Conflicting Signals for an Uneven Economy

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

Data over the past week was likely disappointing for investors who hoped to get a clearer picture of where the Fed and the economy are headed in the coming months. Instead of the “ah-ha” moment many were looking for, we got mixed signals. In comments following the Federal Reserve’s latest move to raise rates by 25 basis points, Fed Chair Jerome Powell acknowledged that disinflation has begun and singled out progress made on the goods side of the economy along with improvements in shelter prices. His comments raised hopes that the Federal Open Markets Committee would soon be able to pause on its course of raising rates. However, Friday’s blowout jobs report showing 517,000 new hires in January — well above consensus estimates of 188,000 — quickly quelled talk of a shift in Fed policy in the next few months.

However, when viewing the above developments in context with other recent data and trends, we believe that while chances of the Fed engineering a soft landing have improved in recent weeks, odds continue to suggest that a shallow, short recession is likely in 2023 and that the impact will be felt differently at both the sector and industry levels. Perhaps nowhere was this more evident than in the latest Purchasing Managers Index (PMI) readings for the manufacturing and services sides of the economy from the Institute of Supply Management (ISM).

The latest data from the ISM shows the manufacturing sector notched a third consecutive month with readings at recessionary levels. The composite reading for the index came in at 47.4, down from December’s level of 48.4 and November’s level of 49, and now at the lowest reading since May 2020 (readings below 50 signal contraction). Judging by demand, it appears that the weakness for manufacturers is unlikely to ease anytime soon. New orders fell to 42.5, marking the fifth consecutive month of declining demand and the sixth of the past seven readings that showed a drop in new orders. Inventories continued to grow although the pace has slowed modestly in the past month. It’s worth noting that weakness was widespread, with none of the 18 industries surveyed reporting growth in orders while just one reported an uptick in production.

Prices paid by manufacturers crept higher to 44.2 but remain solidly in contractionary territory. Finally, employment, which has been the main source of strength for the economy, softened modestly to 50.6, down 0.2 percentage points from December with a modest five of 18 industries reporting employment growth.

While the ISM data on the manufacturing side is hovering at recessionary levels, readings for the services sector paint a much different picture.

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 bounced back to 55.2 (readings above 50 signal expansion) after December’s weak showing of 49.2. Similarly, new orders jumped to 60.4 from the prior month’s reading of 45.3. However, the survey’s employment reading of 50 suggests that payrolls are holding steady, with less than half of the 18 industries reporting an expansion of payrolls. The tepid employment numbers in the ISM surveys underscore why last week’s jobs number appears to be an anomaly. As we’ve noted during the past few months, the Nonfarm Payroll report has been somewhat of an outlier when viewed against several other measures of job market strength, and the latest reading underscores the disconnect that has grown between this report and other readings.

When viewed along with the jobs report, in which 397,000 of the 517,000 new hires were in the services sector, we believe the data suggests that the economy is in the final stages of a lumpy return to normal, which we forecasted in 2022. As a result, we expect that just as the manufacturing side of the economy was an early beneficiary of the COVID shutdowns and has since entered contraction territory, the growth in services will begin to slow and eventually soften. As such, we anticipate the employment picture will weaken; given the already significant progress made on reducing inflation, the Fed will be able to pause the current rate hiking cycle and, with inflation expectations well anchored, will have the option to pivot and cut rates late in the year should a potential recession deepen and become more widespread.

Wall Street Wrap

While the ISM data provides a clear example of the rolling weakness of the economy, other data out last week reinforced the narrative of rapidly unwinding inflation and uneven economic data.

Housing weakness continues: The latest S&P CoreLogic Case-Shiller Index shows prices in November were down 0.6 percent from the prior month and have now registered five consecutive months of declines. November’s reading indicates home prices rose 7.7 percent year over year, down from October’s year-over-year gain of 9.2 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 fell for a fifth consecutive month. The latest reading has home prices up 6.7 percent year over year, down from the prior month’s rate of 8.6 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 should have a long runway.

Tempered consumer expectations: The latest Consumer Confidence report from the Conference Board showed overall that consumer confidence declined slightly in January on the back of falling expectations. Most noteworthy to the inflation and wage outlook is that despite relatively strong gains in wages, respondents don’t expect to see the increases continuing into the future. The income differential (those who expect higher wages less those expecting lower wages over the next six months) fell to 3.8 percent — compared to January’s differential of 4 percent and 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 the prospects of landing a job, 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 36.9 in January, up from 34.5 in December. 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’ balance sheets remain strong, but savings rates have eased lately, and we will be looking to see if inflation has led to any weakening of the financial health of consumers.

Wednesday: Final wholesale inventory numbers for December will be released after market open. Of interest will be any revisions to the direction of inventories from initial readings.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings have shown some volatility in the past few weeks and have fallen for three consecutive weeks; however, continuing claims have inched higher in the past several months, signaling that displaced workers are having a harder time finding new employment. Fed Chair Powell reiterated last week that the labor market remains a point of focus for the Fed, and we will be watching this report for signs of a cooling labor market.

Friday: The University of Michigan will release its preliminary report on February consumer sentiment as well as inflation expectations. Consumer expectations for inflation in the intermediate term have remained well anchored 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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