Markets Bounce Back, but Risks Remain

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

A volatile week ended with the major indices regaining most of the losses from Monday’s sharp sell-off. The drop on Monday, which saw the S&P 500 down 3 percent at close, was a carryover from the prior week, when weaker than expected employment data and signs of a slowing economy had investors fearing a recession may be on the horizon. Concerns of an economic contraction have since eased as many investors were cheered by fewer than expected initial jobless claims last week. Additionally, there was a growing sense that the Fed has the greenlight to cut rates aggressively at its September meeting and may approve a cut beforehand should employment show more signs of economic weakness. In some ways, last week wasn’t all that different than what we’ve been highlighting for the past several months. Yes, volatility spiked in the market; and yes, the size of the sell-off after the weaker than expected jobs data was unusual. However, just as we’ve seen for most of this year, concerns sparked by weak economic news eventually faded as investors found a “but” to counter the latest data point.

The casting aside of warning signs about the economy for much of this year has been bolstered by two factors. First, as we noted in last week’s commentary, many normally reliable economic indicators have been signaling an approaching recession for up to two years—yet economic growth has continued. And second, while parts of the economy showed signs of strain, the job market remained robust, which many reasoned would help the economy stay afloat. However, the recent climb of the unemployment rate to 4.3 percent has triggered the so-called Sahm rule and weakened the case for a soft landing. This rule shows that since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the prior 12-month low, a recession followed. While some on Wall Street have countered that aggressive rate cuts by the Fed could still offset any momentum of an economic slowdown, we believe the Federal Open Markets Committee may be more conservative in reducing rates than many expect. That’s because consumers remain in relatively good financial shape, and inflation pressures have eased but not completely dissipated.

While we continue to believe the economy is likely headed for a contraction based on a wide array of forward-looking indicators, we also acknowledge that it is impossible to predict with any certainty when a recession may arrive. Indeed, the many head fakes from the data since COVID have understandably made investors somewhat desensitized to many of the warnings we’ve seen. But while it’s natural that there are differing opinions on how long the current growth cycle can continue, we believe it is fair to say that risks in the economy—and the markets—have risen as the weight of higher interest rates continue to act as a drag on growth. As such, we believe investors would be well served by asking “what if?” What if the labor market, which is widely considered a lagging economic indicator, falters further? What if the previously reliable indicators are still directionally right even if the timing is delayed? By no means are we suggesting that these what-if questions should prompt you to abandon your investment plan. Instead, we believe the acknowledgement that economic risk is heightened and, given signs of a weakening labor market, that we are closer to a recession now than we were at the start of the post-COVID economic recovery should encourage you to lean into your investment and financial plans.

Put another way, we suggest the best way of dealing with uncertainty is to 1) develop a financial plan and 2) always adhere to diversification. Work with your advisor to develop a financial plan that you follow through both good times and bad. Embedded within that plan is the reality that life and markets are uncertain. Any resulting asset allocation acknowledges that potential volatility. We believe the best manner to deal with that volatility is through diversification, which acknowledges that no one knows for certain what will happen. And while diversification is often viewed as a defensive tool, we believe it should be considered an all-weather approach that allows investors to have exposure to asset classes that typically perform well even as others lag. At Northwestern Mutual, our advisors have tools to help prepare for all of life’s challenging events and uncertainties.

Wall Street wrap

Data out last week suggests that the slowdown in the economy may be gaining momentum, which could lead to further softening of the employment picture.

Services sector activity perks up: The latest headline reading from the Institute for Supply Management (ISM) shows activity in the services sector rebounded in July with a reading of 51.4, up 2.6 points from June’s reading of 48.8. New orders rose to 52.4 from the previous month’s level of 47.3. Along with rising growth, demand for workers moved higher, with the employment index coming in at 51.1 compared to June’s reading of 46.1. It’s worth noting, however, that July was only the second month this year that saw growth in employment. Additionally, the six- and 12-month average readings for employment are at levels that typically signal rising unemployment and a looming recession. This is why we believe that the recent triggering of the Sahm rule is a warning sign despite some on Wall Street suggesting the rule may not be a valid indicator in this economic cycle.

While the report offered some positive news compared to the prior week’s Institute for Supply Management (ISM) report on the manufacturing side of the economy, there were also some details that warrant further watching. On the inflation front, the prices paid index in the survey rose to 57 from June’s 56.3 reading. Additionally, of 18 industries covered by the survey, 11 reported paying higher prices, and readings on inventory sentiment continued to suggest that companies believe they have too much inventory on hand. July’s reading came in as 63.2, down modestly from June’s level of 64.1. Digging deeper, subtracting the inventory sentiment reading from the new orders reading has proven to be a reliable indicator of recessions. The latest calculation results in a -10.8 reading, which is slightly less negative than last month but is still at a level that has been consistent with recessions going back to 1997.

The rising costs on the services side of the economy, along with renewed demand for workers, could complicate the Fed’s ability to be aggressive once they begin cutting rates. That’s because members of the Fed will still be wary of reigniting price pressures and losing the hard-fought progress they’ve made on inflation over the past two years.

This report, taken with the most recent ISM data on the manufacturing side of the economy, shows that the economically weighted ISM (reflecting the contribution percentage of the services and manufacturing sectors in total economic activity) is at 50.9. Going back to 1997, this level has pointed to a weak economy on the verge of recession. Importantly, two of the past four weighted Purchasing Managers’ Index (PMI) readings were at contractionary levels.

Debt delinquencies edge higher: The latest report from the Federal Reserve Bank of New York shows consumers took on more debt during the second quarter of the year and that they were falling further behind on their loan payments. According to the report, household debt levels grew by $1.09 billion during the quarter to $17.8 trillion. At the same time, 3.2 percent of all loans were in delinquency, with credit card debt (9.1 percent) and car loans (8 percent) showing the highest rates of delinquency. The modest uptick in delinquencies means credit card and auto loans that are seriously delinquent (more than 90 days) are now above levels they were at just prior to the 2007 and 2001 recessions.

Mortgage debt delinquency levels remain relatively low compared to levels seen before past recessions. The latest data shows 0.95 percent of mortgages were delinquent, up just .04 percent from the first quarter and below the 1.18 percent rate seen in 2001. For further context, mortgage delinquencies spiked to 3.68 percent in 2007 at the beginning of the Great Financial Crisis.

More tightening by lenders: Businesses and consumers saw lending standards tighten modestly during the second quarter, according to the results of the Federal Reserve’s Senior Loan Officer Opinion Survey on Lending Practices. Overall lending standards tightened during the quarter, but a lower net share of banks reported ratcheting up their lending credit terms and requirements.

The net percentage of lenders reporting tighter lending standards for commercial and industrial loans for large and middle-market firms came in at 7.9 percent in the second quarter, down from 15.6 percent in the first quarter. Of those who reported tightening lending standards for commercial and industrial loans, 88.9 percent cited worsening or uncertain economic conditions as a contributing factor in their decision to tighten standards. Standards for commercial real estate tightened, with a net 23.8 percent of all banks noting that they had tightened standards during the second quarter.

While overall banks reported basically unchanged lending standards for households, 20 percent of respondents reported tightening credit standards for issuing credit cards, down modestly from 21.2 percent in the first quarter. Auto loan standards were basically unchanged, but demand for auto loans weakened. The continued tightening of standards for credit card issuance comes at a time when consumers are increasingly turning to credit card usage to fund their spending. Should credit standards continue to rise, it could affect consumer spending in the future.

Continuing jobless claims rise: Initial jobless claims were 233,000, down 17,000 from last week’s level and below Wall Street estimates. However, the four-week rolling average of new jobless claims came in at 240,750, an increase of 2,500 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.875 million, up 6,000 from the previous week’s revised total and now at the highest level since November 2021. The four-week moving average of continuing claims came in at 1.862 million, an increase of 7,000 from last week and the highest level since November 2021. We view continuing claims as a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data.

The week ahead

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index readings for July will be out prior to the opening bell. Recent readings have shown a modest uptick in optimism but have indicated that price pressures and the state of the labor market continue to weigh on small businesses, with many firms raising wages. We will watch for signs that suggest these challenges are easing.

The latest readings from the Bureau of Labor Statistics on its Producer Price Index will offer a look at changes in costs for buyers of finished goods for July. We will be watching to see if input costs continue to creep higher, which could put pressure on profit margins or slow the pace of disinflation.

Wednesday: The Consumer Price Index report from the Bureau of Labor Statistics will be the big report for the week. Recent data has shown the disinflationary process has restarted, and we will be dissecting the data to see if it suggests prices continue to ease.

Thursday: 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 further signs of eroding strength of the employment picture.

The U.S. Census Bureau will release the latest numbers on retail sales for July before the opening bell. Last month’s report showed tepid sales, and we will be watching to see if consumers have continued to pull back on spending.

The Federal Reserve Board will release industrial production data for July. This measure has been weak since late 2022 but has recently shown signs of perking up. We will be watching to see if the manufacturing sector is showing additional signs of strengthening.

The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders has been under pressure lately as high mortgage rates have persisted. With hopes of rate cuts reigniting during the past few weeks, we will be watching to see if optimism has perked up.

Friday: The University of Michigan will release its preliminary report on August consumer sentiment and inflation expectations. We will be watching to see if recent concerns on Wall Street about a potential recession has taken a toll on the outlook of consumers.

We’ll get July housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Thursday, will provide insight into the home construction market.

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