U.S. first-quarter GDP revised upward. Does this increase the chances of a July rate hike?

by BeiChen Lin, Russell Investments

Executive summary:

• U.S. economy grew at 2% clip in Q1, latest report shows
• 6% year-over-year decline in Q2 earnings anticipated
• Core inflation is declining in key developed markets, but additional rate hikes are still possible

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin discussed the upward revision to U.S. GDP (gross domestic product) for the first quarter. He also provided a preview of second-quarter earnings season and discussed the likelihood of additional rate hikes by central banks around the world.

U.S. Q1 GDP growth revised upward

Lin kicked off the segment with a look at the latest U.S. GDP number for the first quarter of 2023, which was revised upward by the Commerce Department on June 29. “Many investors look to GDP growth to gauge the strength of a country’s economy, and since the U.S. is such a big economy, the government prepares three estimates of GDP growth for each quarter, updating the number as more data becomes available,” he explained.

Lin said the latest revision showed that the U.S. economy grew at a 2.0% seasonally adjusted annualized rate in the first quarter—up from an earlier estimate of 1.3%. While that’s a step down from the 2.6% pace of expansion logged in the fourth quarter of 2022, it’s still a robust pace of growth, he stated, emphasizing that the new numbers show continued resilience in the U.S. economy. Drilling deeper into the data, Lin noted that consumer spending was a big driver of first-quarter growth, with personal consumption expenditures up 4.2% on an annualized basis.

He stressed that strong growth is not always a good thing, especially in times like today, when the U.S. Federal Reserve (Fed) is waged in a battle to bring down high inflation. “Just like you might need some rest after a brisk run on a treadmill, the U.S. economy might need a period of softer growth to help cool off excess demand and reduce inflationary pressures,” Lin remarked.

He said that because Fed Chair Jerome Powell has already warned that the central bank could deliver two more rate hikes by year-end, the stronger-than-expected Q1 GDP number may increase the possibility of another Fed rate hike by as soon as late July. All told, the next jobs and inflation reports will be important watchpoints to help gauge when another rate increase might be expected, Lin concluded.

Q2 earnings season preview

Shifting to corporate earnings, Lin said analysts are worried about the outlook for second-quarter earnings season. “Consensus expectations are for S&P 500 companies to see an aggregate 6% year-over-year decline in earnings in the second quarter of 2023,” he stated, adding that analysts have been downgrading their earnings expectations over time.

Lin explained that weak earnings could eventually pressure U.S. companies to enact more job cuts, further contributing to the risk of a recession. On the other hand, it’s possible that the data could turn out to be less bleak than anticipated—similar to what happened in first-quarter earnings season, he said. “After all, sometimes, even students who don’t study for the final exam get lucky,” Lin remarked.

Digging into analysts’ longer-term earnings expectations, Lin said he thinks that their estimates might actually be too optimistic. “Analysts expect 2024 Q1 earnings-per-share (EPS) growth of nearly 9% year-over-year for the S&P 500 and 12% for 2024 as a whole. At Russell Investments, we see a recession as being more likely than not over a 12- to 18-month horizon—and during recessions, EPS growth tends to fall by 10-15%. This means there could be some downside risk to equities if recession concerns creep back into market psychology,” he explained.

Are global inflation rates falling at a fast-enough pace for central banks?

Lin wrapped up the segment by assessing the latest core inflation numbers—and the likelihood of additional rate hikes. While countries can vary in how they define core inflation, one popular approach is to look at inflation excluding food and energy, he said. “Using this methodology, year-over-year core inflation rates for the month of May stepped down from April readings in Canada, Australia and the eurozone, signifying that central banks have made some progress in their inflation fights,” Lin stated. However, with inflation rates still well above the targets of the respective central banks, further rate hikes in the short term are possible, he said.

He stressed that each additional rate hike carries risk, because interest rates in each of these regions are likely already deeply restrictive. “The further you take interest rates into restrictive territory, the greater the risk of inadvertently tipping the economy into a recession,” Lin remarked.

While Lin believes that a recession is more likely than not in many developed market economies over the next 12 to 18 months, he expects it to be on the mild-to-moderate side, rather than severe. He noted that the strategist team’s just-released Q3 Global Market Outlook could serve as a useful resource for investors as they try to navigate today’s challenging investment landscape. “Ultimately, at the end of the day, we encourage investors to stay disciplined and be methodical in their decision making,” Lin concluded.