Hawkish Comments From the Fed and Renewed Recession Fears Drive Markets Lower

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

Recession fears reemerged last week as Fed Chair Jerome Powell’s comments on Capitol Hill dampened investors’ hopes that the Fed may be wrapping up its rate hiking cycle soon. Instead, Powell noted that there was “a long way to go” in bringing inflation back down to the Fed’s stated target of 2 percent. During his semiannual appearance before legislators, he reiterated the Fed’s stance that the economy would need a prolonged period of sub-trend growth before the remaining hotspots of inflation would be fully extinguished.

The possibility of more rate hikes and a sustained period of below-trend growth spooked investors and led equities lower for the week. Data out last week, including the S&P Global Purchasing Managers Index (PMI) series, suggests concerns about a potential recession may be warranted, as the economy showed continuing signs of softening.

The latest data from the S&P Global Composite PMI highlighted further weakening on the manufacturing side of the economy, while the services side continues to prop up the overall economy.

The Composite Output Index reading came in at 53, down from May’s reading of 54.3 and the lowest level in three months. However, the latest numbers show that while overall activity is in expansion territory, manufacturing remains mired in contraction.

The headline reading for manufacturing dropped to 46.3 in June, down from the prior month’s reading of 48.4 (readings below 50 indicate contraction). The drop was the largest of 2023 and was driven by a drop in new orders, which saw the largest decline since December 2022. The sub-50 reading continues a trend of contractionary levels that began in November 2022 and was interrupted only once by an above-50 reading in April of this year. The slump in sales was attributed to economic uncertainty felt by customers and some signs that customer inventories were sufficient to meet current demand. It’s worth noting that for the second month in a row, respondents indicated they had an easier time finding workers to hire. The seemingly increased availability of workers may help keep wages in check. Additionally, costs for manufacturers declined as input cost pressures reached the lowest level since May 2020.

While the manufacturing side of the economy remains mired in contraction, the services side showed solid strength with a reading of 54.1 (although down from the prior month’s level of 54.9). New orders climbed in June, and once again orders from abroad moved higher. We view the growing divergence in strength between manufacturing and services as an indicator of the unevenness of the economy during the past several months; it may be a precursor of headwinds for the current economic cycle. In a statement released with the latest S&P data, Chris Williamson, chief business economist at S&P Global Market Intelligence, noted, “The question remains as to how resilient service-sector growth can be in the face of the manufacturing decline and lagged effect of prior rate hikes. Any further rate hikes will, of course, have a further dampening effect on this sector, which is especially susceptible to changes in borrowing costs.”

We agree with Williamson’s take and believe that the cumulative effects of the Fed’s aggressive rate hiking cycle, along with continued tightening in the credit markets due to strained balance sheets among regional banks, make an elusive soft landing unlikely and that we will instead see a mild, short-lived recession. The upshot to any such contraction, we believe, is that it will put an end to lingering inflation pressures and give the Fed room to cut rates and spur economic growth as needed.

Wall Street Wrap

Last week’s PMI data was just one of several items we followed that reaffirm our view of a slowing economy and the potential for ongoing moderation of services inflation thanks to declining shelter prices.

Leading economic indicators continue to point to weakness: A look at the latest Leading Economic Indicators (LEI) report from the Conference Board suggests that the economy is either in recession or on the cusp of one. The May LEI reading declined 0.7 percent. The latest measure marks the 14th consecutive month of decline. The six-month annualized reading is at 8.4 percent, down slightly from April’s rate of 8.7 percent. Weakness continued to be widespread, with the six-month diffusion index (the measure of indicators showing improvements versus declines) registering just 40 percent. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.2 percent or greater over the previous six months, the economy is in or on the cusp of recession. For context, the diffusion index first fell below 50 in April 2022, and the overall reading exceeded the negative 4.2 level in June 2022.

While the Conference Board’s Q2 GDP forecast was revised modestly higher, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted in a statement accompanying the report, “Rising interest rates paired with persistent inflation will continue to further dampen economic activity. While we revised our Q2 GDP forecast from negative to slight growth, we project that the U.S. economy will contract over the Q3 2023 to Q1 2024 period. The recession likely will be due to continued tightness in monetary policy and lower government spending.”

Housing prices fall, while help with inventory may be on the way: According to data out last week from the National Association of Home Builders (NAHB), optimism among home builders continued to improve. The latest sentiment reading in its Home Builders Index came in at 55, up from the prior month’s reading of 50 and the first reading in positive territory since July 2022. The sentiment index hit a recent peak of 84 in December 2021 but has slumped since then, hitting a low of 31 in December 2022. The break into positive sentiment territory (readings of 50 or above indicate expansion) reflects the move among more buyers to new construction in the face of limited supply of available existing homes on the market. In a statement accompanying the release, NAHB Chief Economist Robert Dietz noted, “Builders are feeling cautiously optimistic about market conditions given low levels of existing home inventory and ongoing gradual improvements for supply chains.” While readings for current conditions for sales of new homes climbed five percentage points to 61, one-quarter of builders reported offering price concessions in June to bolster sales, and 56 percent of respondents reported offering some sort of incentive to entice buyers.

Improved builder confidence may have reflected an uptick in building activity. Single-family housing starts in May jumped 18.5 percent from the prior month and are up 5.7 percent on a year-over-year basis, according to data from the U.S. Commerce Department. The upward trend in housing starts may have legs, as permits for single-family units rose 4.8 percent from the prior month (although the latest reading is 13.2 percent lower on a year-over-year basis). A steady rise in new single-family homes and multi-family rental units should help alleviate some of the supply challenges that contributed to the rise in shelter costs during COVID and have been a driving force of still-sticky core inflation readings.

While the new construction side of the housing market showed some signs of life, existing home sales, which represent the majority of the housing market, saw subdued gains. The National Association of Realtors reported that existing home sales in the U.S. rose 0.2 percent in May to a seasonally adjusted annual rate of 4.3 million units. The small uptick marks a departure from the streak of declining sales that began in January 2022 and was interrupted only in February of this year. On a year-over-year basis, sales were down 20.4 percent. The inventory of unsold homes grew 3.8 percent to 1.08 million units but remains below pre-pandemic levels. Prices continued to fall, with the median sales price in May down 3.1 percent from year-ago levels. Price movements continued to vary by region, with sale prices falling in the South and West but rising in the Northeast and Midwest. Given the more than 12-month lag for shelter prices to make an impact on both the Consumer Price Index and Personal Consumption Expenditures readings, we expect the year-over-year decline in home prices will provide continued momentum for the disinflationary process in the months to come.

Although the data out last week showed some signs of stabilization in the housing market and positive news on the supply side of the equation, the industry remains well off its highs, and prices continue to soften.

Jobless claims rise: Weekly jobless claims were unchanged from last week’s upwardly revised 264,000 new claims. While weekly filings can be volatile, the four-week rolling average of new jobless claims rose to 255,750, an increase of 8,500 from the previous week’s upwardly revised figure and the highest reading since mid-November 2021. We pay particular attention to the four-week rolling average because it smooths out some of the volatility seen in the weekly claims. Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.759 million, a decrease of 13,000 from the last reading.

The week ahead

We will be monitoring economic releases over the next week, including additional reports on the state of the housing market as well as the latest Personal Consumption Expenditures Price Index (PCE). There will be no commentary next week as we enjoy the holiday (and hope you will as well). We’ll be back the following week to dissect the latest economic data and market movements.

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