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It's too early to declare victory on the economy By Kenneth J. Entenmann A t the beginning of 2023, Hart- ford Business Journal readers placed a 60% probability for a recession. It never happened! GDP grew modestly in the first half of the year, up 2% and 2.2% in the first two quarters, respectively. The third quarter saw strong growth of 5.3%. Overall, the economy should finish 2023 with decent annual growth around 2%. Not great, but not a recession! Indeed, in the closing months of 2023, the shift in market sentiment for 2024 economic growth has been astounding. The quest for a "soft landing" became more probable. The economy was weakening, but not enough to cause a recession. Inflation continued to trend lower. Interest rates dropped significantly. Commodity prices declined. Third quarter S&P 500 earnings season was pleasantly surprising, up nearly 11%. "Soft landing," declining infla- tion, lower commodity prices, lower interest rates and strong earnings — what's not to like? The equity market rally has been impressive, with the S&P 500 going from 4,117 on Oct. 27, to 4,622 on Dec. 12. The market has declared victory! However, HBJ's 2024 Economic Forecast Survey says not so fast, and I agree. I would describe the overall tone of the HBJ survey and my forecast as "cautiously optimistic." Caution is warranted due to several significant risks that persist from the previous year, such as recession fears, inflation, labor and interest rate uncertainty. Taming inflation The HBJ survey is particularly cautious on economic growth: 43.5% of respondents call for 2024's economy to improve significantly or slightly. Only 45.2% say the economy is better than last year. This is hardly an overwhelming endorsement of the economy. Indeed, after a robust GDP report in the third quarter, the Atlanta Fed's "GDPNow" forecast calls for fourth quarter 2023 growth of just 1.2%, and the consensus forecast for 2024 GDP hovers around 1%. While the recent data does suggest the overall economy is slowing, the consumer remains solid. Ironically, the market views this slowdown as a positive as it will potentially allow for lower interest rates. But, it could also lead to recession. The margin of error is razor thin. Inflation continues to be a concern. Clearly, the rate of inflation growth is trending lower, but it remains "sticky." That is reflected in the survey, which highlights inflation, at 17.65%, as the second-biggest impediment to growth behind only taxes (some things never change in Connecticut!). The Consumer Price Index for November was up 3.1% year-over- year, while the core CPI, excluding food and energy, remained at 4%. While these numbers are significantly down from their COVID-induced elevated levels, they remain well above the Fed's 2% target. Is the trend enough to allow for more aggressive Fed policy? The market may be overly optimistic on the size and pace of rate cuts for early 2024. Workforce shortages The labor market is modestly improving, but remains tight, partic- ularly for the types of companies in this survey. The JOLTS (Job Opening and Labor Turnover) number has declined to 8.2 million, down from peaks near 11 million. The official unemployment rate is still historically low at 3.7%, and the economy created 199,000 jobs in November. Labor participation is grudg- ingly creeping higher. The survey confirms that labor remains an issue in Connecticut. Over 54% of respondents claim that it is "very difficult to find qualified workers," and 51% anticipate raising wages to attract employees. A strong labor market does not suggest Fed rate reductions any time soon. Interest rates are materially higher than they were at the beginning of 2023. The benchmark 10-year Treasury note yield began 2023 at 3.6%, rose to a high near 5%, and is currently yielding 4.25%. The Fed has increased the fed funds interest rate from 0% to 5.25% in just 18 months. However, the Fed has been on "pause" since July. Milton Friedman educated us that monetary policy works with "long and variable lags," meaning the full brunt of rate hikes may yet to have impacted the economy. The market has concluded the Fed is done. The futures market calls for no addi- tional rate hikes and has pulled forward the first interest rate cut to March. The HBJ survey takes a much harsher view on interest rates, with only 11% believing that rates have peaked at their current 5.25%-5.5% range. Other economic risks Whether the Fed is done or not is not the pertinent question. Instead, we should be asking: When will the Fed begin to cut rates? With recent strong employment and sticky inflation numbers, the projections for the timing and size of interest reductions in 2024 may be too optimistic. Yes, the recent economic data indicates that the economy is gently slowing, and inflation is trending toward the Fed's 2% target. The Fed is "mostly done" raising interest rates, and perhaps even done. The prospect of lower interest rates seems to be the primary driver of the recent market rally in the financial markets. However, economic history tells us that declaring victory is a dangerous game. There are still many risks that continue to be worrisome. Inflation can remain "sticky." The strong labor market can persist, supporting robust consumer spending (and inflation). The Fed is likely to continue to talk tough on interest rates, setting the markets up for disappointment. Lastly, geopolitical risk — in the form of military conflict and govern- ment dysfunction in an election year — all have the potential to impact the economy. The results from this year's HBJ economic outlook survey gets it right by putting a heavy dose of caution in the optimism for 2024. It is too early to declare victory. Kenneth J. Entenmann is chief investment officer and chief economist at NBT Wealth Management. Kenneth J. Entenmann 4 ECONOMIC OUTLOOK SURVEY | JANUARY 8, 2024