Latest Data Follows a Familiar Trend and Further Complicates the Fed’s Job

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

Equities had a mostly good week as the S&P 500 and Dow Jones Industrial Average both notched gains, while the tech-heavy NASDAQ was little changed for the week. A positive week for stocks came despite several economic reports suggesting the weight of high interest rates is taking a toll on growth. Retail sales came in weaker than expected, and existing home sales fell for a third consecutive month. And although initial jobless claims inched lower, continuing claims rose again, nearing levels last seen in early January.

While most of the data out last week was consistent with an economy buffeted by high interest rates and persistent inflation, the latest preliminary reading of the S&P Global Purchasing Managers Index (PMI) was a noteworthy outlier. It showed a strong services sector and improvement on the manufacturing side of the economy while also indicating some slowing in the pace of inflation. However, as we often note, economic reports are best viewed as single pieces of a larger picture made up by all the data. Trends are also more telling than data points representing a single month of information. Pertaining to trends, in some ways last week is very much in line with what we’ve been seeing for months—data painting an inconsistent and, at times, contradictory picture.

During the past two years we’ve seen significant divergence among various reports that historically tend to move in the same direction over longer periods. The examples are many, including the gap between the Bureau of Labor Statistics’ two employment reports—the Nonfarm payroll report and Household report. The Nonfarm data has shown robust growth, while the Household data has shown weak growth and even some months of losses. Similarly, the Gross Domestic Product data historically syncs up over time with the Gross Domestic Income report from the Bureau of Economic Analysis. However, over the past few years, these two measures offer have often offered differing views of the pace of economic growth in the U.S.

Normally reliable forward-looking indicators have also been less predictive in the post-COVID economy. For instance, the yield curve has been inverted (meaning short-term bonds yield more than long-term bonds) for just shy of two years. In the past, this would have been seen as a likely sign of a coming recession, yet the economy is seemingly still strong. Likewise, measures such as the Conference Board’s Leading Economic Indicators have been at or near levels that typically signal a recession for the better part of two years.

We note these contradictions and anomalies to highlight the challenge the Federal Reserve faces in achieving its goal of bringing inflation sustainably down to 2 percent while avoiding a recession. Put simply, in the best of times, walking the tightrope between cutting rates too early and allowing inflation to reignite versus cutting too late and pushing the economy into a recession is daunting. Given that formerly reliable indicators have proven less reliable as of late only adds to the challenge. Indeed, one area that has been consistent, by many measures, has been the pace of wage growth. On that front, wages continue to grow faster than the 3 to 3.5 percent rate the Fed believes is consistent with inflation sustainably at 2 percent.

Unfortunately, given that the pace of wage growth is heavily influenced by the overall strength of the job market, which is a lagging indicator of economy, we believe the Fed won’t be able to make a meaningful adjustment to interest rates until either the job market shows consistent signs of weakening or there is a surge in workers or a meaningful rise in productivity. Unfortunately, we don’t believe any of those scenarios will materialize until after the current level of interest rates have taken a toll on economic growth and pushed the economy into a mild, short-lived recession.

Wall Street wrap

Business activity and price pressures rise: U.S. business activity climbed in June, building on May’s strong uptick. The latest preliminary data from the S&P Global Composite Purchasing Managers Index, which tracks both the manufacturing and service sectors, shows that the Composite Output Index came in with a reading of 54.6 (levels above 50 indicate growth), up 0.1 points from May’s final reading of 54.5.

Optimism about the future—particularly on the services side of the economy—along with stretched production capacity led to a rise in employment readings for the first time in three months. The latest employment reading reached a high-water mark last seen nine months ago. Service sector employment readings rose by the largest amount in five months, while manufacturing employment jumped at the fastest clip since late 2022.

Activity in the services sector came in at 55.1, a gain of 0.3 points from May’s reading and the highest level in the past 26 months. The report shows the manufacturing side of the economy also grew with a headline reading of 51.7, up from May’s final reading of 51.3 and the highest reading in three months.

On the inflation front, the pace of rising input costs cooled. While still running higher than historic averages, the latest reading shows the pace was slower than any seen during the past year. However, employment costs continued to drive cost pressures for service providers, while manufacturers reported higher raw material and shipping costs. As the pace of rising input costs slowed, so did price increases to customers—selling prices increased at the slowest pace in five months.

While the report was positive overall, the outlook between the two sides of the economy continues to differ. Views of future prospects for business in the services side of the economy reached a five-month high and hit a level above the long-term average. Conversely, manufacturers remained cautious about the prospects for sales in the future and optimism fell to the lowest level in more than 18 months.

Lackluster retail sales: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in May grew 0.1 percent up from April’s decline of 0.2. The latest report shows retail sales are up 2.3 percent on a year-over-year basis. Sales figures are adjusted for seasonal variation and holidays but not for price changes. That means that year-over-year sales have risen slower than inflation. Eight of 13 categories measured saw increases, led by sporting goods, hobby, musical instruments and bookstores. Notably, sales at bars and restaurants declined 0.4 percent. This category has seen strong growth since the end of COVID, with sales up 3.8 percent year over year. The latest lackluster retail data comes on the heels of April’s weak report. Consumer spending has been a driving force in the post-COVID recovery, and we will be watching to see if the recent weakness is an emerging trend as depleted savings and rising credit card balances begin to affect consumers.

Forward-looking indicators fall again: The Leading Economic Index (LEI) from the Conference Board fell 0.5 percent in May, the third straight month of decline and the 26th of the last 27 months. Over the past six months the LEI has fallen at an annualized pace of 4 percent. While the latest six-month annualized reading is better than the −4.4 percent threshold that has historically indicated a coming recession, the latest level still suggests weakness in the coming months. The Conference Board notes that for a second straight month the index is no longer signaling a recession. However, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “While the Index’s six-month growth rate remained firmly negative, the LEI doesn’t currently signal a recession. We project real GDP growth will slow further to under 1 percent (annualized) over Q2 and Q3 2024, as elevated inflation and high interest rates continue to weigh on consumer spending.”

Existing home sales drop as prices rise: The National Association of Realtors reported that existing home sales in the U.S. fell 0.7 percent in May to a seasonally adjusted annual rate of 4.11 million units. The decline marks the third consecutive month of declining sales; on a year-over-year basis, sales of existing units are down 2.8 percent. The decline in sales comes despite strong activity in the high end of the market, with sales of properties of $1 million or more up 22.6 percent from year-ago levels, while sales of properties priced at less than $500,000 or less were mostly down. This highlights how higher interest rates are weighing on less affluent consumers while having a less significant impact on wealthy households. We’ll be watching future reports to see if the slowdown in sales starts to creep into higher-priced properties.

While sales once again declined, prices continued to edge higher. The median price for existing single-family homes rose to $419,300 in May, an increase of 5.8 percent from year-ago levels, and the highest amount on record. The latest figure marks the 11th consecutive month of year-over-year price gains.

The inventory of unsold homes was 1.28 million units, up 6.7 percent from April and a jump of 18.5 percent from year-ago levels. Unsold inventory is equal to a 3.7-month supply. Historically, a five-month supply of inventory is consistent with moderate price appreciation. A steady uptick in supply may eventually start to ease price pressures on homes, as current high mortgage rates have made long-time homeowners who have fixed-rate mortgages at much lower rates hesitant to sell. As a result, we expect it may take a while for inventory level to cap price gains.

Housing starts decline: Similar to existing home sales, new construction activity declined last month. The latest housing starts data from the U.S. Census Bureau shows residential starts dropped 5.5 percent in May from the prior month to a 1.28 million annualized rate. The latest figure marks the fewest monthly starts since June 2020. On a year-over-year basis, starts were down 19.3. Single-family housing starts shrank by 5.2 percent from April’s revised pace to a seasonally adjusted annualized rate of 982,000 units. Meanwhile, multifamily starts for buildings with five or more units were 278,000, down 10.3 percent from April’s revised pace and down 51.7 percent year over year.

Total building permits also declined in May by 3.8 percent to 1.39 million. Single-family permits declined 2.9 percent from the prior month to 949,000. Multi-family permits came in at just 437,000, which is the lowest level since April 2020. Overall, permits are at the lowest seasonally adjusted annualized pace since June 2020.

Homebuilders’ confidence moves lower: Elevated interest rates and rising construction costs are wearing on homebuilder optimism. The latest sentiment reading from the National Association of Home Builders came in at 43, down two points from May and the lowest level since December 2023. As mortgage rates continue to hover around 7 percent, homebuilders are increasingly turning to price cuts to spur demand. The latest survey shows 29 percent of builders offered price cuts, up from May’s level of 25 percent and the highest portion since January 2024. In total, the latest survey shows 61 percent of respondents reporting offering some sort of concession, which is up 2 points from May.

The downbeat mood of builders is not expected to change anytime soon. The latest survey shows sales expectations for the next six months fell four points to 47 after a nine-point tumble in May. Until interest rates move lower or expectations of rate cuts surge as they did at the beginning of this year, we expect builders will continue to have a cautious view of prospects ahead.

Continuing jobless claims rise: Weekly initial jobless claims were 238,000, down 5,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 232,750, up 5,000 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.828 million, up 15,000 from the previous week’s revised total and just off the highest level of 1.829 million in January of this year. The four-week moving average for continuing claims came in at 1.8 million, up 10,250 from the previous week. Both of these are on an uptrend, and we are watching this measure closely.

The week ahead

Tuesday: The Chicago Federal Reserve Bank releases its national activity index. The report looks at economic activity across the country and related inflationary pressures. Last month showed a step back in progress. We’ll be watching for indications of whether the recent downtick was statistical noise or a reemergence of weakness after two months of improved readings.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher in the past several months. We will be looking to see if home prices continue to rise despite elevated interest rates, which could lead to higher inflation readings several months from now.

The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus 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 in finding work. We will also be watching to see if expectations for the economy are continuing to soften amid the recognition that the Fed is unlikely to cut rates until later this year.

The Bureau of Labor Statistics releases state unemployment data mid-morning. While the overall national unemployment rate has not violated the so-called “Sahm” rule for predicting where the economy is headed, state-level data shows 21 states have already crossed the threshold, which has not occurred in the prior 50 years without a recession following.

Wednesday: The U.S. Census Bureau will release data on new home sales for May. We’ll be looking at this data to assess the impact the recent uptick in inflation and fluctuations in mortgage rates have had on demand for newly built homes.

Thursday: Data on durable goods orders for May will be released to start the day. We’ll be watching for signs of the direction of business spending in light of solid economic growth despite rising inflation pressures.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have been trending higher, and we’ll continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The May 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’ll be watching to see if the latest data shows a change in the pace of inflation.

Follow Brent Schutte on X (formerly Twitter) and LinkedIn.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.