The Year Ahead

THE PAST 12 MONTHS have been a turbulent period for the global economy, to say the least. In what was supposed to be a year of solid growth and a return to business as usual after two years of pandemic-fueled disruption, we instead experienced historic price spikes for energy, food and other commodities as geopolitical tensions escalated into war. Russia’s invasion of Ukraine triggered an unprecedented economic and financial decoupling process as U.S. corporations scrambled to withdraw from the Russian market. U.S. consumers were forced to contend with the resulting sharp increases in gas prices and inflation, which was already above 7% Y/Y at the beginning of the year and ultimately rose to 9%, a level not seen since the early 1980s. The economy contracted in real terms during the first half of the year, and recession worries intensified.

Amid these headwinds, however, equipment and software investment boomed. Growth averaged over 9% (annualized) during the first three quarters of the year as supply chains improved and businesses were able to acquire equipment that had been unavailable for months or longer. Indeed, despite persistent recession fears, last year was one of the strongest in recent memory for equipment and software investment. Here are six predictions and expected trends that we believe will shape the economy and industry in 2023.

1. The economy will enter a recession in 2023.

We expect that the combined effects of falling real incomes and higher interest rates will eventually force the U.S. economy into recession in 2023. The U.S. economy has been mostly resilient in the face of tighter monetary policy thus far, largely because the labor market has remained strong and consumers, who account for two-thirds of economic activity, have continued to spend money. However, change is in the air: pandemic-era accumulated savings are eroding, the personal savings rate has fallen to nearly an all-time low (and roughly one-third its pre-pandemic level), and consumers are increasingly turning to credit cards to meet spending needs. Further complicating matters for consumers, the labor market is likely to buckle under the strain of 450 basis points (and counting) of rate hikes in less than a year. With the housing market in freefall, several key trading partners heading toward recession, and the federal government understandably reluctant to buoy the economy with more stimulus and risk even higher inflation, we believe a recession is the most likely outcome, likely beginning in the late spring or summer. While we hope we are wrong about the economy’s trajectory, we believe there are reasons for cautious optimism about the equipment finance industry even if a recession materializes.

2. Equipment and software investment will perform better than it normally does in a recession.

During previous recessions, equipment and software (E&S) investment has fallen 3–5 times more than overall GDP. However, though the U.S. economy is slowing, equipment and software investment remains strong, and several of the factors that propped up growth in late 2022 make us more optimistic than usual about E&S investment in a recessionary environment. For example:

• There is a significant backlog of equipment demand. Per the Census Bureau, as of late 2022 the backlog was at or near all-time highs in many end-use verticals, including industrial machinery, materials handling equipment, computers, and motor vehicles.
• The Infrastructure Investment and Jobs Act (“IIJA”) should provide a boost to construction activity across the country and will also provide significant benefits to the manufacturing sector.
• The Creating Helpful Incentives to Produce Semiconductors (“CHIPS”) and Science Act has already resulted in tens of billions of dollars in new investments in the semiconductor fabrication industry, which should provide tangible benefits to several equipment verticals.
• Of particular relevance to equipment finance companies is the Equipment Leasing & Finance Foundation’s 2023 Equipment Leasing & Finance U.S. Economic Outlook (jointly produced with Keybridge) which forecasts 4.2% growth in equipment and software investment this year. All told, we expect the combined effects of pent-up demand and legislative tailwinds to cushion the blow of a recession, though the effects may not be felt evenly across end-use markets.

3. CPI inflation will decline to about 4% by the end of the year, but further improvements will be hard to come by.

CPI inflation cooled substantially in late 2022, dropping from 7.7% in October to 7.1% in November. Much of this cooling can be attributed to easing energy and commodities prices, even as price pressures for shelter and services remain elevated. We expect price growth will continue to slow for things like medical, transportation, and recreational services as the economy cools, but there is one major factor that will likely put a floor on inflation: wage growth. Even though wages have lagged inflation for nearly two years, wage pressures are notoriously difficult to squeeze out of the labor market. When inflation falls to a level near that of wage growth — which was 4.6% Y/Y as of December — we expect that further progress on bringing down inflation will be much more difficult. We expect equipment finance firms will be operating in a higher inflation environment (e.g., 4-5%) for longer than may market-watchers expect. Industry leaders may wish to review Keybridge’s Summer 2022 article in the Journal of Equipment Lease Financing for a look at what to expect in such an environment.

Download your copy of the Equipment Leasing & Finance Foundation’s 2023 Equipment Leasing & Finance U.S. Economic Outlook Report from www.leasefoundation.org/industry-resources/u-s-economic-outlook/.

4. Equipment finance firms will have to contend with higher interest rates, for longer.

In our view, inflation is unlikely to return to the 7–9% range of 2022 (absent unforeseen geopolitical events), but we still believe the Fed will raise rates higher — and hold them there for longer — than markets currently anticipate. Indeed, toward the end of 2022, cooler-than-expected CPI readings gave financial markets reason for hope that the Fed might soon take its foot off the brake pedal. However, inflation is still running hotter than short-term interest rates, implying that the “real” fed funds rate is still negative (and thus accommodative). Chairman Powell has repeatedly emphasized the need to smother inflation and to make sure that it does not reemerge in the near term, and we believe the Fed’s actions to date demonstrate its seriousness about the issue and willingness to stand firm, even if it leads to higher unemployment and/or a recession. We expect that the fed funds rate will have to hold above inflation for several months before the Fed will entertain the idea of cutting rates.

5. Re-shoring and near-shoring of industrial capacity will accelerate.

Last year, “onshoring and reindustrialization” was a key theme in Keybridge’s economic outlooks, and we believe this trend will be even more important in 2023. The pandemic and ensuing supply chain crisis set into motion a fundamental shift in how corporations source inputs and manage production, and Russia’s invasion of Ukraine intensified this transition. The supply chain decoupling and realignment is well underway, and we believe it will be both historic and beneficial to domestic manufacturers. For example, in East Asia, China’s COVID lockdowns and growing concerns about potential military action directed toward Taiwan have thrown supply chains into turmoil. To mitigate this risk, there will be growing need for producers to shorten and diversify their supply chains, which should lead to significant growth in manufacturing and other industrial capacity in the United States in 2023 and beyond.

6. Divided control of Congress will result in a possible government shutdown and debt ceiling brinksmanship.

In a story that we have seen play out several times in recent years, we anticipate an acrimonious political environment in a newly divided Congress with razor-thin majorities in both the House and Senate. A partial government shutdown sometime this fall is a distinct possibility, and while shutdowns typically don’t have large or long-lasting economic impacts, the threat of a shutdown would likely increase economic uncertainty, reduce consumer confidence, and make a soft landing more difficult to achieve. A threat that is perhaps less likely but would possibly result in far larger economic consequences relates to the federal debt ceiling. If the debt ceiling were breached — something that has never happened in the United States — it would amount to a technical default by the U.S. government. Given that U.S. Treasuries are among the most important and highly liquid financial instruments in the world, the impact of a breach on the U.S. and global economy, while uncertain, could be devastating. Let us hope that cooler minds prevail, and political battles do not lead us into uncharted economic territory.