The Big Idea
Lessons learned from the economy in 2023
Stephen Stanley | December 15, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Market opinions on the economy and the Fed swung over a wide range this year, testing the fortitude of any economist or forecaster—me, included. Deciding whether to stick with a call or change it involved a constant push-and-pull between the often-extreme opinions in the market and analysis of economic and policy fundamentals. That applied to calls on economic growth, on a hard or soft landing and on the Fed path, among others. I learned a few things about economic forecasting along the way that happen to have applications for investing as well.
Don’t be afraid to have a strong view
A year ago, I was quite confident that strong household balance sheets and still-torrid demand for labor would support the consumer in 2023 and propel the economy to a decent performance. Meanwhile, the consensus forecast called for a recession, with negative real GDP growth estimates for the first and second quarters. In fact, my real GDP forecast of 2.0% for the year was tied for the highest in the January 2023 Blue Chip Economic Indicators panel of 43 forecasters, and fewer than 10 economists in the panel had a growth estimate of more than 1%.
As it turns out, growth for the year is likely to turn out even stronger than I had imagined, somewhere close to 2.5%. And just as I had expected, the consumer led the way, for exactly the reasons that I had suspected. The lesson here is that the consensus is not always right. If you have a strong out-of-consensus view and a compelling rationale behind it, do not be afraid to buck the herd. Mind you, this does not mean to take reckless risks. I would have been far less comfortable departing so sharply from the consensus if my analytical framework had not been so compelling.
A corollary of this lesson is not to hold onto the trade too long. The forecast of a robust consumer served me exceedingly well in 2022 and in 2023, and I feel a strong temptation to stick with the same theme going forward. However, my analysis suggests that these forces have largely played out, and I am calling for noticeably weaker economic growth—though I still find myself slightly stronger than consensus—in 2024 than in 2023.
Beware of past correlations in an evolving economy
Even though economic growth and the labor market sharply outperformed consensus expectations in 2023, inflation still managed to decelerate substantially. Fed officials, including Chair Powell, said dozens of times over the past year that getting inflation back to the 2% target would likely require a period of below-trend growth and a noticeable moderation in the labor market. However, at the recent FOMC meeting, Powell abandoned this notion and signaled optimism that inflation is headed back to 2% more quickly than previously forecast, even though the FOMC is projecting barely below-trend growth for next year and only a modest increase in the unemployment rate.
The latest shift in Fed thinking may or may turn out to be accurate, but it serves as a reminder that no two cycles, in the economy or in financial markets, is exactly the same. Trades that are put on solely based on the historical correlation between two asset prices may or may not work, depending on whether the underlying structural relationships still hold. Again, this is not to say that past correlations have no value, but it is important to examine the underlying dynamics behind the historical link between two asset prices to make sure that they still hold.
Watch out for wild swings
Psychology can take over sometimes in economic forecasting and in financial markets. The swings around Fed expectations, for example, can sometimes gyrate wildly. This year, for most of January, the January 2024 fed funds futures contract, a proxy for the year-end 2023 policy setting, was hovering just a few basis points above the spot funds rate, implying virtually no tightening for the year. A payroll gain of more than 500,000 for January led to a sell-off in the futures contract that lasted over a month and totaled well over 100 bp. Then, the banking turmoil in March and April produced a rally of nearly 175 bp in about a week. As the worst case was avoided in the banking sector, that rally fully reversed over the next few months.
Later in the year, the wild swings around Fed expectations shifted to 2024. The market sell-off in September and October that pushed 10-year Treasury yields over 5% also took more than 50 bp of easing out of the January 2025 fed funds futures contract. Then, the historic rally across a wide array of financial markets in November and early December has been accompanied by a drop of over 100 bp in the projected end-2024 funds rate.
As a Fed watcher, when financial market pricing swings wildly, I have to decide whether to change my Fed view or hold steady. Resisting the urge to follow the markets’ swing in March and April served me well. I am also skeptical of the massive repricing in Fed expectations seen in recent days, though some of my counterparts at other dealers have altered their 2024 Fed forecasts in response.
It is difficult in real time to distinguish between reality and perception when prices are moving sharply and emotions are running high. Different types of investors may have to handle these types of swings in varying ways. A day trader cannot dig in their heels, but a longer-term real money investor might have the luxury of fading the action when markets move to extremes. In any case, it takes a great deal of skill to have a sense of whether market moves have strong fundamental backing or are ephemeral in real time. If 2023 is any indication, dizzying swings back and forth in asset prices may be a regular feature of the landscape going forward. In that environment, knowing when to go with the flow and when to dig in one’s heels should be a highly valuable skill.