A Strong Job Market Could Spell Trouble for the Economy

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

Many investors have been caught up in a circular stampede during the past few months. Seemingly every new economic data point sets the course for a rush of either bullish or bearish views. The impulse to run headfirst in either direction can be seen in market performance since the beginning of the year. In January, signs the slowdown in inflation was gaining momentum sent markets higher as hopes of a soft landing became the driving narrative. However, sentiment quickly pivoted in February, thanks to a few reports that showed pockets of the economy remained strong and that the path to easing inflation hit a bump.

As we’ve consistently cautioned in these commentaries, the return to normal from the economic distortions caused by COVID would be bumpy, and progress would be felt unevenly. Instead of taking a single data point or even a week’s worth of releases and formulating long-term forecasts based on them, we have argued for taking the longer view. Each bit of information, in our view, should be seen as a single piece of a larger picture and should be examined in the context of how it fits with similar measures over a period of months. When viewed from that perspective, we believe the economy has progressed much as we have forecast, albeit at a slower than expected pace.

Inflation has peaked and continues to recede despite an occasional bump. Consumer spending has shifted away from goods and toward services. The transition has led to easing price pressures and negative growth for goods as rising inflation and heightened labor demand has shifted to the services side of the economy. We remain confident that services will follow in the footsteps of goods, and prices will moderate in the months ahead. Real estate, which makes up a significant portion of the services side of the economy, has already seen a sharp drop in demand as well as significant disinflation.

The one area where month-to-month data has been in near lockstep with the long-term trend is the job market. While we’ve noted discrepancies in the Bureau of Labor Statistics’ two measures of employment — the Nonfarm and Household reports — the general trend of these and other reports suggests a strained labor market with little excess slack. It’s worth noting that this trend has endured since the economy first started to recover from the initial shock of COVID and now through the return to a normal business cycle. The resiliency of the employment picture is a focal point for the Federal Reserve because it fears a tight labor market will lead to rising wages that will then fuel an upward spiral of inflation.

The seemingly unwavering strength of the job market, we believe, has heightened the Fed’s fears of inflation embedding into the economy. As such, we believe members of the Fed will be willing to set aside positive trends on prices and continue to raise rates until it sees what it interprets as meaningful signs that the labor market is faltering. The Fed’s insistence on focusing on this lagging indicator is why we continue to view a recession as the likely outcome in the months or quarters ahead. However, given the relative financial strength of consumers and businesses, we believe a potential downturn will be shallow, short and uneven.

Fortunately, we believe that the arrival of a recession will mark the end of all remaining inflationary pressures in the economy and will allow the Fed to ease policy if needed to keep the downturn from deepening. Much as the Fed’s rate hikes had a nearly immediate impact on the economy in 2022, we believe any such future easing will also quickly reverberate through the economy.

Wall Street Wrap

Manufacturing remains weak: The latest data from the Institute of Supply Management shows the manufacturing sector notched a fourth consecutive month with readings at recessionary levels. The composite reading for the index came in at 47.7, up slightly from January’s level of 47.4 (readings below 50 signal contraction). Weakness was widespread, with only four of the 18 industries in the sector reporting gains. The release noted that current levels are consistent with a 0.3 percent decline in economic growth. Costs rose for manufacturers, with the February reading coming in at 51.3, up from the prior month’s level of 44.5. However, it is important to note that the latest reading suggests only marginal increases in costs.

Notably, staffing contracted; the latest employment reading came in at 49.5, 1.5 percentage points lower than January’s level. In a statement accompanying the release, Chair of the ISM Business Survey Committee Timothy Fiore noted, “Labor management sentiment at panelists’ companies still favors attempting to hire rather than reducing employment levels. Although layoffs continued in February, the hiring-to-reduction ratio among panelists’ comments was 2:1 (compared to 4:1 in the previous month). Many companies opted to maintain workforce levels to support projected second-half growth, but to a lesser degree compared to January.”

Services Remains Strong: While the ISM data on the manufacturing side is hovering at recessionary levels, the services sector continues to shine.

Although well off the highs seen in May 2022, the services side has remained resilient as consumers continue to favor spending money on services and experiences over buying goods. The headline reading for the services sector came in at 55.1 (readings above 50 signal expansion), down slightly from January’s reading of 55.2. New orders rose to 62.6 from the prior month’s reading of 60.4. Employment also ticked up to 54.

Housing downturn continues: The latest S&P CoreLogic Case-Shiller Index shows prices in December were down 0.8 percent from the prior month and have now registered six consecutive months of declines. December’s reading indicates home prices rose 5.8 percent year over year, down from November’s year-over-year gain of 7.6 percent and well below the recent peak of 20.8 percent registered in March of 2022.

The survey’s 20-city composite of the largest metro housing markets in the country also fell for a sixth consecutive month. The latest 20-city reading has home prices up 4.6 percent year over year, down from the prior month’s rate of 6.8 percent. The continued easing of home price appreciation is noteworthy given that shelter has a significant weight in the calculation of the Consumer Price Index (CPI), with price movements taking 12 months or longer to begin to affect the CPI reading. With shelter costs having peaked in the first quarter of 2022, we expect this portion of the CPI calculation should fall significantly in coming months, and the latest reading suggests the unwinding of shelter price pressures in the inflation calculation has staying power.

Consumers look to the future with uncertainty: The Conference Board Consumer Confidence Index declined in February for the second consecutive month. The Index now stands at 102.9, down from January’s revised level of 106. The report showed that consumer views of the current economic climate improved in February on the back of falling inflation expectations. However, expectations fell to a reading of 69.7 from the prior month’s level of 76. The authors of the report note that readings of below 80 typically coincide with recessions. Expectations about where wages and the economy were headed in the next six months fell sharply in February.

The income differential (those who expect higher wages less those expecting lower wages over the next six months) fell to 1.8 percent from January’s reading of 4.0 percent — well off the recent high of 11.6 percent registered in June 2021. For further context, this income differential was 16 percent just prior to the arrival of COVID. The subdued wage expectations come despite consumers feeling slightly more optimistic about their job prospects, as measured by the labor differential reading. The differential is a measure of the gap between the number of respondents who believe jobs are easy to land and those who report challenges finding work. The measure ticked up to 41.5 in February, up from 37 in January. For context, the differential was at 47.1 in March 2022. 

The week ahead

Tuesday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers have begun to take on more credit card debt in recent months, but overall balance sheets have remained strong. We will be watching for changes in debt levels in light of recent data showing increased spending.

Wednesday: Fed Chair Jerome Powell heads to Capitol Hill to present his semi-annual monetary policy report. We will be listening to his comments for indications of how he views the balance of risks between controlling inflation and economic damage and a rise in unemployment that may result from additional rate hikes.

The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for January. The comprehensive report will provide a clearer picture of the health of the labor market, including job openings and quits data. The report is of particular interest given the Fed’s focus on the employment market as it seeks to stamp out any threat of inflation reigniting. We will once again be watching for signs that the gap between job openings and job seekers is narrowing, which could lead to easing wage pressures for businesses.

The Federal Reserve will release data from its Beige Book. The book will provide recent anecdotal insights into the nation’s economy and could highlight emerging regional economic trends.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings fell modestly again last week, and we will be watching for any signs of loosening of the employment picture.

Friday: The Bureau of Labor Statistics will release the February Jobs report. As we’ve noted in recent months, a significant gap has opened between its Nonfarm Payrolls report and its other measure of employment, the so-called Household report. We will be looking for signs that the gap between the two measures is tightening. We will also be watching for changes in hourly earnings for workers to gauge whether wage growth has continued to recede.

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