Op-Ed: The Calm Before the Storm – These 3 Drivers Will Dictate the Landing Ahead for the U.S. Economy

• Look to consumers, labor and the Federal Reserve to determine whether we see a hard or soft landing this year.
• Consumer spending has been solid, but is increasingly reliant on credit. Household debt has jumped by nearly $400 billion in the fourth quarter of 2022, according to data from the Federal Reserve Bank of New York.

Growing up in Florida, I saw my share of hurricanes. The approach of those storms seems an appropriate analogy to the U.S. economic outlook today.

Storm tracks were highly uncertain, the result of several interconnected, quickly changing meteorological conditions. Preparing for the arrival of a storm was equally fraught – the path could shift at the last minute and your preparations would be for naught or, at times, insufficient for the damage that ensued.

Investors today are keenly focused on what kind of economic landing the U.S. will have and how best to position for different outcomes. But just as weather conditions influence a hurricane's path, the U.S. economic outlook will mainly rest on three variables that will influence each other: the U.S. consumer, labor markets and the Federal Reserve. Both in Florida years ago and today as a macro investor, I would start with the potential worst case and make sure I had a plan to manage well through it. But equally, I would consider other scenarios and how to make sure I could benefit if the rain and wind missed me.

Given that portfolios today are often heavily tilted toward equities, the worst case is likely a resolute Fed that tightens more than expected and undermines the consumer while pushing companies to trim costs partly by shedding workers. This storm would pull down earnings and push up risk premia, weighing heavily on cyclical assets and overall returns.

Shifting a bit of exposure to short-duration fixed income could lessen the hit, as would leaning more within an equity allocation to more defensive sectors such as utilities. Importantly, you want that protection to be liquid so you can redeploy quickly into market weakness, and you want it to be incremental – not the whole portfolio – given the difficulty in timing market tops and bottoms with any precision. How much you move into "rainy day" assets should be a function in part of how much damage you feel comfortable sustaining short term.

Consumers, labor and the Federal Reserve

Beyond having a plan, you need markers to track the storm. Start with the consumers. The last year saw them spend down excess savings accrued from pandemic fiscal transfers. Spending has continued to be solid, though, in large part as credit (both mortgage and credit card) has been increasingly tapped. Fourth-quarter data from the Federal Reserve Bank of New York showed total household debt balances rising by nearly $400 billion, the largest nominal quarterly increase in 20 years. Average credit-card rates also rose to multi-decade highs, reaching 20%.

For now, the strong labor market means consumers have enough income and confidence to keep borrowing and spending – as was evident in January real consumption, up 1.1% on the month. That's critical for the broader growth outlook, given that consumption represents around two-thirds of the economy. But it's exactly those incomes and spending, and the inflation that results, that will push the Fed – the second critical factor in play – to potentially tighten more than is already discounted.

The Fed is getting the disinflation it has sought, though so far mainly through goods and energy prices. Service sector inflation, supported in large part by tight labor markets, is still a challenge with wage growth running between 4% to 6%, depending on the metric one watches. This is still way too high if the central bank is serious about its 2% target. So the longer the consumer demand for services persists, the more the Fed may need to do. Even if we see the Fed pause later this spring to assess the impact of tightening already underway, that's different from the easing cycle reflected in market pricing to begin around the end of the year.

This takes us to the third force that will shape this macro storm track – labor markets. For all the focus on layoffs announced in recent months by mega-tech companies, they are more a factor for equities given their weight in stock indices than for the underlying economy. The U.S. tech sector represents only about 2% of the labor force. That's a fraction of the jobs in the service sector – health care and hospitality alone account for more than a quarter of the labor force.

While many U.S. firms are expressing their nervousness about the economic outlook, they are at the same time still seeking to hire. This dichotomy between growth and labor outlooks was evident in the latest small-business sentiment survey from the National Federation of Independent Business, which suggested that nearly half of all small and medium-sized U.S. firms still can't fill open positions.

Fed action to further increase borrowing and debt-servicing costs could lead a broader set of companies to pare back those openings, and potentially reduce existing headcount. In turn, that would push more consumers to put their plastic away. A negative feedback loop would likely ensue, with less income weighing on spending and less spending making companies more cautious.

Preparing for tough times

What could cause this figurative storm to miss land and move out to sea? A further reduction in commodity prices (especially gasoline and food for U.S. consumers) could help sentiment and real incomes, allowing for spending to continue while reducing pressure on the Fed. But that alone would not likely be enough to bring wage pressures down in line with a 2% overall inflation rate. Further, the outlook for key commodity prices is itself uncertain, especially with supply-and-demand questions ranging from the degree of demand from a reopening China to supply from an unsettled Middle East.

Putting temporary storm windows on a portfolio is an opportunity cost if the hurricane turns into a passing shower. But longer-term investors who want to limit downside in order to better compound returns over time would be well served by thinking about potential storm tracks now.

Rebecca Patterson is a globally recognized investor and macro-economic researcher with more than 25 years' experience studying how politics and policy intersect with economic trends to drive financial markets.

Most recently, Rebecca was chief investment strategist for Bridgewater Associates. In that role, Rebecca shaped the firm's research agenda across geographies and asset classes, oversaw development of new strategies to help large institutional clients solve their most pressing challenges, and shared her insights via Bridgewater's "Daily Observations" publication.

Previously, Rebecca was chief investment officer of Bessemer Trust, overseeing $85 billion in client assets. Before joining Bessemer in 2012, Rebecca spent more than 15 years at JPMorgan, where she worked as a researcher in the firm's investment bank in Europe, Singapore and the U.S., served as chief investment strategist in the asset management arm of the firm and ran the private bank's global currency and commodity trading desk.