Dueling Narratives and an Economy in Transition

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

The markets kicked off the third quarter on an up note. Solid gains during the holiday-shortened week marked the second time in the last three weeks the indices posted positive returns. While the move higher was welcomed, two economic narratives that have been driving volatility for months served as bookends to the week. Concerns of a looming recession hovered over investors as they returned from their July 4th festivities. The worries were largely driven by data from the prior week that pointed to further slowing growth for manufacturers. However, by Friday the narrative flipped thanks to a stronger than expected jobs report that was interpreted as a sign the economy was running too hot and the Federal Reserve would need to maintain an aggressive posture on rates.   

While the back and forth between competing narratives may be head-spinning, it is also a reminder that each economic report provides just a small sliver of a much larger picture. Do recent data suggest the economy is slowing? Yes. But thanks in part to slowing demand, inflation is also coming down. Do recent jobs numbers suggest wage pressures will persist? Not necessarily, and wage growth going forward is likely to vary significantly by industry. Put simply, no single data point tells the full story. However, when we view inflation as part of a larger picture, we continue to believe that it is receding and the economy is slowing, but consumers and corporations remain in a strong position to weather a potential contraction.       

Wall Street wrap  

Recent reports continue to show an economy transitioning away from demand for goods and toward an appetite for services. The migration of consumer spending should alleviate supply shortages, which we believe will help cool inflation further. 

Continuing gains in services industry. The latest Services Index readings released by the Institute for Supply Management (ISM) showed continued growth in the services sector, with a June reading of 55.3, down from May’s level of 55.9 (readings above 50 indicate expansion). This report, along with the prior week’s data showing continued expansion in manufacturing, points to an economy that is slowing but not in a recession. 

Despite the latest reading being the lowest in two years, each of the 18 industries included in the report saw growth — the first time that has happened since November 2021. Growth of new orders edged lower but remains at a healthy 55.6, while inventory sentiment came in at 46.2, up from recent levels of the low 30s. The improvement in sentiment points to inventories being replenished. While new orders have slowed, the new orders minus inventory sentiment number still stands at a healthy 9.4. By comparison, shortly before the 2001 recession, the difference stood at -14 — and -10 before the Great Financial Crisis of 2007. This number typically turns negative prior to a recession, and the fact that it’s still positive is another reason we think we’re not in recessionary territory at this point. 

Supplier delivery readings stayed near recent lows at 61. 9 – up modestly from May’s reading of 61.3 but still near the lowest levels since March 2021, when consumers began to emerge from the COVID shutdown.  

The report, along with last week’s look at Manufacturing from ISM, provides evidence that supply chain bottlenecks are improving while the economy continues to grow slowly.  

Concentrated job growth. Employment growth remains strong, with 372,000 jobs added in June, according to the latest report from the Bureau of Labor Statistics. The report was stronger than expected on Wall Street; however, it contained downward revisions of 74,000 for the previous two months. Most of the gains came in leisure and hospitality with 67,000 new jobs (but still 1.3 million below pre-pandemic levels) and health care and education up 96,000. Just as we expect the shift in spending toward services and away from goods to continue, we anticipate employment gains will continue to favor the services side of the economy, while there may be an uptick in layoffs at businesses focused on goods.  

The unemployment rate remained at 3.6 percent; however, underlying data used in the calculation along with additional information from the ISM reports suggest the pace of job creation is slowing. 

Despite the report showing workers remain in high demand, wage gains slowed to 5.1 percent year over year, down from last month’s 5.3 percent reading. As job creation continues to decelerate, we expect wage pressure will ease further. The employment participation rate edged down for the month but remains above 2021 levels. Additional gains in the participation rate would likely further offset wage pressures.  

The week ahead  

In addition to the key economic reports listed below, we’ll be keeping an eye on earnings releases from some bellwether companies as an early indicator of what the earnings season may have to say about valuation in the equity markets. 

Tuesday: NFIB Small Business Optimism Index readings for June will be out before the opening bell. The report should provide an update on the future for labor costs as well as signs on the direction of prices at both the consumer and wholesale levels. 

Wednesday: The U.S. Bureau of Labor Statistics will release its Consumer Price Index for June. This report, while not as heavily relied upon by the Fed as the Personal Consumption Expenditure price index, will give an early read on whether inflation is continuing to ebb for consumers and whether the most recent rate hike by the Federal reserve is making an impact on inflation. 

Thursday: The latest readings from the U.S. Bureau of Labor Statistics on its Producer Prices Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into how changes in input costs, such as raw materials and commodities, are impacting the prices of goods bought by end consumers. 

Friday: The University of Michigan will release its preliminary report on July consumer sentiment as well as five-year economic expectations. Sentiment has slumped in the last two reports, and we’ll be watching for changes that could affect consumer spending decisions in the near term. 

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