Easing Inflation and a Softer Tone From the Fed Send Markets Higher

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

Investors appeared to be encouraged by signs of continuing progress in the fight against inflation, as well as Federal Reserve Chairman Jerome Powell’s statement last week that suggested the Federal Open Markets Committee may begin to temper the size of rate hikes as early as its next meeting. The focus on forward-looking data and the Chair’s statements were enough to overcome concerns raised by a stronger than expected Nonfarm Payroll reading from the Bureau of Labor Statistics (BLS). The latest report showed 263,000 new jobs were created in November, above consensus expectations of 200,000. Wage growth was also strong, with hourly pay rising .6 percent month over month and up 5.1 percent compared to November of last year.  

The measured response to the payroll numbers suggests that investors are increasingly focusing on the broader picture painted by a variety of reports as opposed to trading around each individual scrap of data released. Consider that as recently as October, a jobs report showing a similar increase in new positions led to heavy selling and pushed the S&P 500 down nearly 3 percent on the day of its release. The difference between then and now is that the latest data came on the heels of a string of economic releases over the past several weeks that continue to point to waning price pressures going forward. As we’ve noted in recent commentaries, a significant gap has opened between the BLS Nonfarm Payrolls report and its other measure of employment, the so-called Household report. The trend continued this month, with the Household report showing a decrease of 138,000 jobs in November. Since the end of March, the Household report has shown a net gain of 12,000 jobs in the labor market, which is in stark contrast to the 2.7 million new hires captured in the Nonfarm data. Discrepancies between the two reports are not uncommon over short periods of time; however, the gap between readings this year has been significant, and we believe other data suggest the potential for a weakening labor market in the coming months. For example, layoff announcements are beginning to increase, according to recent reports from Challenger, Gray and Christmas Outplacement Services, with November seeing 76,835 announced cuts compared to just 14,875 for the same month last year. 

While the trend in forward-looking data has been encouraging on the inflation front, it also suggests that the economic slowdown prompted by the Fed’s aggressive actions this year is likely to ebb and flow and may result in sectors and industries experiencing rolling recessions in the months ahead. Just as we had a strong but rolling recovery as the economy emerged from COVID, we are seeing signs of what could be characterized as rolling recessions. We’ve already seen this in broad swaths of the economy; the goods sector was the first to recover from the initial shock of COVID and has seen a marked slowdown in recent months. This trend continued in November, with the latest manufacturer data from the Institute for Supply Management (ISM) showing the manufacturing side of the economy slid into contraction for the first time since May 2020, with a reading of 49 percent (readings below 50 indicate economic contraction). The latest reading is down from October’s level of 50.2. For context, this measure was as high as 63.7 in March 2021 and 56.1 in May of this year.  

Notably, demand continued to fall, with new orders coming in at 47.2, marking the fifth sub-50 reading in the past six months. Order backlogs also fell and are now down to 40.6, marking the second consecutive month in contraction territory. As recently as February of this year, backlog readings were at 65 percent, and the measure hit a recent peak of 70.6 in May 2021. Meanwhile, supply has recovered, with inventories at the factory level continuing to climb, reaching a level of 50.9. Customer inventories have returned to pre-COVID levels, with the latest reading at 48.7, well up from a record low reading of 25 in November of 2021. Finally, we’ve seen input costs drop dramatically, with the latest reading coming in at 43 percent, well off the 87.1 level recorded in March of this year and the recent high of 92.1 on June 2021. With input prices falling, demand subsiding and inventories rebuilt, manufacturers will likely lack pricing power in the months ahead, which should continue to put downward pressure on overall inflation as we head into 2023. 

Just as demand has softened in manufacturing, so too has the employment picture. The ISM survey showed demand for workers contracted, coming in at 48.4 and marking the fifth time in the past seven months that employment readings have been below 50. The latest reading is consistent with details from the ADP National Employment Report out last week, which showed overall a weaker employment picture with 127,000 jobs created, including 213,000 new hires in the services sector, but a net loss of 86,000 positions on the goods-producing side of the economy.  

This week we’ll get a clearer picture of the health of the services sector from a pair of reports out on Monday. While we’ve seen signs that it too is beginning to plateau, job growth has appeared to remain robust. However, as we’ve noted in past commentaries, employment is a lagging indicator, and we expect in the months ahead that demand for employees will begin to ease. 

While recent numbers for manufacturing paint a dour economic picture, we continue to believe that should a recession arrive in the coming months, it will be mild and uneven given the overall financial strength of U.S. consumers and that it will give way to rising but volatile equity markets in 2023. 

Wall Street Wrap 

While many of the headlines were focused on Federal Reserve Chair Jerome Powell’s comments and Friday’s payroll data, other reports suggest the trend of easing inflation continues.  

Housing weakness continues: The latest S&P CoreLogic Case-Shiller Index shows prices in the index of 20 city major metropolitan areas for September were down 1.24 percent from the prior month and have now registered three consecutive months of declines. September’s reading showed home prices in the Index were up 10.4 percent from September 2021 but well below the recent peak of 21.3 percent registered in April of this year. Further evidence of eroding demand for homes can be found in data from the National Association of Realtors, which shows pending home sales fell by 4.6 percent in October, marking the fifth consecutive month of declines. The latest reading is 36.7 percent lower than the same period last year. Pending sales are a forward-looking measure, and the latest figures suggest softer demand will continue to contain prices in the near term.  

Beige Book suggests further weakening: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that in aggregate the economy continued to tread water, with only five of the Fed’s 12 districts reporting slight or modest improvements in economic activity, while the remainder experienced either no change or slight to moderate declines. 

Noteworthy in the report was insight into the labor market. While labor continues to be tight, most districts reported slight improvements for businesses seeking to fill roles. 

Inflation pressures continue to recede: The latest Personal Consumption Expenditures (PCE) price index from the Bureau of Economic Analysis shows core inflation continuing to ease on a year-over-year basis. The index, which is the Federal Reserve’s preferred measure of rising costs, shows core inflation, which excludes volatile food and gas, stands at 5 percent year over year in October, down from September’s reading of 5.2 percent. Headline PCE, which includes food and gas, also showed a slower pace of growth at 6 percent versus September’s 6.3 percent year-over-year growth. Noteworthy in the report was an uptick in the price of new vehicles. Car prices have wavered during the past several months, as used car prices rose when new vehicles were scarce but have retreated as vehicle production has increased. We view this as just one example of what rolling pockets of weakness in the economy may look like in the coming months.  

The week ahead 

It’s a relatively light week for economic data; however, there are a few reports we’ll be watching for further insights into the services side of the economy, the employment market and the strength of consumers’ finances.  

Monday: Investors will get an update on demand for services in the morning from a pair of reports when the Institute for Supply Management and S&P Global release data on the sector. We will be watching the report for signs that growth in demand for services is beginning to cool as well as changes in employment expectations in the sector.  

Wednesday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers’ balance sheets have been an area of strength, and we will be looking to see if inflation has begun to erode any of that strength.  

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. Employment numbers out last week showed wages continued to climb, and we will be looking to see if consumers anticipate higher wages in the coming months, which could impact their willingness to pay higher prices for goods and services. 

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