Market Cheers New Evidence of Easing Inflation Pressures

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

The broad indices posted a strong week as evidence mounted that the likely path forward for inflation is lower. Data on everything from housing prices to cost pressures in the services industries showed signs of weakening. And while weekly jobless claims came in modestly lower than expectations, investors got a welcome sign that wage pressures may be reaching a tipping point.

The ongoing improvement in inflationary inputs included a significant slowdown in private-sector wage growth, as measured by the U.S. Labor Department. According to the latest report, wages for private sector employees rose 1.2 percent during the third quarter, down 0.4 percentage points from the 1.6 percent pace during the second quarter. On a year-over-year basis, private-sector wages were up 5.2 percent through the end of September, compared to 5.7 percent year over year at the end of June. The decrease is noteworthy given that the employment market has remained tight. The Federal Reserve has viewed the strength of the job market as a concern because competition for workers leads to rising wages. Higher wages can, in turn, be used by consumers to pay higher prices for longer, creating an upward spiral of inflation, as was the scenario in the late 1970s and early ’80s. However, we’ve long argued we don’t believe the current economic backdrop will result in a replay of that period, and this report reinforces our view. The slowing wage growth suggests competition for workers among employers is beginning to ease.

Workers have also begun to sense the cooling job market, according to the latest Consumer Confidence report from the Conference Board. The report includes a measure of the difference between the number of respondents who believe jobs are easy to land and those who report challenges finding work. The latest reading showed 45.2 percent of those surveyed believed it was easy to find a job, a decline of 4 percentage points from the prior reading. Conversely, the number of people who believe it is currently harder to find work came in at 12.7 percent, up from September's reading of 11.1 percent. The difference between the two is important because it can be an early indicator of changes in the employment climate. The latest differential is down 5.5 percentage points from the prior reading and now stands at 32.5, which is well below the high of 47.1 percent set in March of this year. Historically, a decline of this measure has coincided with rising unemployment rates.

Should the employment picture weaken in response to softening consumer demand, we expect the pace of wage growth will fall further.  

Last week’s data also highlighted that the once-resilient housing market continues to struggle as a result of higher mortgage rates. The latest S&P Core Logic Case-Shiller Index shows the appreciation of home prices year over year in August was down 2.6 percent from July’s reading and marks the fastest pace of year-over-year declines in the index’s 35-year history. The index of 20 city major metropolitan areas from Case Shiller showed prices fell 1.32 percent month over month following a 0.69 percent decline in July. The latest report marks the second consecutive month of falling prices and highlights the bite higher mortgage rates are having on home sales. Further evidence of eroding demand for homes can be found in data from the National Association of Realtors, which shows pending home sales fell by 10.2 percent month over month in September and are down 31 percent on a year-over-year basis. Pending sales are a forward-looking measure, and the latest figures suggest softer demand will keep a lid on home prices during the coming months.

Despite the latest data, we believe the Federal Reserve’s decision to raise rates this week by 75 basis points is all but a foregone conclusion. However, as wage pressures and housing costs continue to wane, we believe signs of cooling inflation may become too great to ignore going forward and should lead to an easing or possible pausing of rate hikes in the coming months.

Wall Street wrap  

While we will have to wait until later this week to see if the latest data is making an impact on the Federal Reserve’s thinking on rate hikes, the data released last week continues to show demand is weakening, which should result in a cooling job market and easing wage pressures.

Slowing demand and improving supply chains: Preliminary readings from the S&P Global Purchasing Managers Index show manufacturing contracted in October, with a reading of 49.9, down from 52.0 in September (readings below 50 indicate contraction). However, production increased as survey respondents reported continued easing of supply chain bottlenecks. The report also highlighted input cost pressures eased during October, with price increases for manufacturing inputs rising at the slowest rate in almost two years. New orders were down for the period, registering the sharpest decline since May 2020. Easing input costs and weakening demand translated to price breaks for end consumers; the report showed the weakest increase in prices since January 2020.

The easing of input costs noted in the report is consistent with what we have seen in the commodities market, where prices for raw materials used in manufacturing are essentially flat on a year-over-year basis. If demand for goods remains sluggish, we expect commodity prices will continue to hold steady, which will further ease price pressures for goods.

Likewise, the services side of the economy fell further into contraction territory, with a reading of 46.6 for October, down from September’s level of 49.3. The decline in activity was the second largest in almost 30 months. Weak demand led services businesses to pare back payrolls by backfilling fewer positions vacated by workers and, in some instances, laying off existing employees. We expect that if businesses continue to see a slowdown in sales, layoffs will become more common, and the employment market will weaken.

A rebound in gross domestic product (GDP): Third quarter GDP came in at a positive 2.6 percent annualized rate. The latest reading reverses a trend of two consecutive quarters of contraction; however, a deeper look at what drove the expansion suggests the rate of growth may not be sustainable. The uptick was driven largely by a surge in exports that we don’t believe will persist in the coming quarters. Instead, we view real final sales as a more reliable indicator of the strength of the domestic economy. The real final sales measure strips out exports, government spending and inventory investment and focuses instead on consumer and business spending. Based on that number, quarter-over-quarter annualized growth was up a paltry 0.1 percent and down significantly from the 2.1 percent pace this spring. Apart from a period during the height of COVID, the most recent real sales reading signals the weakest aggregate consumption growth since the fourth quarter of 2009. 

Backward-looking inflation data in line with expectations: The latest Personal Consumption Expenditure Price Index showed prices ticked up 0.3 percent on a month-over-month basis and were up 6.2 percent year over year – unchanged from last month’s report. Core inflation rose 0.5 percent from the prior month and 5.1 percent year over year. The annual rate was slightly higher than last month’s 4.9 percent but was modestly lower than market expectations of 5.2 percent. The market shrugged off the latest backward-looking data, which we believe is a sign that investors are finally focusing on forward-looking measures that suggest inflation pressures are falling.

The week ahead

Tuesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for September. The comprehensive report will provide a clearer picture of the health of the labor market, including job openings and quits data. A tight employment market has been the last domino standing in the Fed’s ongoing effort to rein in inflation. We will be watching for signs that the gap between job openings and job seekers is narrowing, which could lead to easing wage pressures for businesses.

The health of the manufacturing sector will be in the spotlight today as the Institute of Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index for October in the morning. Demand for manufactured goods has softened considerably from COVID highs as inventories have returned to near normal levels. The ISM services report will come out on Thursday, and we will be watching the two for updates on the strength of the economy.   

Wednesday: All eyes will be on the Federal Reserve as it releases its statement following its monthly meeting. The Fed has raised rates by 75 basis points at the last three meetings, and we expect it will once again opt for a three-quarters of a point hike this week. We will be watching the Fed’s statement for indications of how it is balancing backward-looking inflation data against more recent numbers that point to a slowing economy and easing cost pressures, as well as its comments on the current state of economic conditions.

Friday: The BLS releases the October Jobs Report. As we’ve noted in recent months, a significant gap has opened between its Nonfarm Payrolls report and its other measure of employment, the so-called Household report. We will be looking for signs that the gap is tightening between the two measures. Additionally, we will be looking for any changes to the labor force participation rate.

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