Investors Look to Washington as Economic Questions Remain

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

Markets moved higher last week with the S&P 500 notching its best weekly performance since March. With relatively limited economic data out during the period, investors turned an eye to Washington and the ongoing negotiations around raising the nation’s debt ceiling.

President Biden and House Speaker Kevin McCarthy plan to meet again today after talks over the weekend. The ultimate form of a resolution to the impasse remains uncertain at this point, and we continue to monitor developments closely. While we would not be surprised if negotiations dragged on until closer to X-date—the date the federal government will run out of money to pay its outstanding obligations—and market volatility increased in the days ahead, we believe the two sides will find a solution, and the U.S. will avoid defaulting on its debt. However, we view the current impasse as a precursor to more aggressive budget negotiations in the fall.

In addition to monitoring the debt ceiling talks, investors once again debated whether the Federal Reserve would hold rates steady at its upcoming meeting in June or raise an additional 25 basis points in response to a still strong labor market. Conflicting views on the topic were spurred in part by comments from various members of the Federal Open Markets Committee during the week. However, expectations of a pause grew stronger after Federal Reserve Chair Jerome Powell said that additional rate hikes may not be needed to stamp out lingering inflationary pressures.

While investors were largely consumed by events in Washington last week, the ongoing debate surrounding whether the economy will slip into recession in the coming months continued to percolate in the background. Those who believe the Fed may yet engineer a soft landing were likely heartened by Powell’s comments on rates, some initial indications of progress on the debt ceiling negotiations and signs that concerns surrounding regional banks have once again subsided.

While we welcome each of the above developments, we believe that the economic data continues to point to declining price pressures; and jobless claims, which have been a focal point for the Fed, also suggest a mild recession is on the horizon. Fortunately, as we catalogued in depth in last week’s commentary, inflation has declined considerably and now is being driven primarily by food and lagging shelter readings. It’s worth noting that data out last week showed declining home prices, and the two most recent inflation reports have shown food prices unchanged. Additionally, business inventories released last week show normal to modestly elevated inventories relative to sales across the goods sector and, importantly, in the foods and beverage category. With home prices retreating and food and beverage inventories returning back to historic norms, we believe price pressures are set to drop further. As such, we believe the Fed will have room to cut rates should an economic contraction deepen and unemployment rise significantly. 

Wall Street Wrap

Last week’s economic data continued to point to a slowing economy ahead and the potential for ongoing moderation of housing prices in the coming months.

Leading economic indicators continue to point to weakness: A look at the latest Leading Economic Indicators (LEI) report from the Conference Board suggests that the economy is either in recession or on the cusp of one. The April LEI reading declined 0.6 percent. The latest measure marks the 13th consecutive month of decline. The reading is now down 8.8 percent on an annualized basis over the past six months. Weakness continued to be widespread, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering just 20 percent. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.2 percent or greater over the previous six months, the economy is in or on the cusp of recession. For context, the diffusion index first fell below 50 in April 2022, and the overall reading exceeded the negative 4.2 level in June 2022.

While April’s reading marked a modest improvement from March data, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted in a statement accompanying the report, “Importantly, the LEI continues to warn of an economic downturn this year. The Conference Board forecasts a contraction of economic activity starting in Q2 leading to a mild recession by mid-2023.”

Retail sales tread water: The latest retail sales numbers out from the U.S. Census Bureau came in below Wall Street expectations. The report shows overall retail sales in April were up 0.4 percent month over month, falling short of Wall Street expectations of a 0.8 percent increase. It is important to note that the retail numbers are not adjusted for inflation. When accounting for price increases during the month, sales were essentially flat. Sales were up 1.6 percent on a year-over-year basis, which marks the smallest year-over-year increase since May 2020. While sales figures were tepid when adjusted for inflation, April marked the first month of increased purchases since January and a marked improvement over March’s decline of 0.7 percent.

Mixed bag for housing: According to data out last week from the National Association of Home Builders (NAHB), optimism crept higher for home builders. The latest sentiment reading in its Home Builders Index came in at 50, up from the prior month’s reading of 45 and now at the highest level in 10 months. The sentiment index hit a recent peak of 84 in December 2021 but has slumped since then, hitting a low of 31 in December 2022. The improvement to neutral sentiment (readings of 50 or above indicate expansion) comes as more buyers are turning to new construction in the face of limited supply of available existing homes on the market. In a statement accompanying the release, NAHB Chief Economist Robert Dietz noted, “In March, 33 percent of homes listed for sale were new homes in various stages of construction. That share from 2000–2019 was a 12.7 percent average. With limited available housing inventory, new construction will continue to be a significant part of prospective buyers’ search in the quarters ahead.” While readings for current conditions for sales of new homes climbed five percentage points to 56, more than half of builders—54 percent—reported offering some sort of incentive to entice buyers.

Improved builder confidence may have reflected an uptick in building activity. Single-family housing starts in April rose 1.6 percent from the prior month, according to data from the U.S. Commerce Department. Meanwhile, multi-family starts were up approximately 5.2 percent. The report suggests that the supply of single-family units may be set to increase, as permits for single-family dwellings rose 3.1 percent from the prior month, although the latest reading is 21.1 percent lower on a year-over-year basis.

While the new construction side of the housing market showed some signs of life, existing home sales, which comprise the lion’s share of the housing market, remained subdued. The National Association of Realtors reported that existing home sales in the U.S. fell 3.4 percent in April to a seasonally adjusted annual rate of 4.28 million units. The latest figure continues a streak of declining sales that began in January 2022 and was interrupted only in February of this year. On a year-over-year basis, sales were down 23.2 percent. The inventory of unsold homes rose 7.2 percent. Prices continued to fall, with the median sales price in April down 1.7 percent from year-ago levels. However, price movements were uneven, with half of the country seeing gains in median sale price, while areas such as the West are seeing declines. Given the 12-plus-month lag for shelter prices to make an impact on both the Consumer Price Index and Personal Consumption Expenditures readings, the year-over-year decline in home prices should provide continued momentum for the disinflationary process in the months to come.

Although the data out last week showed some signs of stabilization in the housing market, the industry remains well off its highs, and prices continue to soften.

Jobless claims fall: Weekly jobless claims fell last week, with 242,000 new claims filed, down from the prior reading of 264,000 but still well above the low of this cycle (182,000 set in September 2022). The four-week moving average for claims came in at 244,250, which is 28 percent higher than the September low four-week average of 190,500. The magnitude of the percentage increase since the recent lows is historically consistent with levels that have coincided with the onset of a recession. Continuing claims (those people remaining on unemployment benefits) remain elevated at just shy of 1.8 million. For further context, continuing claims were at 1.292 million in September 2022. The increase in continuing claims over the past eight months suggests those who previously lost their jobs are having a harder time finding new employment and may signal a quietly softening job market.

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 May. Activity for manufacturing continues to show weakness; however, the services side has shown signs of treading water. We will be watching for signs that growth on the services side has begun to wane.

New home numbers for April will be released before the markets open. We’ll be watching to see if easing mortgage rates have impacted demand for new homes.

Wednesday: Wednesday offers a look at the minutes from the most recent meeting of the Federal Reserve board. We’ll be looking for comments related to forecasts on economic growth for the remainder of the year and the likelihood of a recession.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings declined last week, and we will be watching to see if recent signs of some softening in the job market resume.

Friday: The April 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. We will be scrutinizing this report with a particular focus on the services side of the reading.

Data on durable goods orders for April will be released to start the day. We’ll be watching for signs that consumers are pulling back on big-ticket purchases in response to concerns about a potential recession.

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