Is the Economy at Risk Despite Strong Market Gains?

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

Better than expected inflation data led to a surge in equities last week, with the major indices recording a strong week of gains. This welcome news on prices reinforced the growing sentiment that the 20-month rate hike cycle started by the Federal Reserve in March 2022 is now complete and that next steps will be interest rate cuts, potentially as soon as late Q1 2024.

While investors welcomed the latest inflation readings, we believe the markets may be ignoring lingering warning signs about the economy and risks that the last mile in the fight against rising prices may prove the most difficult. While it’s good news that inflation is subsiding, we think the Fed will want to see evidence that it’s sustainably back to its 2 percent target before it loosens the tourniquet it has put on liquidity.

The reality is it’s going to be hard to stick the landing, and it all comes back to the unemployment rate. Once unemployment starts rising, it tends to trend and become a recession. In fact, in every business cycle since WWII, once we go past a small increase in the unemployment rate (historically it is less than a 0.5 percent increase), it keeps going until the unemployment rate rises by 1.9 percent or more. There is nothing in between. We have been painting a picture the past few weeks of a weakening labor market in which some of these rules are being breached (like continuing claims, which we address later).

The margin of error is so small for the Fed to cool off the economy but keep it positive in terms of both economic growth and jobs. While it is difficult to gauge how much of the Fed’s 5.25 percentage points in rate hikes have already fully taken hold in the economy, we believe they are likely to create a continued drag on growth. As the cumulative effects of the hikes continue to stunt economic activity, we believe it will be extremely difficult for the Fed to perfectly create a balance in the job market while allowing the economy to continue to grow.

As we noted in last week’s commentary, today’s high interest rates are starting to wear on consumers’ perceptions of buying conditions for everything from houses to durable goods. Likewise, small businesses continue to struggle in the face of inflation pressures and challenges finding workers. Commentary issued along with the results from the latest Small Business Optimism Index from the National Federation of Independent Business notes that small businesses’ “sales growth does not show the strength reported in the government numbers.” Sales growth fell to minus 17, which is the lowest level since July 2020, when the economy was exiting the COVID lockdown. This figure is consistent with or below the six recessions that occurred since 1980, and the only time it was lower was during the Great Recession and the short but sharp COVID Recession.

Meanwhile, labor costs, energy costs, and most everything else small business owners pay for to operate their businesses are not falling, so firms continue to raise prices to keep up.

Further, the survey shows optimism among small business owners ticked lower in October to 90.7, down 0.1 points from September. The reading marks the 22nd consecutive month of readings below the 49-year average of 98. Optimism over business conditions in the coming six months was unchanged from the prior reading at a net negative 43 percent.

The quality of available labor continued to be a big concern for small business owners, with 23 percent of respondents singling it out as their top challenge and 90 percent of hiring respondents indicating they received few if no qualified applicants. What’s more, inflation continues to worry respondents, with 22 percent citing it as their primary concern, down 1 point from last month.

Regarding wage strength, a net 36 percent of those surveyed reported raising wages during the period, unchanged from the prior month but still historically high. Additionally, 24 percent expect to raise wages in the next three months, an uptick of one percentage point from September and up three percentage points from April, which tells us that these figures don’t appear to be moving lower. While the percentage of small businesses raising pay has eased over the past few months, the pace of the decline has been slow. Concerns about qualified labor and a willingness for business owners to raise pay could signal that wage pressures will prove resilient absent a drop in demand.

As cost concerns remain, businesses have attempted to pass costs along to consumers, with 30 percent of respondents saying they raised prices during the survey. That’s up one percentage point from September and five points from July. Historically, the only recent time you’ll find a number this high was during the Great Recession, and before that you’d have to go back to 1981. Moreover, 33 percent of respondents expect to raise prices during the next three months—up 3 percentage points from the prior month and 12 since April. This is the largest increase in nearly a year and a historic high. These are moving in the wrong direction, and this is again why we think the last mile in the fight against inflation is going to be hard. Companies may be starting to embed it in their plans. 

The last mile in the fight against inflation is going to be hard. Companies may be starting to embed it in their plans.

While inflation is indeed declining, it looks like the economy is, too. For the Fed to reach its 2 percent inflation target, we believe that wage growth will need to fall sustainably to 3.5 percent or lower. Given signs that the economy is slowing, consumers are tempering their spending habits, and the employment market is cooling. We continue to believe the pieces are in place for a mild recession in the coming quarters. That said, thanks to the significant progress made in reining in COVID-induced price pressures, we believe the Fed will be able to pivot quickly and stem the economic contraction from gaining momentum and becoming a deep recession.

Wall Street wrap

Inflation heads lower: The latest Consumer Price Index (CPI) release showed that headline inflation was flat in October on a month-over-month basis, below Wall Street’s expectations. The latest reading compares to September, when prices rose 0.4 percent month over month. On a year-over-year basis, prices rose 3.2 percent, down from last month’s reading of 3.7 percent. Energy prices tumbled in October, down 2.5 percent for the month. Shelter prices continued to move higher, rising 0.3 percent for the month; however, growth slowed to 6.7 percent on a year-over-year basis, down from September’s reading of 7.2 percent. As a reminder, shelter has a large and lagging effect on inflation readings in services (it accounts for 35 percent of the total CPI measure and has around a 12-month lag). In recent months we’ve seen price increases for the category ease as year-ago highs roll off the year-over-year calculation.

Core CPI, which excludes volatile food and gas prices, rose 0.2 percent in October, down from September’s pace of 0.3 percent. On a year-over-year basis, the core reading came in at 4.0 percent, down 0.1 percent from the level of 4.1 percent recorded in September. The latest year-over-year figure marks the slowest 12-month increase since September 2021. The good news is that when you remove the lagging impact of shelter, both all-in CPI excluding shelter (+1.5%) and core CPI excluding shelter (+2.0%) are at or below the Fed’s 2 percent target.

Consumers pull back on spending: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in October fell 0.1 percent, down sharply from September’s upwardly revised reading of 0.9 percent. The latest data shows retail sales are up 2.5 percent on a year-over-year basis, down from September’s year-over-year reading of 4.1 percent. Given that the sales numbers are not adjusted for inflation, the latest monthly reading indicates that consumers may have begun to pull back on their purchases as excess savings accumulated during COVID are exhausted and bank account balances have dipped below pre-pandemic inflation adjusted levels.

Price-conscious consumers may translate into lower prices for some items. In fact, Walmart’s CFO John David Rainey said over the past week, "we are more cautious on the consumer than we were 90 days ago at this time." He also noted that there was a sharper falloff in sales during the last two weeks of the fiscal third quarter that ended October 31.

Input costs decline: Producer input final demand prices declined 0.5 percent in October, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The latest monthly reading is down from September’s 0.4 percent increase. October’s reading marks the largest decline in final demand prices since April 2020. On a year-over-year basis, headline PPI is up 1.3 percent. Goods PPI declined 1.4 percent, marking the first decline since May of this year. Final demand services PPI was unchanged in October, breaking a streak of six consecutive months of increases. Core PPI, which strips out volatile food and energy, was up 0.1 percent for the month compared to 0.2 percent in September. Core PPI was up 2.9 percent on a year-over-year basis, down from September’s reading of 3 percent. The PPI measures price increases for finished goods leaving the factory. It is generally a forward-looking measure of where prices for consumers are headed.

Manufacturing production declines due to strikes: According to the latest data from the Federal Reserve, industrial production fell 0.6 percent in October, and manufacturing (the largest component of industrial production) fell 0.7 percent. According to the report, “Much of this decline was due to a 10 percent drop in the output of motor vehicles and parts that was affected by strikes at several major manufacturers of motor vehicles.” Manufacturing continues to be a source of weakness for the economy, with industrial production down 0.7 percent year over year and manufacturing down 1.7 percent on a year-over-year basis.  

New home construction unexpectedly increased in October: Despite continued concern among homebuilders regarding interest rates, housing starts unexpectedly increased in October. The latest sentiment reading from the National Association of Home Builders came in at 34, down from the prior month’s reading of 40. The latest report marks the fourth consecutive month of declining optimism and the third straight sub-50 reading as mortgage rates continue their climb to decades-high levels. Builders continued ramping up incentives to generate demand, with the number of builders cutting new home prices reaching the highest level since November 2022. The average price cut was 6 percent.

The outlook for builders was consistent with the latest housing starts data from the U.S. Census Bureau. Overall, residential starts increased 1.9 percent to a 1.372 million annualized rate but is 4.2 percent below the October 2022 rate. Single-family housing starts in October were up a slight 0.2 percent from September’s revised pace to a seasonally adjusted annualized rate of 970,000 units.

While starts were slightly stronger than expected, permits rose to 1.487 million. Both single-family and multi-family permits rose, with single-family units notching a 0.5 percent rise above the revised September figure of 963,000. These numbers continue to remain well below their post-COVID highs. High mortgage rates continue to negatively impact housing affordability, and we believe the housing sector as a whole will continue to face headwinds in the coming months.

Continuing jobless claims increase: Weekly jobless claims numbered 231,000, an increase of 13,000 from last week’s 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 1.87 million, an increase of 32,000 from the previous week. The upward trend in continuing claims is a timely market indicator that ties back into our opening on weakening signs of the labor market and why a recession may be likely. In fact, with figures up 28 percent from a year ago, these levels are consistent with all of the eight last recessions.

The week ahead

Monday: The Conference Board’s latest Leading Economic Index survey for October will be out mid-morning. For months, these reports have suggested the U.S. economy may be on the cusp of or is in a recession. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.

Tuesday: We’ll get a look at existing home sales mid-morning from the National Association of Realtors. This report, along with the new homes data released last week, should give a clearer picture of whether recent signs of stabilization continue in the face of an uptick in mortgage rates.

Wednesday: Initial and continuing jobless claims will be announced before the market opens. Initial filings were up 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.

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 unemployment and economic growth for 2024.

Friday: 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 November. Activity in manufacturing is essentially flat, while the services side has shown continued resilience. We will be watching for signs to determine whether the services sector is seeing erosion of strength as the cumulative effects of rate hikes continue to work their way through the economy. We’ll also be looking at demand for employment in both industries.

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