Investors Cheer Recent Data, but Uncertainty Remains

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

Stronger than expected GDP growth for the fourth quarter and continued declines in the Personal Consumption Expenditure (PCE) Index, a key inflation measure watched by the Federal Reserve, pushed the markets higher last week and added to a strong January for equities. The two reports breathed new life into recent hopes that the Fed may be able to avoid driving the economy into recession. While the odds of a soft landing have increased, we believe (based on a closer look at recent economic reports) that a mild, shallow, rolling recession remains the likely base case for 2023.  

Initial estimates of gross domestic product showed the U.S. economy grew by 2.9 percent in the fourth quarter. The rate of growth was less than the third quarter’s 3.2 percent pace but was above consensus estimates. However, a closer look at the underlying data suggests that economic growth may not be as robust as the numbers indicate. A full 1.5 percent of growth was driven by a surge in inventories. An additional 0.6 percent of the total stemmed from net exports. If you strip those two items out, growth in final sales to domestic buyers came in at a modest 0.8 percent, with the bulk (0.6 percent) driven by government spending. Seasonally adjusted real private final sales to domestic consumers grew at 0.2 percent quarter over quarter, down from the third quarter’s pace of 1.1 percent and the second quarter’s reading of 0.5 percent. The PCE report out last week provided additional evidence of slowing consumer demand that accelerated during the quarter. October saw an 0.8 percent increase in consumer spending. However, in November consumer spending fell by 0.1 percent and dropped further by 0.2 percent in December as consumers continue to pull back on purchases.  As we’ve noted in recent commentaries, rising inventories in the face of slowing demand suggest that growth is poised to slow further as businesses scale back production to reduce a glut of products on suppliers’ shelves. While excess inventories are likely to keep a lid on already cooling inflation, slowing production could translate to fewer workers needed and lead to the kind of spike in layoffs that typically coincides with recessions. 

Preliminary readings from the S&P Global Purchasing Managers Index also bolster our view of an economy on the cusp of (or in) recession. The latest numbers show manufacturing continues to be in recession territory, with a reading of 46.8, up marginally from December’s 46.2 (readings below 50 indicate contraction). Meanwhile, production fell for a third straight month, and new orders declined at the second fastest rate since May 2020. It’s worth noting that weak demand and excess capacity resulted in manufacturers cutting staffing levels for the first time since July 2020.  

Likewise, the services side of the economy remained in contraction territory, with a reading of 46.6 for January, up from December’s level of 44.7. Backlogs continued to decline during the period as weaker demand allowed providers to work through outstanding orders. While businesses in the sector continue to hire, the pace of adding workers was up only fractionally in the latest survey. We expect that if backlogs continue to dwindle and new orders remain subdued, hiring may show further signs of plateauing. 

While spreading weakness in the economy may give cause for the Federal Reserve to press pause on this rate hiking cycle, it is far from certain. Fed Chair Jerome Powell has been steadfast that board members want to see the labor market weaken before they will consider the fight against inflation won, and recent data continues to show a seemingly strong employment picture. Indeed, last week saw another unexpected drop in weekly jobless claims, with 186,000 filings, shy of consensus forecasts of 205,000 and down from the prior week’s level of 192,000. However, as we’ve noted in recent commentaries, it appears that wage growth has softened in a seemingly strong job market. Given slowing demand, we expect the employment picture will begin to soften. Additionally, with inflation showing significant signs of retreating, we believe the Fed will have room to pause hikes or even reduce rates later in the year. 

Wall Street Wrap 

Inflation continues to shrink: The latest PCE reading shows headline inflation was up a modest 0.1 percent month over month in December. On a year-over-year basis, prices were up 5 percent compared to 5.5 percent year over year in November. For further context, year-over-year readings were at 7.0 percent as recently as June. Core PCE, which strips out the volatile food and energy categories, rose 0.3 percent for the month and has dropped to 4.4 percent year over year, the lowest annual rate since October 2021. Much as we forecasted, goods prices peaked in June 2022 and now are down 1.67 percent since then.  

However, the services side of the economy saw an uptick in price pressures, with December’s measure at 0.5 percent, up from November's pace of 0.3 percent but still below the recent peak of 0.7 percent recorded in June. As we’ve noted in the past, the goods side of the economy was the first to see a surge in demand as well as prices. Since then, demand has shifted away from goods and toward services. Likewise, price pressures have receded on the goods side and risen along with demand for the services sector. As the recovery in the services sector continues to slow, we expect prices will moderate in the months ahead. Indeed, the Trimmed Mean PCE report from the Dallas Federal Reserve Bank, which provides an alternate estimate of core inflation, shows that as of December, prices were rising at an annualized rate of just 2.34 percent, much lower than the 7.17 percent reading in June 2022 and more in line with the Fed’s long-term target of 2 percent. 

Leading indicators point to weakness ahead: The Conference Board’s latest Leading Economic Index (LEI) dropped 1 percent in December and is now down 8.2 percent on an annualized basis over the past six months. The latest reading marks the tenth consecutive month of declines — and third straight month of declines of 1 percent or more. This may point to the U.S. economy already teetering on the cusp of or being in recession. 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. In our view a recession is likely approaching; however, we continue to believe it will be mild and uneven given the overall financial strength of U.S. consumers, banks and corporations. 

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.  

A final word on the markets to start the year: In light of the waning inflation pressures, markets continued their January advance and pushed higher last week. It’s important to remember that markets often move higher before recessions end, and we believe investors spent much of 2022 discounting the likelihood of an economic slowdown that could result from the Federal Reserve’s well-telegraphed focus on slowing economic growth.  

The week ahead 

Tuesday: The S&P CoreLogic Case-Shiller index of property values will be out before the opening bell. Home sales and prices have plummeted in recent months as interest rates have climbed in response to the Fed’s rate hikes. We will be watching to see if recent easing in mortgage rates has had an impact on the recent trends of pricing weakness.  

Wednesday: All eyes will be on the Federal Reserve as it releases its statement following its monthly meeting. We expect the Fed will opt for a 25-basis-point hike this week. We will be watching the Fed’s statement for indications of how it views the current employment picture, as it has been identified as an ongoing point of concern by Fed Chair Powell. 

The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for December. The comprehensive report will provide a clearer picture of the health of the labor market, including job openings and quits data. A tight employment market has been the last domino standing in the Fed’s ongoing effort to rein in inflation. We will once again be watching for signs that the gap between job openings and job seekers is narrowing, which could lead to easing wage pressures for businesses. 

The health of the manufacturing sector will be in the spotlight as the Institute of Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index for January. The last two readings of this report have shown the manufacturing sector in contraction with demand subsiding and supply levels returning to normal. Recent readings of this report have shown demand for manufactured goods contracting while inventories have risen. The ISM services report will come out on Friday, and we will be watching the two for updates on the strength of the overall economy.    

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings have shown some volatility in the past few weeks, including two consecutive weeks of declines; however, continuing claims have inched higher in the past several months, signaling that displaced workers are having a harder time finding new employment. The labor market remains a focal point for the Fed, and we will be watching this report along with Friday’s Nonfarm Payrolls report for signs of the underlying strength of the labor market. 

Friday: The BLS releases the January Jobs Report. As we’ve noted in recent months, a significant gap has opened between its Nonfarm Payrolls report and its other measure of employment, the so-called Household report. We will be looking for signs that the gap between the two measures is tightening. We will also be watching for changes in hourly earnings for workers to gauge the impact of inflation on wages.  

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