Focus Shifts to the Labor Market as Inflation Slows

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

Equities recorded a third straight week of strong gains as investors viewed the final estimate of gross domestic product (GDP) growth and a tame inflation report as giving the Federal Reserve the green light to cut rates further during the rest of the year. The thinking goes that additional rate cuts will help the economy to continue to post solid growth.

The final estimate for GDP from the Commerce Department pegged growth at an annualized pace of 3 percent in the second quarter of this year, unchanged from last month’s reported estimate. While the figure is a backward-looking measure, details in the report showed a jump in gross domestic income and the personal savings rate compared to initial estimates. The latest report shows real gross domestic income grew by 3.4 percent in the quarter, an upward revision of 2.1 percentage points. Similarly, the personal savings rate came in at 5.2 percent, up from the previous estimate of 3.5 percent. These two measures mean consumers are likely in better shape than originally thought.

Meanwhile, the latest personal consumption expenditures (PCE) report shows that headline inflation was up 0.1 percent in August from the prior month and that prices are up 2.2 percent on a year-over-year basis. Core PCE, which strips out volatile food and energy, also rose 0.1 percent for the month and is up 2.7 percent on a year-over-year basis.

Taken together, these reports suggest that the chances of the current growth cycle persisting have increased, but we still believe a soft landing is far from certain. While inflation concerns have diminished over the past few months, the economy may still slip into a recession if recent softening in the labor market gains momentum. Indeed, as we’ve highlighted over the past several months, trends in the Bureau of Labor Statistics’ (BLS’s) Household employment reports as well as downward revisions to its Nonfarm payroll figures and the labor differential in the Conference Board’s Consumer Confidence Index show that weakness on the jobs front is gaining momentum. The negative tone of these reports is bolstered by employment data we have been watching in survey reports, including last week’s S&P Global Purchasing Managers Index (PMI) readings which we detail later in this commentary. While it is possible that aggressive rate cuts by the Federal Reserve could stem the tide of weakening, history suggests that it is far from certain (recall that the Fed cut rates before each of the past four recessions). These risks exist against a backdrop where investor optimism is elevated, which historically has been a contrarian indicator about the equity markets. Indeed, the most recent reading of the American Association of Individual Investors Sentiment Survey shows that just shy of half (49.6 percent) of respondents are bullish on the stock market for the coming six months. Similarly, the most recent consumer confidence survey from the Conference Board shows that nearly half of respondents (47.6 percent) expect the stock market to climb. While this is down modestly from the recent high of 50.6 percent in July, this level remains historically high. There have been only two other readings that have eclipsed the current level—January 2018 and January 2000. Each of those occurrences happened before stock markets moved lower. This level of seeming certainty that the economy will not falter and equity markets will move higher, in our view, underestimates the risks posed by the recent wobbling of the job market.

That isn’t to say that the risks of a potential setback for the economy require you to become overly defensive. Instead, we believe investors would be well served by balancing current risks against potential upside performance. As we have noted over the past several months, there are ample opportunities in the market—such as small- and mid-cap equities—that are trading at relatively attractive valuations and should be well positioned to perform over the next 12 to 18 months whether 1) the economy slips into a recession or 2) a soft landing occurs that results in a broadening of both the economy and equity market strength. We continue to believe investors will be well served by following 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

While GDP and inflation data caught most of investors’ attention, other reports out last week suggest challenges remain in the economy and that a soft landing is far from a sure bet.

Cost pressures persist as economic activity slows: The latest S&P Global Composite PMI report shows that U.S. business activity pulled back modestly in September, as both the services and manufacturing sides of the economy reported slightly weaker activity. The latest preliminary data, which tracks both the manufacturing and service sectors, shows that the Composite Output Index came in with a reading of 54.4 (levels above 50 signal growth), off from August’s final reading of 54.6.

While the headline number suggests continued economic growth, details highlight that the economic picture is unbalanced. The Manufacturing PMI came in at 47, down 0.9 points from August and marking the lowest reading since June 2023. Meanwhile, the Services Business Activity Index came in at 55.4, down from August’s reading of 55.7.

The weakness in manufacturing is nothing new and looks to be set to continue as new orders for manufacturers notched the greatest month-over-month decline since December 2022. Meanwhile, the services side of the economy recorded the second strongest uptick since June 2023.

While activity slowed, cost pressures on both the services and manufacturing sectors are still elevated. In recent months businesses have largely absorbed those higher costs, but September’s data suggests that trend may be ending. As input costs in total increased at the fastest pace in a year, selling price inflation for both sides of the economy rose at the fastest pace in six months and pushed the rate of inflation further above pre-pandemic long-run averages. The bulk of the higher costs stemmed from increased payroll costs on the services side.

The composite employment reading declined for a second straight month and has now fallen four of the past six months. Indeed, an increasing number of manufacturers reported cutting positions due to weak sales. The result was the sharpest decline in factory jobs since June 2020 and—excluding the pandemic—the sharpest decline since January 2010. Conversely, the modest downtick in employment on the services side was mostly due to challenges in backfilling open positions.

The rise of input costs and selling prices against a backdrop of declining employment index readings highlights the challenges the Fed is navigating—a point underscored by chief business economist of S&P Global Market Intelligence, Chris Williamson. In comments released with the report, he noted, “The survey’s price gauges meanwhile serve as a warning that, despite the PMI indicating a further deterioration of the hiring trend in September, the FOMC may need to move cautiously in implementing further rate cuts. Prices charged for goods and services are both rising at the fastest rates for six months, with input costs in the services sector—a major component of which is wages and salaries—rising at the fastest rate for a year.”

Consumer confidence tumbles: The Conference Board’s Consumer Confidence Index fell to 98.7 in September, down 6.9 points from August’s revised reading of 105.6. The drop was the largest recorded since August 2021, with each of the five components measured showing declines. Consumers’ assessment of their present situation dropped 10.3 points to 124.3. Likewise, their expectations for the future declined 4.6 points to 81.7. The decline in expectations left the reading hovering just above the threshold of 80 that has typically signaled a coming recession.

Respondents’ views of their families’ financial situations—both now and looking ahead to the next six months—weakened. The gap between those who expect their pay to increase versus decrease fell to 5 percent, down from 6.9 percent in August. While these measures are not included in the calculation of the Consumer Confidence Index, it is worth noting that the trend is consistent with respondents’ views on the labor market in general, which continue to deteriorate. The labor differential, which measures the gap between those who find it hard or easy to get a job, fell to 12.6 percent, down from August’s revised reading of 15.9 percent and well below the record high level of 47.1 recorded in March 2022. This has significantly weakened over the past few months and suggests that the labor market weakness is growing. Since March of this year, the differential has dropped by more than half from 29.5 to its current level of 12.6. This shrinking differential is another sign that the labor market has weakened and continues to do so, with the current level consistent with the unemployment rate moving higher in the coming months.

The overall drop in optimism came despite 33.3 percent of consumers expecting lower interest rates in the coming year, which marks the highest percentage on this topic since April 2020. Much like we’ve seen with other economic and sentiment measures, the pain felt by higher interest rates is most apparent for those on the lower end of the economic scale. The report shows those earning less than $50,000 a year reported the largest decrease in confidence. On a rolling six-month basis, consumers who make $100,000 or more remain the most confident.

Another sign of slowing growth: While we typically discuss national economic data, we also find it valuable to look at indicators at the state level to assess whether trends in the national data are being distorted by a few outliers or represent a broad trend. One such report we find useful is the State Coincident Index produced by the Federal Reserve Bank of Philadelphia. The index looks at various employment data at the state level to calculate a state-based growth diffusion index. The latest reading based on August state data shows that the index increased in 23 states, decreased in 17 states and was stable in 10, for a one-month diffusion index of 12, down from 24 the previous month and a recent high of 82 in March of this year (the higher the index reading, the stronger the employment picture and economy). Longer-term trends also signal a notable decline in the measure with the latest three-month diffusion index coming in at 42, down 12 points from July and well off its level of 98 at the start of this year. For further context, the current one-month diffusion reading of 12 is typically seen in the months shortly after a recession has occurred. Similarly, except for a three-month stretch in the fall of 2023, three-month diffusion readings at or below the latest measure have reliably coincided with recessions over the past 40 years.

Durable goods orders may point to weakness in the economy: Preliminary results for August showed that durable goods orders were essentially flat for the month after rising 9.9 percent the prior month. While economists often shrug off this volatile number, the report also contains non-defense capital goods orders and shipments, excluding transportation, that are viewed as proxies for overall business spending. That measure rose 0.2 percent after falling 0.2 percent in July. Capital goods shipments rose 0.1 percent after declining 0.4 percent in July. Since rising 1.3 percent in January, shipments have been negative in four of the past six months.

Existing home prices hit new record high: Home prices reached another record high in July, according to the latest S&P CoreLogic Case-Shiller Index. The latest report shows that home prices nationally rose 0.18 percent on a seasonally adjusted basis from the prior month. July’s reading shows home prices are up 5 percent on a year-over-year basis, compared to June’s year-over-year pace of 5.5 percent. While the pace of year-over-year gains slowed again in July, mortgage interest rates have come down in recent weeks. The continued rise in selling prices means affordability issues may persist for average buyers.

The week ahead

Tuesday: The Institute for Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index. Recent readings show inflation pressures for manufacturers have risen even as activity in the sector has slowed. We will monitor it for signs of additional price pressures and the pace of growth in activity.

The BLS will release its Job Openings and Labor Turnover Survey report for August. We’ll watch for whether the gap between job openings and job seekers has narrowed further, which could point to further weakening of the employment picture. We’ll also keep an eye on the so-called quits rate to see if workers are feeling confident in their ability to find different or better jobs.

Thursday: The ISM's latest Purchasing Managers Services Index will be out mid-morning. Given that the services side of the economy has driven much of the economy’s growth over the past two years, we will be looking for signs of any changes in underlying strength in this report.

Friday: Employment will be in the spotlight as the BLS releases the September jobs report. We’ll see if the slowdown in job gains in July continued. Importantly, we will monitor wage growth and unemployment. We’ll be watching for any more signs of softening in light of last month’s unexpectedly weak report.

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