Investors Contemplate a Recession

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

With little more than a trickle of economic data out last week, investors began to contemplate the size and depth of a potential recession in 2023. Recent lower than expected readings of the Personal Consumption Expenditures Index (PCE) and Consumer Price Index (CPI) appear to have been enough to quell concerns (at least temporarily) about the stickiness of inflation going forward, but investors remain uneasy about the Fed’s focus on a seemingly strong employment picture and the perception that board members will ignore economic weakness in its single-minded focus on returning inflation to a long-term target of 2 percent.

Many of these concerns have been fueled by comments from members of the Federal Open Markets Committee. Despite acknowledging that it may be time to reduce the size of future rate hikes, members are quick to note that they believe rates will need to remain higher for longer to permanently rein in inflation to the Fed’s long-term target. The higher-for-longer warnings have been interpreted as a sign the board will ignore economic weakness and potential rising unemployment until it sees evidence that backward-looking price pressure data have weakened significantly and remained subdued for an extended period.

While we understand the source of these concerns, we believe a look at the Fed’s actions over the past year suggests its tough talk may be susceptible to revisions as the data dictate. Consider that in December 2021, the Fed’s so-called dot plot of rate expectations showed a majority of members believed rates would be at just 0.875 (up 75bps) at the close of 2022. A few outliers were on record with forecasts for rates of 1.125 percent (up 1.0 percent). Fast forward to September’s meeting, when the latest available dot plot was released (it will be updated at this week’s meeting), and the median forecast had climbed to 4.375 percent by year-end. The five-fold increase in expectations was driven by changes in the underlying economic and inflation data. Put simply, for all its tough talk, the Fed remains a data-dependent entity. The strong jobs market of the past year has allowed the Fed to focus almost entirely on half of its dual mandate: maximum employment and stable prices. However, should the economy continue to weaken and anecdotal signs of softening in the employment picture begin to spread, we believe the Fed will have no choice but to reevaluate its stance on holding rates at economically constrictive levels.

If, as we expect, the Fed pivots to a softer stance on rate hikes as the employment market begins to show cracks, we believe the economy will see uneven contraction and growth that rolls through various industries. Just as we had a strong but rolling recovery as the economy emerged from COVID, parts of the economy are already experiencing what could be characterized as rolling recessions. Housing, which was an early beneficiary of COVID, has gone from red-hot to seemingly ice-cold in a matter of months as mortgage rates climbed in response to Fed tightening. Similarly, the goods economy was an early beneficiary of the COVID shutdowns and has seen meaningful declines in demand during the past several months. Conversely, the services side of the economy was late to show signs of recovery following the peak of COVID and has held up better in recent months as the manufacturing side has weakened. However, here too we are beginning to see some unevenness below the headline numbers.

A pair of reports out last week measuring the strength of the services sector painted seemingly contradictory pictures. The headline reading for the Institute of Supply Management (ISM) measure of the services sector shows 56.5 (readings above 50 signal expansion) for November, an uptick of 2.1 percentage points from the prior month. Meanwhile, the S&P Global Purchasing Managers Index shows contraction in the U.S. services sector with a November reading of 46.2, down 1.6 percentage points from October’s 47.8 level. The discrepancy between the two reports stems from the difference in businesses surveyed. ISM is skewed toward large companies, including all companies not involved in manufacturing, as well as public-sector activity, which can mask the overall strength or weakness of the economy. S&P includes businesses of varying sizes but only those directly involved in services and only non-public economic activity. Because of the way it is constructed, it gives a more nuanced reading of economic activity. Looking past the headline discrepancies, it is worth noting that the reports also included some common themes. Both measures have reflected similar trends over the past months: declining backlogs, softening new orders and improving cost pressures.

As the full effect of the Fed’s previously implemented rate hikes emerges, we expect further softening in services and the economy’s pockets. However, we believe the rolling nature of a potential economic contraction will limit its severity and staying power. And while we have been critical of the Federal Reserve for its stubborn focus on backward-looking inflationary data, we continue to believe that it can be nimble and will pivot quickly if the job market weakens, thereby preventing a deep recession.

Wall Street Wrap

While last week was relatively light on economic data, it did contain some insights on the job market and inflation expectations.

Jobless claims edge higher: Initial jobless claims for the week ending Dec. 3, 2022, rose by 4,000, to 230,000. Continuing jobless claims (the number of people already collecting jobless benefits) rose for the eighth straight week and are now at 1.671 million, which is up from the recent mid-September low of 1.346 million and post-COVID low of 1.306 million in May 2022. Increases of this level are common leading into a recession as indications of how hard it is for people to find work after they’ve lost their jobs.

Year-ahead inflation expectations decline: In this month’s preliminary results from the University of Michigan Consumer Sentiment survey, overall consumer sentiment rose 4 percent above November’s reading. Year-ahead inflation expectations declined by 0.3 percent, to 4.6 percent in December, the lowest reading in 15 months, while long-run expectations remained anchored at 3.0 percent.

The week ahead

It’s a heavy week for economic data, with reports out on everything from inflation to retail sales. Additionally, the Federal Reserve meets this week, with a rate announcement expected Wednesday.

Tuesday: The big report for the day will be the Consumer Price Index (CPI) report from the Bureau of Labor Statistics, as the markets will be scrutinizing the report for signs that prices continue to cool. We will be paying particular attention to inflation readings on the services side of the economy. Housing has been a driver of elevated prices on this side of the economy, and we will be watching for signs that the downturn in real estate and easing rent pressures are beginning to show up in this backward-looking measure of prices.

The NFIB Small Business Optimism Index readings for November will be out before the opening bell. The report should provide insights about the state of the labor market as well as signs on the direction of prices at both the consumer and wholesale levels.

Wednesday: All eyes will be on the Federal Reserve as it releases its statement following its monthly meeting. The Fed has raised rates by 75 basis points at each of the last four meetings; however, based on Federal Reserve Chair Powell’s recent comments, expectations are for a 50-basis point hike this time around.

Importantly, we will be focused on Federal Reserve Chair Powell’s comments when announcing the hike for indications that the Fed is beginning to take forward-looking data into consideration as it relates to future rate hikes. We will also get a look at the latest dot plot, showing where members of the committee believe rates are headed in the coming year.

Thursday: The U.S. Census Bureau will release the latest numbers on retail sales before the opening bell. The data should yield insights into whether consumers are continuing to pull back on discretionary spending in the face of rising costs. We will also be watching for changes in the trend of consumers turning away from buying goods.

Weekly jobless claims will also be announced. We’ll be watching for any signs that the job market is softening, which could help ease payroll costs for businesses.

Friday: We’ll get a look at the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Index reports for December. We’ll be watching for continued improvements in costs for manufacturers as well as indications of the trajectory of the job market on the services side.

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