Investors Embrace Bad News as a Sign the Rate Hiking Cycle Is Over

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

Equities closed the week adding to the exceptional gains made by the major indices during the past month. November marked a sweet spot for investors, wherein both good and bad news was viewed as cause for optimism. On the good news front, inflation readings during the month showed further progress in the disinflationary process. Indeed, last week’s Personal Consumption Expenditures Index (PCE) release from the Bureau of Economic Analysis echoed the tone of the latest Consumer Price Index report released earlier in November. The PCE report, which is the preferred inflation measure of the Federal Reserve, showed headline inflation essentially flat in October compared to a rise of 0.4 percent in September. On a year-over-year basis, the headline reading fell to 3.0 percent, down from September’s year-over-year reading of 3.4 percent. Similarly, core PCE, which strips out volatile food and energy prices, also slowed, with prices rising 0.2 percent in October, down from September’s reading of 0.3 percent. On a year-over-year basis, core PCE came in at 3.5 percent, down from September’s 12-month pace of 3.7 percent. 

Just as investors cheered the recent progress on inflation, they’ve also embraced data that shows the economy is slowing. That’s because bad news reinforces the growing belief that, given the strides made in unwinding inflation, the Fed will view signs of slowing growth as reason to declare mission accomplished and put an end to the rate hiking cycle with room to pivot to cutting rates in early 2024. For some time now, we have been watching many of the recent signs of a slowing economy, including weak manufacturing numbers, signs of a loosening employment picture, and consistently poor leading economic indicators. But perhaps the clearest way to illustrate how bad news led the market higher for the past month is with the Citi Economic Surprise Index, which tracks the difference between official economic results and consensus forecasts—the greater the index level, the more the economic data is surprising to the upside. The index was as high as 63.7 in late October but since then has fallen to just 25.6 last week. In other words, the news is worse than the expectations. During the same time frame, the S&P 500 gained roughly 10 percent. Not coincidently, the embrace of bad news as an impetus for rate cuts also drove bond yields lower. The growing belief that the Fed will cut rates the next time it takes action can be seen in the rapid decline in bond yields as reflected by yield on 10-year Treasurys. Yields on the 10-year have dropped from 4.93 percent at the end of October down to 4.19 percent at the close of trading last week. This drop in yields fueled the surge in equities.  

The bad-news-as-good perspective is based on a belief that the Fed will be able to wield the blunt instrument of monetary policy in such a way that it will lead to a soft landing despite the unpredictable lags of such policy. We believe such a soft landing, where growth is just fast enough that unemployment remains controlled but not so fast as to fuel wage pressures, is unlikely.   

While price pressures continue to unwind, we believe areas of concern remain for the Fed. Inflation on the services side of the economy remains elevated. Meanwhile, recent consumer sentiment surveys have shown inflation expectations are creeping higher, which could lead to greater inflationary pressures and the pace of wage growth. While down from its post-COVID peak, wage growth remains at a level incompatible with the Fed’s inflationary target. As such, we believe the Fed is unlikely to loosen monetary policy until there are clear, persistent signs that wage growth no longer poses a threat to pricing stability and other lingering embers, such as services inflation, are fully extinguished. 

Given that the final mile in the battle against inflation is happening at a time when the economy is slowing and the employment picture may be heading for an inflection point, we believe the Fed’s task of navigating a soft landing is daunting. As we noted in a recent commentary, once unemployment starts rising, job losses will likely gain momentum and eventually result in a recession. In fact, in every business cycle since World War II, once the unemployment rate had risen by about 0.5 percent, it continued to go up and didn’t stop until the rate increased by 1.9 percent or more. There was no stopping in between. We aren’t quite there yet, but we’re getting close to breaching the historical 0.5 percent marker.  

While our view is contrarian to the bullishness suggested by recent equity performance, it should not be interpreted as all doom and gloom. Instead, we believe our explanation of our base case of a mild and short recession should provide perspective that helps investors take the emotion out of their financial decisions. Recessions are a natural part of the business cycle. A sound financial plan takes occasional economic downturns into consideration and is designed to weather the ups and downs that result from an ever-evolving business cycle.  

Wall Street wrap 

Manufacturing continues to contract: The latest data from the Institute for Supply Management (ISM) shows the manufacturing sector notched a 13th consecutive month in contractionary territory. The composite reading for the index for November came in at 46.7, unchanged from the previous month (readings below 50 signal contraction). Weakness was widespread, with just two of the six major industries reporting growth. Readings for new orders came in at 48.3, up 2.8 points from October. However, customer inventories rose to 50.8 (indicating too high), up from October’s reading of 48.6. Backlog orders declined to 39.3 from the prior reading of 42.2. Employment moved further into contractionary territory at 45.8, one point lower than in October. Prices paid moved higher and are on the cusp of expansionary territory at 49.9.  

The extended slump in manufacturing may be starting to have an impact on payrolls. In a statement accompanying the latest report, Tim Fiore, chair of the ISM, noted, “Panelists’ companies slightly reduced month-over-month production and took more actions to reduce head counts, primarily using layoffs and attrition.” 

Beige Book suggests weakness spreading: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that economic growth in aggregate slowed since the last release in mid-October, with four districts noting modest growth, two indicating economic conditions were flat, and six noting declines in activity. Travel and tourism continued to see healthy activity, demand for transportation services declined, and manufacturing was mixed. While price increases moderated across the districts, they remain elevated. 

Echoing the ISM manufacturing data, the latest report noted demand for labor continues to ease, “reductions in headcounts through layoffs or attrition were reported, and some employers felt comfortable letting go low performers.” Most districts’ reported wage growth remained modest to moderate.  

Continuing jobless claims increase: Weekly jobless claims numbered 218,000, an increase of 7,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 220,000. Continuing claims (those people remaining on unemployment benefits) were at 1.93 million, an increase of 86,000 from the previous week. The upward trend in continuing claims is a timely market indicator that suggests that the labor market is weakening and those who have lost their jobs are finding it harder to find new employment. The latest figure is 24 percent higher than the same period a year ago, and an increase of this size is consistent with the rise seen in each of the eight last recessions. 

Consumer confidence continues to flash recession warning: Consumer confidence moved higher in November, but forward expectations remained at levels that have historically coincided with coming recessions. The Conference Board’s consumer confidence index rose to 102 in November, up from the prior month’s downwardly revised reading of 99.1. The expectations index, which measures consumers’ short-term outlook for income, business and labor market conditions, came in at 77.8, up from October's downwardly revised reading of 72.7 As a reminder, readings below 80 on the expectations index have typically coincided with the arrival of a recession in the coming 12 months. Despite a slightly more positive view, consumers’ outlook on the job market stayed mostly steady.  

As a part of the index, the Conference Board measures how easy or difficult respondents find it to land a job. In November, those saying it’s hard to get a job rose to 15.4 percent, up from 14.1 percent the prior month. Meanwhile, those who viewed jobs as plentiful edged higher, to 39.3, up modestly from October’s level of 37.9. The gap between those who find it hard or easy to get a job is the labor differential, something we’ve been tracking closely due to the Fed’s focus on the employment picture. November’s labor differential came in at 23.9, barely changed from October’s revised reading of 23.8. This measure is considered a leading indicator of the labor market. As such, it is worth noting that, while the latest reading is in line with the prior month, the trend is toward a tighter differential. The gap stood at 40.7 as recently as February of this year and was at 47.1 in March 2022, suggesting that the labor market is cooling. 

GDP revised higher: The revised estimate for gross domestic product (GDP) showed that real GDP grew at a seasonally adjusted annual rate of 5.2 percent. While the pace of expansion is impressive, it is not uncommon to see a surge in GDP preceding a recession. Furthermore, a measure closely related to GDP tells a different story. Gross domestic income (GDI) is the other measure calculated by the Bureau of Economic Analysis. The measure calculates economic activity based on income. In theory, GDI should equal GDP. Over intermediate to longer periods of time, these two tend to equal out, albeit with some deviations in between. Over the past few quarters these deviations have been historically large.  

While GDP for the third quarter is now estimated at 5.2 percent, GDI came in at a subdued 1.5 percent. On a year-over-year basis GDP is up 3 percent, while GDI is down 0.2 percent. The gap between the two measures is the greatest on record going back to 1947. How the gap will close is uncertain, but the sheer size highlights the anomalies that have taken place during the post-COVID period.  

New home sales decline as prices fall: New home sales fell to a seasonally adjusted annual rate of 679,000 units in October, according to the latest data from the U.S. Census Bureau. The latest figure is down 5.6 percent from September’s revised total of 719,000. However, the latest figure represents a 17.7 percent increase from the pace set in October 2022. The decline in sales came as prices on new homes fell for a third consecutive month. The median price of a new home fell to $409,300, which represents a roughly 3.1 percent decline from September and a 17.6 percent decline from year-ago levels. The inventory of new homes crept higher to 439,000, or approximately a 7.8-month supply at current sales rates. While new homes represent a small fraction of total home sales, the portion has grown of late, as owners of existing properties have been hesitant to sell given that interest rates have risen and moving may result in higher interest payments on new mortgages. With interest rates at multi-decade highs, we would not be surprised to see further erosion in prices for new construction due to affordability issues caused by elevated rates.  

Existing home prices move higher: The latest S&P CoreLogic Case-Shiller Index shows home prices climbed 0.7 percent in September on a seasonally adjusted basis from the prior month, marking the eighth monthly increase in a row. September’s reading shows home prices are up on a year-over-year basis, rising 3.9 percent since September 2022. While recent data suggests that the housing market has stabilized after the swoon experienced during the first half of the year, we believe high interest rates will continue to cause affordability issues for potential buyers and that limited inventory is the primary cause of the recent trend of higher prices. 

The week ahead 

Monday: The latest readings on October factory orders will be released by the U.S. Census Bureau. 

Tuesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report. We’ll watch for whether the gap between job openings and job seekers is continuing to narrow, which would help ease wage pressure for businesses.  

The Institute for Supply Management releases its latest Purchasing Managers Services Index. Recent readings have shown growth in the sector slowing, and we will watch for any signs of additional weakening. 

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings were again last week as were continuing claims, and we will continue to monitor this report for sustained signs of changes in the strength of the employment picture.  

The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers have begun to take on more credit card debt in recent months, but overall balance sheets have remained solid. We will be watching for changes in debt levels now that the financial cushion many consumers built during COVID has been depleted.  

Friday: The BLS will release the Jobs report. We’ll be watching to see if the slowing pace of job and wage gains continued in August. Importantly, we will be monitoring the labor force participation rate to see if the recent rise in new entrants joining the workforce is continuing. A rise in labor force participation could help ease the current elevated wage pressures. 

The University of Michigan will release its preliminary report on December consumer sentiment and inflation expectations. We will be watching to see if the latest rise in inflation expectations for the five- to 10-year period is showing signs of taking root. 

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