Fed Fears Reemerge

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

Investors’ hopes for a soft landing took a step back last week as new data heightened fears that the Federal Reserve’s focus on slowing a seemingly tight job market may cause it to raise rates too high and push the already slowing economy into recession. Disappointing retail sales figures and an unexpected drop in initial unemployment claims sent most of the major indices lower for the week, despite a strong rally Friday. 

The downbeat reaction by the markets to the latest economic readings highlights the growing split between how investors view recent data and the Fed’s focus on lagging indicators and the labor market. It was only last summer that both investors and the Fed were focused on the threat that persistent elevated price pressures represented for the long-term health of the economy. However, during the past few months, a steady stream of reports showing the economy slowing, supply chains and inventories returning to pre-COVID norms, and consumer inflation expectations anchored have led many investors to believe the worst inflation is largely over and that a recession is the growing threat. Conversely, the Fed continues to beat the drum for higher rates for longer as it waits for signs that the labor market has weakened and that wage pressures have fully subsided, taking away the risk of a self-perpetuating upward spiral of rising costs and income. 

We felt that the renewed hope for a soft landing that sent the markets higher to start the year was overly optimistic. Instead, we view a shallow, short and uneven recession as a base case. In our view, the type of labor market equilibrium the Fed is seeking will most likely be achieved through rising layoffs, which would likely coincide with a recession. While it is possible an influx of new workers could bring about a balanced employment picture, millions of employees who left the workforce during COVID have yet to return, and we believe it’s unlikely they will come off the sidelines in the foreseeable future. However, should the Fed remain too aggressive for too long in raising rates, we still believe a deep recession can be avoided for two reasons: First, it appears that wage growth has softened in a seemingly strong job market. Second, inflation pressures are unwinding, and that momentum is gaining steam. We believe the combination of the two will allow the Fed to pivot to cutting rates if any potential recession threatens to deepen.  

Wall Street wrap 

Retail sales and jobless numbers grabbed most of the headlines last week, but when viewed alongside other data releases, the data paints a picture of a slowing economy facing waning inflation pressures.  

Cool housing market persists: The National Association of Realtors reported that existing home sales in the U.S. dropped 1.5 percent in December to a seasonally adjusted annual rate of 4.02 million units. The latest drop marked the eleventh straight month of falling sales — the longest streak of declines since 1999. The decline in the annualized rate of sales represents a 34 percent drop from the pace recorded in December 2021. For all of 2022, just more than 5 million homes were sold, down 17.8 percent from 2021, marking the largest drop-off in sales since 2008. Likewise, prices for existing homes rose at the slowest rate since the beginning of COVID and are now up just 2.3 percent from where they ended 2021. As we’ve noted in the past, shelter has a large and lagging effect on inflation readings in services (shelter accounts for 33 percent of the total Consumer Price Index (CPI) measure and has a 12-month lag). This latest data suggests that as measured by CPI, price pressures tied to shelter will continue to drop throughout 2023. 

On the supply side, single-family home building permits fell 6.5 percent in December, according to data from the U.S. Commerce Department, and multi-family permits were up 5.3 percent; however, total permits for both single- and multi-family units were down 1.6 percent in December. For the full year, housing permits were off 5 percent from 2021 levels, with approximately 1.65 million units authorized. Housing inventory dropped 13.4 percent in December from the previous month, according to the latest figures from the National Association of Realtors; however, it finished the year 10.2 percent higher than at the end of 2021.  

While the housing sector has been among the hardest hit by the Fed’s rate hikes, pessimism among builders is showing signs of stabilizing. The latest survey from the National Association of Home Builders shows a modest uptick in builder confidence in January (albeit at recessionary levels), as mortgage rates recently declined. Optimism rose 4 points to a still low 35. The modest improvement is noteworthy, as it broke a string of 12 consecutive months of declines. The increase also suggests that builders may be willing to bring more new housing supply to the market in 2023, which would help alleviate renewed price pressures should interest rates drop. 

Consumers not in a spending mood: The latest retail sales numbers out from the U.S. Census Bureau came in well below Wall Street expectations. The report shows overall retail sales in December were down 1.1 percent month over month, and were off 0.7 percent when excluding auto and gas purchases. Weakness was widespread, with 10 of the 13 categories measured showing declines. The release also contained a revision of November’s figures, pegging sales at a 1 percent decline. On a year-over-year basis retail sales were up 6 percent. For all of 2022, retail sales were up 9.2 percent. However, it's important to note that these figures are not adjusted for inflation. As such, much of the gains were due to higher prices as opposed to more goods sold. The lack of buying appetite for goods could lead to further weakness on the manufacturing side of the economy and could further erode already weakened pricing power. 

Input costs continue to ease: Producer input costs fell 0.5 percent in December, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. Declines in food and energy prices drove the downside move, leaving the core PPI number up 0.1 percent. The latest number continues a downward trend that began following March’s red-hot increase of 1.7 percent. The index measures price increase for finished goods leaving the factory. As the costs producers face for finished goods continue to ease, we expect to see further price relief for consumers at the retail level. 

The week ahead 

Monday: The Conference Board’s latest Leading Economic Index (LEI) survey will be a key release during the week. Recent reports are at levels that have historically coincided with recessions, and this is one of the reasons we believe an economic contraction is on the horizon. We will be scrutinizing the data for any indications of a change in the pace of softening. 

Tuesday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for November. Activity for both manufacturing and services has weakened in recent months. Likewise, cost pressures have been easing for manufacturers as inventories have been rebuilt and supply chain bottlenecks have cleared. We will be watching for signs that the trend of ebbing costs is broadening into the services side of the economy. 

Thursday: We get our first estimate of fourth-quarter GDP. Wall Street estimates project growth to come in at 2.7 percent quarter over quarter. Despite the expected growth, we continue to believe that other measures, such as the Conference Board’s LEI, point to a likely recession in 2023. 

Initial and continuing jobless claims will also be announced. Initial filings unexpectedly dropped last week; however, continuing claims have inched higher in the past several months, signaling that it is becoming harder for displaced workers to find new employment. The labor market remains a focal point for the Fed, and we will be watching for signs that initial claims are heading higher. 

Friday: The October Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions. As with the recently released CPI reading for October, we will be watching for evidence that recent trends in forward-looking data are beginning to gain traction in this backward-looking inflation measure. 

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