A Slowing Economy and Easing Inflation Pressures Have Investors Hoping for a Soft Landing

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

The markets ended the first week of the new year with strong gains as a mix of data gave investors renewed hope that the Federal Reserve may still be able to navigate an economic soft landing. The optimism was fueled in part by the latest Institute of Supply Management report that showed the services side of the economy has joined the manufacturing side and slowed materially with price pressures and supply chain bottlenecks evaporating. The composite reading for the services index for December came in at 49.6 (readings below 50 signify contraction), down 6.9 percentage points from November's level of 56.5. The sub-50 reading marks the first contractionary level for services since May 2020. The report also suggests weakness is likely to persist in the near term. New orders fell to 45.2, a sharp pullback from November’s level of 56. For further context, demand was as high as 69 in October2021 and started 2022 at 62. Easing orders come at a time when inventory sentiment spiked to 55.9, up from November’s reading of 44.2. The current level reflects survey respondents’ views that inventory levels are too high given expectations of future demand. The drop in demand has allowed supply chains to heal as reflected in the latest reading of 48.5 (lower numbers indicate faster deliveries), down 5.3 points from the prior month.

Perhaps most importantly as it pertains to the Fed’s focus on the labor market, demand for workers came in at 49.8, down from November’s reading of 51.5. The latest reading marks the sixth monthly reading in 2022 in which hiring contracted.

The manufacturing side of the economy, which began to cool far earlier in 2022, registered a second consecutive month of contraction, with the latest composite reading coming in at 48.4, down 0.6 percentage points from November’s level of 49. Notably, just two of the 18 industries surveyed reported growth, which marks the fewest since April 2020. Demand showed continued weakness, with new orders coming in at 45.2, off 2 points from the prior month. Price pressures continued to decline, with the latest reading of 39.4, down from November’s level of 43. The latest reading highlights how dramatically price pressures have retreated. As recently as March 2022, this reading was 87.1. The current trend of monthly declines is now the longest since 1974-75, when the economy was recovering from high inflation following the U.S. oil embargo.

While investors could have interpreted the twin ISM reports as an indication that the economy is headed for recession, Friday’s Nonfarm Payroll release from the Bureau of Labor Statistics softened that take and reopened the door to the possibility of a soft landing. The latest report showed 223,000 new positions filled, slightly above consensus estimates but the lowest since December 2020. For further context, the prior 11 months saw an average of 392,000 jobs added each month. While the latest data suggest gradual weakening in the employment picture, we believe the downtick in hiring will fail to impress Federal Reserve board members. However, wage data included in the release may provide a starting point for the Fed to reconsider its incredibly hawkish stance and outsized rate hikes. The latest release shows hourly pay inched up by a smaller than expected 0.3 percent in December and is up 4.6 percent year over year as of November, down from the 5.6 percent pace in March 2021. While annualized wage increases remain elevated, it is important to note that hours worked continued their downward trend and fell in the latest survey. The upshot is that the higher wages are being paid on fewer manhours, which translates to workers’ weekly paychecks growing at a more moderate 3.1 percent year over year.

While the Fed has been vocal about wanting to see weaker job numbers, that desire is based on concerns that a tight job market will continue to fuel wage pressures. Should wage growth continue to slow while employment remains resilient, we believe the Fed may be willing to soften its stance on rate hikes should the economy continue to contract despite a strong job market.

In our view, it is too early to call a soft landing. However, we are encouraged by the steady stream of data that show the economic distortions caused by COVID are largely behind us. Given the progress made in slowing the economy and wages, this week’s Consumer Price Index data will be pivotal in determining whether the Fed downshifts to a more historically “normal” and smaller 25-basis-point hike at its February 1 meeting, down from December’s level of 50 basis points. Regardless, we believe that if the economy falls into recession, it will be a mild and short-lived contraction. Given that wage growth has begun to soften despite still strong jobs numbers and that inflation trends have improved considerably, we believe that the Fed will be able to pivot to cutting rates if any such recession threatens to deepen and should be able to spare consumers the hardship of a steep and protracted recession.

The week ahead

Monday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers’ financial situation have been an area of strength; however, recent reports suggest inflation is beginning to take a toll on their balance sheets. We will be looking to see if that trend has eased as inflation has shown signs of retreating.

Tuesday: The NFIB Small Business Optimism Index readings for December will be out before the opening bell. The report should provide insights about the state of the labor market for small companies as well as expectations related to price increases at the consumer level in the year ahead.  

Thursday: The big release for the day will be the Consumer Price Index (CPI) report from the Bureau of Labor Statistics. A string of recent data has pointed to easing price pressures, and we will be dissecting the data to see if the slowing of inflation is gaining momentum.

Friday: The University of Michigan will release its preliminary report on December consumer sentiment as well as inflation expectations. Consumer expectations for inflation in the intermediate term have remained steady for the past several months. We will be watching the report for signs that respondents continue to believe inflation will return to historical norms in the years ahead. We will also be focused on wage expectations for the coming year.

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