3.3% (compared with 3.6% in April 2024), while the Blue Chip raised its from 2.9% to 3.1% (within a range of 2.8% to 3.4%).
• We also left unchanged our year-end 2024 estimate for core PCE inflation at 2.8% (compared with 2.8% in each of February, March, and April 2024), while the Blue Chip raised its from 2.4% to 2.6% (within a range of 2.4% to 2.8%). Base effects are rolling off at present, pushing inflation higher.
• We left unchanged our full-year 2025 forecast for GDP at 2.1%, while the Blue-Chip consensus raised its estimate from 1.7% to 1.8% (within a range of 1.3% to 2.4%).
• We lowered our year-end 2025 forecast for core CPI inflation from 2.9% to 2.8%, while the Blue Chip raised its higher from 2.3% to 2.4% (within a range of 2.1% to 2.8%).
• We left unchanged our year-end 2025 estimate for core PCE inflation at 2.4%, while the Blue Chip consensus raised its from 2.1% to 2.2% (within a range of 2.0% to 2.4%).

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