Investors Focus on Jobs as Economy Slows Further

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

Last week brought a continuation of a trend we’ve seen for the past several months, with investors making outsized moves in reaction to the release of each new economic report. The week started on a high note, with equities surging on further signs of a slowing economy, rebuilt supply and easing cost pressures. However, the momentum evaporated, and Friday saw a selloff in response to data that raised concerns of a still too-tight job market. Still, the net result of the volatility was an uptick for the major indices for the full week.

The back and forth for equities crystallizes the dilemma investors have been facing for months — should they trust the forward-looking data and what it has to say about the direction of the economy and the easing trajectory of inflation? Or do they ignore the numbers that point to easing prices and instead follow the Federal Reserve’s playbook of late and focus on backward-looking reports, including jobs numbers? Judging by the roller-coaster ride for equities last week, it appears that investors have decided to do a little bit of both. The risk for investors trading every headline and data point is the potential of getting caught on the wrong side of an abrupt pivot by the Fed toward slowing the pace of rate hikes or even pressing pause on the march higher.

As we detailed in our recent third quarter market commentary, we’ve grown increasingly concerned that the Federal Reserve has become too focused on backward-looking data, which could lead the board of governors to raise rates more than necessary. This, in turn, could raise the risk of deepening any potential recession. However, we remain confident that the data that show slowing demand and easing cost pressures should begin to filter into inflation readings, such as the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), in the coming months. If we are proven right, the Fed will be able to walk back from its drumbeat of hawkish statements.

Despite the tough rhetoric, Chairman Powell and the rest of the voting members of the board have refrained from making rate hikes of 100 basis points or more despite the likelihood that such moves would severely impact the economy and could finally put a damper on employment. When asked why the board has chosen not to pursue the more dramatic path, the chairman has said it prefers to work through the expectations channel.

In essence, the Fed is taking the same approach I do with my children — I threaten now with consequences later (if they don’t behave now, they won’t play soccer on Sunday) to get the behavior I want. My hope, however, is that I’ll never need to follow through with my original threat. In the case of the Fed, it is talking tough about future rate hikes in hopes of slowing economic growth and seeing the labor market cool. If the threats are successful, the board won’t have to follow through on outsized hikes in the future. And despite the market’s reaction, we believe the Fed may get what it is looking for on the employment front sooner than many expect.

While the jobs numbers released on Friday were roughly in line with expectations, with 263,000 new positions created, the unemployment rate edged lower (to 3.5 percent from the previous reading of 3.7 percent) as fewer people were actively seeking positions. The market interpreted the release as adding more fuel to the Fed’s concerns that a tight labor market will keep inflation elevated, as labor costs will remain high. This is a double-edged sword as companies pass higher costs onto consumers, who are able to pay more for things because their earnings have increased. In this scenario, the concern is that we enter an upwardly spiraling price environment.

However, a closer look at Friday’s survey as well as the Job Openings and Labor Turnover Survey (JOLTS) from the Bureau of Labor Statistics released earlier last week suggest that demand for workers may have peaked and should fall in the coming months. The JOLTS report showed that 1.1 million open positions evaporated from July to August. While unfilled jobs still outnumber job seekers, with approximately 1.67 openings for each worker seeking a job, that is off from July’s ratio of nearly 2:1. While the Fed would like to see openings more in line with available workers, we are encouraged that progress is being made.

Add to the improving picture painted by the JOLTS report some anomalies in the seasonally adjusted numbers released on Friday, and we believe job creation is likely to surprise to the downside over the remainder of the year. If the BLS had applied the same seasonal adjustment to the most recent numbers as it did for the same period last year, the September report would have shown 108,000 jobs added — or nearly 59 percent fewer positions than reported. Considering that between 70,000 and 100,000 people in the country reach working age each month, we believe the employment picture is more balanced than indicated. And it is important to note that at the end of each year the total new positions added using the seasonally adjusted calculations must equal the total number of non-seasonally adjusted jobs. As of the latest report, seasonally adjusted numbers are approximately 1 million more than non-adjusted hires. The current gap is about 250,000 hires greater than at the same point last year. The upshot is that seasonally adjusted numbers will need to come in significantly lower than actual numbers in the remaining three months of the year to close the gap.

Wall Street wrap

As investors digested the two headline employment reports, other data out last week reaffirmed our belief that things are moving in a direction that should give the Fed an opportunity to ease the pace of rate hikes as inflation readings improve.

Manufacturing and Services show encouraging signs of easing price pressures: The latest manufacturers data from the Institute for Supply Management (ISM) show the manufacturing sector is on the cusp of a recession. But more importantly, inflationary pressures in both the manufacturing and services portions of the economy have subsided.

The numbers out last week highlight that the transition away from spending on goods and toward services continues, with the services sector posting a headline number of 56.7, off slightly from August’s reading of 56.9 (readings of 50 or above indicate expansion). While overall activity remained steady, the sector saw improvements in areas that translate to easing price pressures. For instance, the level of backlog orders came in at 52.7, in line with historical norms and well below the reading of 65 in February of this year.

Inventories, too, showed signs of improvement, with the latest reading coming in at 47.2. Although still too low, inventory readings on the services side of the economy can change quickly due to the sector including businesses that operate with no measurable inventory.

Perhaps the most noteworthy elements of the services report came in the form of comments, with respondents noting an improvement in supply chain efficiency, operating capacity and materials availability as well as improvements in employment conditions despite a still tight labor market.

The composite reading for the manufacturing index came in at 50.9, down from August’s level of 52.8 and the lowest reading since May of 2020, when COVID was near peak levels. Sagging new orders contributed to the decline, with the latest reading showing that new orders were at just 47.1, down from a reading of 51.3 the prior month and now at the lowest level since May 2020.

Given that manufacturing demand has slowed significantly over the past several months, easing of inflationary pressures are further along than on the services side of the equation. For example, backlog orders dropped to a level of 50.9 from 53 in August. For context, backlog readings were at 70.6 in May 2021 and 65 as recently as March of this year. Similarly, inventories rose to 55.3, up 2.4 month over month. With backlogs largely cleared, new orders sagging and inventories increasing, manufacturers are faced with deteriorating pricing power as they seek to avoid a glut of products on their warehouse shelves.  

Finally, prices paid by manufacturers fell for the sixth month in a row to a reading of 51.7, down from August’s 52.5 level. For comparison, this measure stood at 87.1 at the close of March 2022.

The week ahead

Monday: No events scheduled for Columbus Day.

Tuesday: NFIB Small Business Optimism Index readings for September will be out before the market opens. 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: The latest readings from the U.S. Bureau of Labor Statistics on its Producer Prices Index will offer a frontline view of changes in costs for buyers of finished goods. It can provide insights into how easing input costs, such as raw materials and commodities, are impacting the prices of goods bought by end consumers.

Thursday: The U.S. Bureau of Labor Statistics will release its CPI for September. This report, while not as heavily relied upon by the Fed as the PCE price index is, will give an early read on whether some of the improvements in the forward-looking data are beginning to register in backward-looking inflation numbers.

Friday: The University of Michigan will release its preliminary report on October consumer sentiment as well as five-year economic expectations. Inflation expectations have remained well anchored in recent reports, and we’ll be watching for changes in sentiment that could affect consumer spending decisions in the near term.

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