Waiting to Land: The Moments that Shaped the 2023 Economy

The year began in the middle of a historic rate hiking cycle aimed at taming inflation. The stress of higher rates seemed to portend an inflection point in the economy. In the first quarter, a series of bank failures threatened system-wide contagion. Tremors in the banking system fueled recessionary fears, which were amplified by slowing US GDP growth. The soft landing eyed by the Federal Reserve and hoped for by optimistic investors started seeming less likely.

Yet, the banking crisis was contained, and the consumer remained resilient. A slowdown in the consumption of goods, which suffered from increasingly inflated prices, was offset by the pent-up demand for services as consumers chose experiences over things. The result of the consumer’s resilience was a surprisingly robust economic expansion over the summer months.

As the labor market and economy held serve, the direction of rates became less clear. Some believed that the Fed would continue to raise rates on the basis of strong employment and inflation that persisted over the Fed’s 2% target. Others saw a potential rate cut by the end of 2023 to jumpstart a stalled housing market and address the household impacts of the higher interest rates and the resumption of student loan payments.

With the first pause in the rate hike cycle in June, and the Fed’s decision to hold steady in September and November, it became clear that the cycle had neared its peak, and a higher-for-longer narrative began driving markets in the second half of the year, sending bond prices sharply lower.

More recently, geopolitical shocks have upended the short-term macroeconomic views. The attack of Hamas on Israel shocked the world, and the fallout so far is not clear. Much of the long-term economic impact depends on whether the conflict expands.

As the year closes out, uncertainty remains, with the potential outcomes of a recession or soft landing still in play. The labor market has shown recent weakness, and the yield curve remains inverted, a generally reliable indicator of recession. Yet, GDP growth has been accelerating, a positive sign as we enter the holiday season, and equity markets have posted solid year-to-date gains despite the recent pullback.

To sum up 2023, predicted by many to be a lost economic year, we can state that the year certainly could have been worse. Here are a few key moments from 2023 that helped the economy avoid a crash.

The Spring Banking Failures

On March 10, Silicon Valley bank failed after higher interest rates and lower bond values led to a precipitous drop in the stock and a run on deposits. It was the first bank collapse in over two years, and it would quickly be joined by Signature Bank, which was closed by regulators on March 12 as it suffered a run due to its cryptocurrency exposure. Global contagion in the banking system was a feared possibility when Credit Suisse’s shares suffered a 25% decline on March 15.

Eventually, Credit Suisse was bought out, as was troubled regional bank First Republic, as larger banks came to the rescue. While the government looked to reinstate and strengthen some banking regulations and create some emergency lending facilities, the government’s response was muted compared to the crisis in 2008. Meanwhile, the Fed controversy continued its rate hikes.

Overall, commercial banking contracted by over $100 billion near the end of March. Woes in the banking sector were feared to spark a recession. But the contagion that was expected never materialized, and the next domino never fell. 

China Struggles out of the Gate

Optimistic investors looked forward to a healthy Chinese economy in 2023 as the country reopened from Covid-19 restrictions. The recovery, though, was much shorter lived than anticipated, as real estate woes weighed on consumers. The weakness in the world’s second largest economy led China’s government to take policy actions, cutting interest rates to support liquidity. The policy supports seemed to have worked, as China’s economy showed robust growth in the third quarter and is on track for the growth targets set by China’s policymakers.

A Better-Than-Expected Summer

After US GDP came in lower than projected in February, March, and April, the US economy began to pick up steam in the summer. GDP grew faster than anticipated, and the job market showed resilience. Headline inflation began easing, leaving many to wonder if a rate cut may be in the cards later in 2023. In June, the Fed finally paused on rate hikes. The federal funds rate, which began the year above 4%, had climbed to 5% by May, and policymakers wanted to see the effects of rates prior to any more decisions. With the economy still growing at a healthy pace, the Fed raised rates once more in July, a move that is likely the last rate hike of this cycle. Despite a fed funds rate at a level not seen since early 2001, the economy continued to grow faster than 2%, with GDP reaching an impressive 4.9% annualized growth rate in October. 

The Bond Market Reckoning

In September, the Fed’s instistance that rates would need to remain at their current levels (a higher-for-longer narrative), the bond market moved sharply to adjust to the new reality. Yields spiked and bond prices cratered, prompting more fears that something in the financial system may crack.

The market recovered somewhat as labor data weakened, in a case of welcome bad news. But higher yields continue to pressure the stock market as corporations see higher borrowing costs and investors see less appeal in equities. Consumer demand has also come under pressure. The yield curve, which has been inverted for all of 2023 so far, has tightened recently, which may indicate a recession is on the horizon. The financial system has seemed to escape largely unscathed, at least so far, but the risks of sharp swings and volatility remain high.

In 2024, the bond market is pricing in two to three rate cuts. Once the higher-for-longer narrative begins to unwind, we will find ourselves in a new economic cycle. And every change in the cycle brings unexpected consequences, new winners, and new losers. This year, in many ways, turned out to be better than expected. At least we avoided the crash that many feared. Will we find our landing in 2024?