Hopes for a Soft Landing Fade

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

The prospects for a soft landing dimmed further last week as stronger than expected readings of inflation and retail sales increased the likelihood that the Federal Reserve will continue to raise rates for longer than recently hoped. The latest data was widely interpreted as a sign that the significant rate hikes during the past year have yet to make a meaningful dent in the economy. However, we would caution that while the reports increase the likelihood that the Fed will continue to raise rates, it is premature to view them as a resurgence in inflation pressures or as a sign of broad strength across the economy. Investors’ reactions last week fit with an ongoing trend of the past several weeks in which the latest data point seems to be viewed in isolation and interpreted as either a sure sign of boom or bust for the economy in the months ahead.

While price pressures have eased considerably over the past several months in areas such as goods and real estate, it is important to note that there have been bumps along the way, and the speed of disinflation (i.e., the falling rate of inflation) has experienced some short-lived setbacks. Similarly, as we’ve highlighted during the past several months, economic activity has been lumpy, with contraction in some areas like manufacturing, while others such as services are still growing. The latest batch of economic data suggests a continuation of the trend. For example, last week’s Manufacturing Business Outlook Survey from the Federal Reserve Bank of Philadelphia paints a picture of further weakness brought on by slowing demand. The Philadelphia survey pegged the diffusion index of business conditions (positive versus negative) at -24.3 for February, down from January’s reading of -8.9 percent. Current orders also weakened, falling three percentage points to -13.6. The report offered a mixed take on inflation, with respondents reporting a small uptick in the prices paid index, which rose to 26.5 — up two points from January’s reading of 24.5, which was a two-year low. The current prices received category (what manufacturers are receiving for their goods) dropped 15 points to 14.9, the lowest reading since February 2021. This report was in stark contrast to the strong retail sales numbers released earlier last week. However, it is important to note that the latest sales figures were a reversal of release for the two previous months, which showed sales slowing. The inconsistency of the trajectory of the data, in our view, is further evidence of an uneven economy.

Although the Philadelphia report is a single snapshot of the state of the economy among many, the weakness it captures underscores our belief that the current economic cycle is not playing out in unison. As such, we believe the Fed’s focus will remain on the employment picture as it seeks to bring inflation levels back to its target of around 2 percent. Put simply, until unemployment rises, or labor slack increases, the Fed is likely to continue to raise rates, which will, in our view, lead to a recession. However, we don’t believe the contraction will be deep but rather shallow and short given the overall still-strong financial condition of consumers and business.

Wall Street Wrap

While much of the focus last week was on strong retail sales and wholesale prices, other reports paint a more mixed picture.

Consumer prices continue to ease: The latest Consumer Price Index (CPI) showed that core CPI, which excludes volatile gas and food prices, rose 0.4 percent month over month in January and 5.6 percent year over year, marking the slowest 12-month increase since December 2021. Headline inflation rose 0.5 percent for the month and increased 6.4 percent on a year-over-year basis. It’s worth noting that, once again, shelter was the driving force of the increase in headline readings and accounted for nearly half of the monthly rise. As a reminder, shelter has a large and lagging effect on inflation readings in services (shelter accounts for 33 percent of the total CPI measure and has around a 12-month lag). The rate of price increases for services also continued to outpace those for goods, with the costs of services rising 0.5 percent for the month and now up 7.2 percent over the past year. Goods inflation came in significantly cooler, with prices up just 1.4 percent year over year after peaking at 12.3 percent on a 12-month basis in February 2022. As we’ve noted during the past several months, the recovery of the services side of the economy lagged that of the goods and manufacturing sector. However, we expect that services will follow the same cycle as we’ve seen play out in goods and will soften in the months ahead.

Independent businesses feeling inflation relief: The latest data from the National Federation of Independent Business shows that inflation pressures continue to ease in January, with 26 percent of respondents identifying cost pressures as their biggest concern, down 6 points from December’s reading. Likewise, the percentage of owners raising selling prices was down one percentage point to just 42, well off the 66 percent reading in early 2022.

Wage pressures remain elevated at 46 percent, up 2 percentage points from December, but still below a high of 50 percent to start 2022. Hiring plans remain subdued, with just 19 percent of respondents expecting to add staff in the next three months — up 2 percent from December. For comparison, hiring intentions reached an all-time high of 32 percent in August of 2021. It’s also noteworthy that small business owners are showing less inclination to raise wages, with 22 percent planning to raise employee pay in the next three months, down from a recent 27 percent recorded in December 2022. For further context, the reading was as high as 32 in October of last year.

Consumer spending bounces back: The latest retail sales numbers out from the U.S. Census Bureau came in stronger than Wall Street forecasts. Food services and drinking places (think restaurants and bars) saw a sharp 7.2 percent month-over-month increase in spending and are now up 25.2 percent during the past 12 months. Motor vehicles and parts dealers saw a 6.4 percent increase in sales during January, but during the past three months, sales for the group are down 2.1 percent.

This report, coming after weaker than expected data in December, underscores the uneven nature of the economy and the ongoing impact of consumers’ changing purchasing habits away from goods and toward experiences. The release shows overall retail sales in January were up 3 percent on a month-over-month basis. On a year-over-year basis retail sales were up 6.4 percent. The latest 12-month figure marks a significant decline from the 9.2 percent increase in prices registered for all of 2022. It is 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 edge higher: Producer input final demand costs rose 0.7 percent in January, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. A rise in goods prices accounted for the bulk of the increase. The latest number represents a blip in what has been a downward trend that began following the March 2022 red-hot increase of 1.6 percent.

Prices for final-demand goods rose 1.2 percent in the month. However, most of the increase stemmed from a 5 percent surge in energy costs. Excluding the volatile food and energy categories, final-demand prices rose at 0.6 percent.

New housing starts continue to fall: Single-family housing starts in January fell 4.3 percent from the prior month, according to data from the U.S. Commerce Department. Meanwhile, multi-family starts were down approximately 5 percent. The report suggests that the decline in home building may be stabilizing, with total permits issued for single- and multi-family units unchanged from December. The report may provide good news for apartment dwellers, as January saw a 3.5 percent uptick in permits issued for multi-family units. As apartment inventory rises, rent pressures should continue to moderate.

Recession risks persist: The Conference Board’s latest Leading Economic Index (LEI) dropped 0.3 percent in January, marking the tenth consecutive month of decline. The reading is now down 7 percent on an annualized basis over the past six months. For context, each time during the past 63 years that LEI readings have been at the levels we are seeing today, the economy has either been in or on the verge of a recession. As we’ve noted in the past, we don’t believe inflation will be able to withstand a recession. While we believe a recession is approaching, we continue to think it will be mild and uneven given the overall financial strength of U.S. consumers, banks and corporations and, importantly, serve to snuff out inflation.

The week ahead

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 February. Activity for manufacturing continues to show weakness; however, the services side has been relatively resilient. We will be watching for signs that growth on the services side has plateaued or begun to ease.

Updated numbers on existing home sales will be released mid-morning by the National Association of Realtors. This report should provide a clearer picture of whether the housing market has stabilized in response to lower mortgage rates during the past several weeks.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings fell modestly last week, and we will be watching for any signs of loosening of the employment picture.

Friday: The January 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. With last week’s CPI reading coming in higher than expected, we will be scrutinizing this report with a particular focus on the services side of the reading.

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