Investors Turn a Cautious Eye Toward the Future

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

The markets were down modestly last week as investors continued to debate whether the economy is heading toward recession and, if so, when. The uncertainty surrounding what comes next could be seen in investors’ mostly muted reactions to solid earnings reports to start the current earnings season. While still in the early innings, the majority of companies that have reported have beaten consensus estimates. Despite the solid showing, investors have been hesitant to bid up equities due to lingering uncertainty of where the economy is headed.

Economic reports out last week suggest the cautious approach is warranted. Much of the data continued to paint a picture of an economy sliding toward recession. Jobless claims ticked higher, some regional economic activity reports showed significant contraction, and 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 March LEI reading dropped 1.2 percent and is now at its lowest level since November 2020. The latest measure marks the 12th consecutive month of decline. The reading is now down 8.8 percent on an annualized basis over the past six months. Weakness was widespread, as it has been for the past six months, with the 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 pierced the –4.2 level in June 2022. Put simply, the latest reading suggests we are well past the threshold that indicates the threat of a recession and are likely in the midst or on the cusp of an economic contraction.

In a note accompanying the release, Justyna Zabinska-La Monica, senior manager of Business Cycle Indicators at the Conference Board, noted, “The Conference Board forecasts that economic weakness will intensify and spread more widely throughout the U.S. economy over the coming months, leading to a recession starting in mid-2023.”

Despite the continued weakness in the LEI data as well as other measures over the past few months, we believe the Fed will raise rates another 25 basis points at its May meeting. The likely move reflects the Board’s ongoing concern that a seemingly tight labor market is a potential flashpoint that could reignite price pressures. However, barring any surprises, we expect the Fed will pause its rate hikes in subsequent meetings as the disinflationary process continues to show progress and the Fed acknowledges that the threat of overtightening rates is now a more significant risk to the economy than is inflation.

Wall Street Wrap

Signs of continued weakness for regional manufacturers: Last week’s Manufacturing Business Outlook Survey from the Federal Reserve Bank of Philadelphia paints a picture of further weakness brought on by slowing demand. The Philadelphia survey pegged the diffusion index of business conditions (positive versus negative) at –31.3 for April, down from March’s reading of –23.2 percent and the eighth consecutive month of negative readings. (Every time since 1968 that the measure has fallen to the levels registered in the latest report, the economy has been in recession. During the past 55 years, the economy has had eight recessions; in seven of those, the diffusion index was at –31.3 or lower. The sole exception was in the recession that began in late 1969 and ran through November 1970. During that downturn, the diffusion index hit a low of –31.2.) New orders moved higher but remained in negative territory at –22.7. Inflation pressures eased as the prices paid category fell in the latest report, down 15 points to 8.2, marking the lowest reading since mid-2020. The current prices received category (what manufacturers are receiving for their goods) dropped 11 points to –3.3 percent, the third consecutive month of declining readings and the first negative value since May 2020.

Manufacturing broadly is treading water: While the Philadelphia report was decidedly weak, the latest data from the S&P Global Composite Purchasing Managers Index showed some stabilization on the manufacturing side. The Composite Output Index reading came in at 53.7, up from March’s reading of 52.6. However, the latest numbers show that despite overall activity moving higher, manufacturing continued to essentially tread water with a reading of 50.4 (readings above 50 indicate expansion). The level was an improvement from March’s 49.2. The move into marginally expansive territory marks the first time since October 2022 that the indicator showed expansion. The services side of the economy showed some strength with a reading of 53.7, up from the prior month’s level of 52.6. While this marks the third consecutive month of expansion, it is important to note that it had strung together a streak of seven consecutive months of contraction beginning in July 2022 through the end of January of this year.

While the latest composite reading indicates growth, recall that it consistently showed contraction beginning in July 2022 through the end of January 2023. The string of sub-50 readings was consistent with what the LEI reports have been showing for the past 11 months. The latest positive reading, in our view, highlights the disparate timing and nature of the various economic indicators we follow as well as the challenge of identifying in real time if or when a recession has begun. While Fed Chair Powell appears to view the job market as a proxy for economic strength, the limitations of this approach are underscored by the Fed’s own forecasts of a recession arriving later this year. The Federal Open Market Committee’s insistence on raising rates despite most indicators suggesting an economic contraction leads us to believe that if the economy is not yet in recession, the Fed’s actions will result in one in the coming quarters.

Jobless claims rise again: Weekly jobless claims moved higher again last week with 245,000 new claims filed, up from the prior adjusted reading of 240,000.  Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.820 million. The latest readings are consistent with the uptick in both measures that began in September 2022. We view the higher level of continuing claims as an early sign that the labor market may be beginning to feel the impact of months of slowing economic activity.

Housing market remains cool: The National Association of Realtors reported that existing home sales in the U.S. fell 2.4 percent in March to a seasonally adjusted annual rate of 4.44 million units. The latest figure resumes 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 22 percent. The inventory of unsold homes rose 1 percent. It’s worth noting that the median sales price for March was 0.9 percent lower than it was one year ago. 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 momentum for the disinflationary process in the months to come.  As mortgage rates have fallen in recent months, affordability has improved modestly and has likely benefited price-sensitive buyers the most. However, high-end housing has remained under pressure, with sales of homes valued at $1 million or more declining 29.4 percent from year ago levels.

The week ahead

Monday: The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures, and we will be watching for signs that the economy is in or on the cusp of a recession.

Tuesday: The S&P CoreLogic Case-Shiller index of property values will be out before the opening bell. Home sales and prices have continued to sag despite easing mortgage rates in recent weeks; however, inventory remains tight. We will be watching to see if the cooling of the housing market has begun to slow.

The Conference Board’s Consumer Confidence report will come out in the morning. Given recent signs that the employment picture is showing signs of dimming, we will be particularly focused on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work.

Thursday: We get our first estimate of first-quarter GDP. Wall Street estimates project growth to have slowed to 1.8 percent quarter over quarter. Despite the expected positive reading, we continue to believe that other measures, such as the Conference Board’s LEI, point to a likely recession in 2023.

Initial and continuing jobless claims will be announced before the market opens. Initial filings grew last week, and we will be watching to see if recent signs of some softening in the job market are beginning to take root.

Friday:  The March 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.

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