Disappointing Jobs Data Suggests an Economy Nearing the Edge

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

Equities tumbled last week as weaker than expected economic and employment data raised concerns that the economy may be headed for a recession—even though the Federal Reserve is all but certain to cut interest rates at its upcoming meeting. To be sure, it is far from consensus that the economy will tip into contraction, but the latest data shows it is fast approaching an inflection point. For instance, last Friday brought more signs of weakening on the employment front as the Nonfarm payroll report from the Bureau of Labor Statistics (BLS) came in weaker than expected for a second consecutive month. The latest report showed 142,000 jobs created in August with 118,000 of the total added to the private sector. The total fell short of consensus estimates of 165,000. Additionally, job figures for June and July were revised lower by 61,000 and 25,000 respectively. The latest revisions translate to just 97,000 private-sector positions added in June and 74,000 in July. The adjustments are consistent with recent trends highlighted in the BLS’s Quarterly Census of Employment and Wages, which showed that revisions for the past several months have been to the downside. Should this trend continue, we believe the Nonfarm numbers may eventually show flat job growth, which would be more in line with the BLS’s Household data. The pace of gains also fell far short of the 12-month average, which has drifted down to 202,000 new positions added. Details of the report also suggest an economy teetering on the edge. For example, nearly half (68,100) of the new jobs created were in health care, social assistance or government roles—three areas that are not dependent on the economy. The diffusion index, which is a measure of the portion of the 250 industries covered by the report that added jobs versus those in which employment is unchanged or declining, rose to 53.2 from July’s downwardly revised 47.8 and June’s 51.6. The fact that the diffusion index has been hovering around the 50 percent mark highlights how the job market—like the economy—appears to be at a potential tipping point.

We highlight the employment data because we have long believed the Fed viewed it as the final frontier in its fight against inflation. However, it is not the only indicator we have watched that has shown an economy that appears could go either way. As we’ve detailed for months, economic reports have been filled with seemingly contradictory data. The Institute for Supply Management’s (ISM’s) Purchasing Managers Index reports have shown consistent weakness on the manufacturing side and an economy being propped up by the services industry. However, the trend in the data on many of the reports we follow shows that the weak areas of the economy continue to struggle, while the formerly strong parts are showing signs of strain.

Much as we forecasted, we’ve arrived at the point in the economic cycle when rate hikes have driven the economy—and the labor market—to the edge. The question now: Will rate hikes keep the economy from tipping into recession? While it’s possible a 25- (or even 50-) basis-point cut next week could stem recent momentum in the economic slowdown, we still believe it is unlikely. Recent history supports our view, as the Fed began cutting rates prior to each of the last four recessions. Just as it took more than a year for the Fed’s rate hike cycle to bring the economy to its current inflection point, so too will it take time for any upcoming rate cuts to seep deep enough into the economy to reverse the slowing trend.

As we’ve often noted, changes in rates have variable and unpredictable lags. In other words, it may take some time before we can tell for certain that the Fed successfully stemmed the slowdown and avoided a recession or if it acted too late and the economy is destined to fall into contraction. Given this uncertainty, we believe investors would be well served by being mindful of taking on outsized risks in their investment portfolios. Doing this does not mean abandoning equities or hiding out in cash. Indeed, there are opportunities in other parts of the market, such as some Small- and Mid-Caps that we believe are cheap and have been overlooked. While these parts of the market may see near-term volatility, we believe they could produce strong intermediate- to long-term relative returns whether we see a recession or a soft landing.

Put simply, we believe investors would be wise to follow an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals.

Wall Street wrap

More on the employment front: Announced job cuts surged in August, according to the latest report from Challenger, Gray and Christmas Outplacement Services, to 75,891—a 193 percent increase from July and up 1 percent year over year. The most commonly cited reason for the cuts was cost cutting, followed by market and economic conditions. Besides August of 2020, this is the highest August total since 2009. The jump in cuts comes as the number of announced new hires dipped to the lowest level recorded by the outplacement firm since the report’s inception in 2005. The latest data shows 79,697 new positions announced year to date through August. For further context, the previous all-time low was 80,387 recorded through August 2008, when the economy was in the midst of or a recession.

The latest Challenger data is consistent with last week’s Job Openings and Labor Turnover (JOLTS) report from the BLS. The release shows that job openings declined 305,100 in July from the prior month and are down 1.1 million on a year-over-year basis.

Despite more signs of cooling job market, wages ticked higher. Details in the BLS Nonfarm report show that wages for production and nonsupervisory employees grew by 0.4 percent in August and are now up 4.1 percent year over year, up from July’s pace of 3.8 percent. The uptick in wage growth, even as the labor market appears to be softening, highlights the challenge the Fed faces as it tries to strike a balance on rates that will keep the economy afloat without fanning any remaining inflationary embers and creating a wage–price spiral.

Finally, the BLS’s other jobs report, the Household survey, showed the unemployment rate virtually unchanged at 4.221 percent compared to 4.253 percent in July. This is still well above the cycle low of 3.4 percent, and as we’ve noted in the past, once the unemployment rate has risen by 0.5 percent or more from the trough in that economic cycle, in every instance since WWII, the next stop during a recession is a rise in the unemployment rate of 1.9 percent or more.

Slump in manufacturing continues: The latest headline reading from the ISM shows manufacturing activity improved modestly but is still sluggish, with August’s measure at 47.2, up 0.4 points from July (readings below 50 indicate contraction for the sector). The latest level marks the fifth consecutive month of contractionary readings and the 21st time in the past 22 months that the reading has been below 50. Readings for new orders showed growing weakness, coming in at 44.6, down 2.8 points from July. Order backlogs also remain in contractionary territory at 43.6 compared to 41.7 for the prior month.

While demand remains sluggish, prices continue to rise, with the latest reading for input costs coming in at 54, up from 52.9 in July. This marks the eighth consecutive month of rising raw material costs following 13 of 15 months of declining input costs. Four of the six largest industries reported higher costs. If cost pressures persist in the face of weakening sales, manufacturers may be unable to raise prices charged to customers and instead face pressure on profit margins.

The employment index improved modestly but remains in contractionary territory at 46 percent, up 2.6 points from July. However, the latest reading, along with July’s measure, mark the two lowest readings since July 2020. Weak demand for employees was widespread, with 10 of 18 industries reporting a decrease in employment and only three industries recording an increase.

Services sector treads water: The latest headline reading from the ISM shows activity in the services sector inched higher in August with a reading of 51.5, up 0.1 points from August’s reading of 51.4. New orders rose to 53 from the previous month’s level of 52.4. Despite the rising growth, demand for workers edged lower, nearing contraction readings, with the employment index coming in at 50.2 compared to July’s reading of 51.1. It’s worth noting that six of the past nine employment readings have been in contraction. The recent trend in services employment, when viewed along with the manufacturing trend, points to economic weakness.

Prices paid by companies increased for the 87^th consecutive month. The prices index came in at 57.3 percent, an increase of 0.3 percent from the prior month. In total, 13 industries reported higher costs, while just three reported lower costs.

While the report offered a brighter picture than that of the struggling manufacturing side of the economy, it suggests lackluster growth for the economy. In a statement issued with the report, Steve Miller, chair of the Institute for Supply Management Services Business Survey Committee, noted, “The past relationship between the Services PMI and the overall economy indicates that the Services PMI for August corresponds to a 0.8-percentage-point increase in real gross domestic product on an annualized basis.” These two surveys taken together indicate an economy on the edge.

Beige Book signals weakness: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that the pace of the economy slowed from the prior reading, with nine of the 12 Federal Reserve districts reporting flat or declining activity, which was four more than last time. The remaining three districts described activity as rising slightly.

Given the weakening employment picture reflected in last week’s jobs report, it’s worth noting that employment levels were generally flat or reflected modest hiring and that employers were being more selective in hiring and less inclined to add staff. The report also noted that “candidates faced increasing difficulties and longer times to secure a job.” Less competition for employees has eased wage pressures for businesses, described as rising modestly.

Pertaining directly to inflation, most districts reported modest price growth, with three regions reporting only slight increases.

The week ahead

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index readings for August will be out prior to the opening bell. Recent readings have shown a rise in optimism but have indicated that price pressures and the state of the labor market continue to weigh on small businesses, with many firms raising wages. We will watch for signs that point to these challenges easing.

Wednesday: The Consumer Price Index report from the BLS will be the big report for the week. Recent data has shown promising steps in the disinflationary process, and we will be dissecting the data to see if it suggests prices continue to ease.

Thursday: The latest readings from the BLS on its Producer Price Index will offer a look at changes in costs for buyers of finished goods for July. We will be watching to see if input costs continue to creep higher, which could put pressure on profit margins or slow the pace of disinflation.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have varied from week to week but overall have been trending higher, and we’ll continue to monitor this report for further signs of eroding strength of the employment picture.

Friday: The University of Michigan will release its preliminary report on September consumer sentiment and inflation expectations. We will be watching to see if recent concerns on Wall Street about a potential recession have taken a toll on the outlook of consumers.

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