Fed Signals Rate Cuts Are Coming—Now Comes the Hard Part

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

Equities sold off and bond yields tumbled as a series of disappointing economic reports out last week reignited fears that the economy was headed for a recession. The selling pressure carried over to this week with the markets adding to losses. The fear was initially sparked by weaker than expected jobs numbers along with evidence that the manufacturing sector continues to struggle swamped a temporary burst of optimism that came from Federal Reserve Chairman Jerome Powell’s press conference following the latest Federal Open Markets Committee (FOMC) meeting. Powell’s comments during the briefing were widely viewed as a tacit acknowledgement that the FOMC will cut rates in September barring some significant surprise in either inflation or employment data. However, weak data in the days following the news conference has investors nervous that waiting until September may be too late to avoid a recession.

The sharp negative reaction is in contrast with the all-news-is-good-news view investors had been taking for the past several months. During the stretch, better than expected economic data was viewed as a sign the economy was resilient and that growth would continue for the foreseeable future. At the same time signs of weakness were widely viewed as paving the way for the Federal Reserve to cut interest rates, which would then allow the economy to avoid a recession and instead achieve a sort of equilibrium where inflation was benign and growth continued at a slow but steady pace.

In contrast, we have been more skeptical. Our contrarian view is based on data trends and historical precedence. For instance, the yield curve has been inverted (meaning short-term bonds yield more than long-term bonds) for just shy of two years. Likewise, measures such as the Conference Board’s Leading Economic Indicators have been at or near levels that typically signal a recession for the better part of two years. Last week added another normally reliable indicator of a potential recession—the Sahm rule. Regular readers of our commentaries may recall this rule, developed by former Federal Reserve Economist Claudia Sahm. According to the rule, since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous low, a recession followed. For months, many were willing to dismiss some of the usual indicators of economic weakness because of the seeming resilience of the job market. However, now that the labor market is showing strains, we believe investors will need to reconsider the risks of a downturn. While these signals have been flashing caution for an extended period without a recession yet arriving, we believe they still hold value. The unusual lag between the signals and an actual recession, in our view, is the result of some of the post-COVID economic anomalies delaying an eventual downturn. We believe they still suggest we are nearing the end of the current economic growth cycle and that this cycle, like all those before it, will eventually end in a contraction.

Indeed, while last week’s sell-off suggests investors are beginning to share some of our concerns about a potential recession, discrepancies remain about the path going forward. After last Friday’s weak employment report, investors ratcheted up their expectations for the size of a September rate cut from 25 basis points to 50 basis points, with some suggesting that an emergency intra-meeting cut is warranted. However, given that the economy is in the late stages of a growth cycle (which typically makes it more sensitive to inflationary pressures) coupled with an equity market that is still positive for the year, we believe that the FOMC won’t make an emergency cut and is unlikely to cut by larger than 25 basis points at its September meeting unless there is significant weakening of the labor market in August or inflation plummets. That’s because, as we’ve noted in the past, the Fed is committed to snuffing out any remaining threat of a rebound of inflation and views the job market and wage growth as the final frontier in achieving its goal of inflation running at a sustainable 2 percent annual rate. In the meantime, the impact of rate hikes, which (as Chairman Powell noted at his press conference last week) have begun to take a greater toll on the economy, will continue to weigh on consumers and businesses alike. Unfortunately, we believe the slowdown in the economy is beginning to gain some momentum, and we continue to view a recession as the most likely outcome in the quarters ahead.

However, as we always stress, our cautious economic outlook does not mean that investors should make dramatic changes to their portfolios or, worse yet, panic and sell when markets falter. Volatile periods are one of the most important times to stick with your plan and remember that a recession does not mean a lack of market opportunity. Recessions and corrections are natural features of the economic and market cycles. Sticking to a long-term plan and staying invested and diversified, even in areas that haven’t done well, remain the core tenets we believe create and maintain financial security for investors. Every part of your portfolio should fit within your carefully crafted financial plan and be tied to a goal or objective—and stocks are investments for the long term. While we are cautious near term, we remain optimistic in the intermediate to long term and reiterate our belief that segments of equity markets are cheap. Reach out to your financial advisor if you find the recent market volatility concerning.

Wall Street wrap

Data out last week suggests that the slowdown in the economy may be gaining momentum, which could lead to further softening of the employment picture.

Job market shows signs of weakening: The Bureau of Labor Statistics (BLS) Nonfarm payroll report showed that 114,000 new positions were added in July—down from June’s downwardly revised total of 179,000 and well below Wall Street estimates of 175,000. The pace of gains also fell far short of the 12-month average of 215,000 new positions added. Details of the report underscored a sense that the job market is weakening. For example, more than half (64,000) of the new jobs created were either in health care or social assistance, two 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, fell to 49.6 percent. Typically, diffusion index readings at the current level have coincided with recessions. Additionally, temporary help services—a leading indicator of the broader labor market—fell by 8,700. This is a timely measure because employers typically let go of temporary workers before cutting permanent staff.

The BLS’s other jobs report, the Household survey, also showed a weakening job market as the unemployment rate rose to 4.3 percent in July, up 0.2 percent from June’s reading. As fewer people were hired, wage growth also slowed. The latest report shows that wages for production and nonsupervisory employees grew by 0.3 percent in July and are now up 3.8 percent year over year, down from June’s pace of 4 percent. The slowdown in wage growth echoed estimates from the BLS’s quarterly Employment Cost Index (ECI), which showed labor costs for non-government workers rose by 0.9 percent in the second quarter, down from the first period's pace of 1.2 percent. On a year-over-year basis, the report showed compensation costs were up 4.1 percent, the slowest pace since the fourth quarter of 2021.

Both the ECI and Nonfarm payroll data measure payroll costs, but they are calculated differently and cover different time frames. While these discrepancies make apples to apples comparisons impossible, they can be useful in identifying changes in trends and what may be behind those changes.

Slump in manufacturing deepens: The latest headline reading from the Institute for Supply Management (ISM) shows activity continues to slow, with July’s measure at 46.8, down 1.7 points from June’s reading (readings below 50 indicate contraction for the sector). The latest level marks the fourth consecutive month of contractionary readings and the 20th time in the past 21 months that the reading has been below 50. Readings for new orders came in at 47.4, down 1.9 points from June. Order backlogs remained low at 41.7—unchanged from June’s reading.

Despite ongoing weakness in the manufacturing industry, costs continued to rise, albeit at a moderate pace. The latest reading for input prices was 52.9, up from June’s reading of 52.1. Three of the six largest industries reported higher costs. The latest reading marks the seventh consecutive month of rising prices. Goods prices have been the driving force in the disinflationary process as price increases shifted to the services sector. Should 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.

One area businesses may look to as they seek ways to cut costs is payroll. Indeed, the latest report shows the employment index in the survey tumbled 5.9 percentage points in June to 43.4. With the exception of the March through June 2020 period in the immediate aftermath of COVID’s arrival, this is the lowest reading since May 2009, when the U.S. was emerging from the Great Financial Crisis. Weak demand for employees was widespread, with 13 of 18 industries reporting a decrease in employment and only two industries recording an increase. “None of the six big manufacturing sectors expanded employment in July. Respondents’ companies are continuing to reduce head counts through layoffs, attrition and hiring freezes. Panelists’ comments in July indicated a notable increase in staff reductions compared to June, supported by the approximately 1:1.8 ratio of hiring versus head-count reduction comments,” noted Tim Fiore, chair of the ISM.

Continuing jobless claims rise: In a further sign of a weakening labor market, weekly initial jobless claims were 249,000, up 14,000 from last week’s level. The four-week rolling average of new jobless claims came in at 238,500, an increase of 2,500 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.877 million, up 33,000 from the previous week’s revised total and now at the highest level since November 2021. The four-week moving average of continuing claims came in at 1.857 million, an increase of 5,250 from last week and the highest level since December 2021.

Consumer confidence inches higher: The Conference Board’s consumer confidence index rose to 100.4 in July, up from June’s downwardly revised reading of 97.8. While consumers’ assessment of their present situation fell to 133.6 (the lowest level since April 2021), their expectations for the future rose to a still low but improved 78.2, up from 72.8 in June. Despite the improvement the reading is still below 80, which has historically been a warning signal for a recession in the near future.

The report also showed that respondents’ views of their families’ financial situations—both now and looking ahead over the next six months—dimmed. The latest results continue a trend of weakening views about household finances that began in January of this year. While these measures are not included in the calculation of the Consumer Confidence index, it is worth noting that according to a release accompanying the report July’s write-in responses showed that “elevated prices, especially for food and groceries, and inflation remain the key drivers of consumers’ views of the economy, followed by the U.S. political situation and the labor market.”

Importantly, the labor differential, which measures the gap between those who find it hard or easy to get a job, fell to 18.1 percent, well below the record high level of 47.1 recorded in March 2022. This shrinking differential is another sign that the labor market has and continues to weaken, with the current level consistent with a higher unemployment rate.

Existing home prices rise: Home prices notched another record high in May, according to the latest S&P CoreLogic Case-Shiller Index. The latest report shows that home prices nationally rose 0.3 percent on a seasonally adjusted basis from the prior month. May’s reading shows home prices are up on a year-over-year basis, rising 5.9 percent since May 2023, marking 12 consecutive readings of year-over-year gains. While the pace of year-over-year gains slowed in May compared to April’s reading, year-to-date prices nationally are up 4.1 percent, which marks the fastest pace in two years. The rise in prices comes despite interest rates on 30-year fixed mortgages hovering above 7 percent.

The week ahead

Monday: A light week of data kicks off with the release of the ISM's latest Purchasing Managers Services Index. Last month’s report showed the services side of the economy joining the manufacturing side and slipping into contraction for the second time in the past three months. We note that this is a condition that has historically occurred during recessions, and we’ll be looking to see if this trend continues or has gained momentum. Another point of focus will be the measure of prices paid as well as the employment situation.

We’ll get the latest results from the Federal Reserve’s Senior Loan Officer Opinion Survey in the afternoon. The most recent survey showed lending standards at large and mid-sized banks continued to tighten. We will watch for signs of a change in lending criteria and the state of loan demand.

Tuesday: The New York Federal Reserve will release its latest look at the financial condition of consumers through its Quarterly Report on Household Debt and Credit report. Consumer credit card debt has risen in recent months, as have the number of credit card and auto loans slipping into severe delinquency. We’ll be watching to see if consumers are continuing to add to their debt levels.

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

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