Mind the Output Gap

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

The major indices notched a fifth straight winning week as earnings releases throughout the week mostly added to a better than expected earnings season. The gains took place despite members of the Federal Reserve continuing their campaign to tamp down investors’ anticipation of several rate cuts in the coming months. While expectations of a cut in March have largely evaporated, the CME Fed Watch Tool shows investors still are betting on four to five cuts in 2024—this despite Federal Reserve Chairman Jerome Powell’s recent comments that he still expects no more than three cuts this year. His assertion has been backed by other members of the Fed who have been out in public during the past two weeks with a message that the Fed has room to be patient and that the data doesn’t support aggressive cutting at this time.

Optimism about rate cuts and the continued belief that the economy will escape without falling into contraction has led the markets higher in 14 of the past 15 weeks. This is despite forward-looking indicators that continue to suggest the economy may be heading for a contraction as well as signs that the disinflationary process has slowed or stalled.

To be sure, forecasting the arrival of a recession with any precision is difficult even in normal economic times. The challenge becomes even more treacherous during a period following a global economic shutdown, unprecedented fiscal and monetary stimulus and a rolling and uneven recovery throughout the economy. And while a recession did not emerge in mid to late 2023 as many—including us—had expected, the data continues to signal a contraction is likely approaching. That’s because economic growth over longer periods is governed by the economy’s capacity to produce.

As we noted in a recent commentary, one way to gauge where we are in the business cycle is to look at the output gap. This is the difference between the actual output of the economy and its potential output. When the gap is positive, the economy is growing in excess of its expected capacity, slack in the workforce has evaporated, and unemployment is very low. Basically, that means companies are having a tough time keeping up with demand. A negative output gap means the economy is sluggish and operating below its expected capacity. The economy can exceed its natural capacity for brief periods but cannot produce above that limit for a sustained period. That’s because when the economy is running above capacity, wages typically start to rise as companies compete for workers. Because the Fed views wages as a potential fuel for elevated inflation, it has historically stepped in with rate hikes to dampen economic (and wage) growth. Unfortunately, this approach usually ends in recession. Every recession since 1950 has occurred after a period of above-capacity growth. While the output gap could move even further into positive territory before the arrival of a recession, we believe the Fed will be wary of the current data and view it as another reason to keep rates elevated.

So where are we now? According to the latest estimates from the nonpartisan Congressional Budget Office (CBO) released last week, the U.S. economy had an output gap of 0.2 in the fourth quarter of 2023 and 0.6 in the third quarter, meaning the economy has been running above its natural trend growth capacity for the past six months. This suggests that the economy is in the late stages of an economic/business cycle. While estimates of output potential are inexact, it’s worth noting that the output gap during the second quarter of 2020 at the height of COVID-related economic disruption reached negative 9.15. Indeed, CBO forecasts call for the output gap to turn negative in the second quarter of this year, with underperformance accelerating into 2025. Perhaps not surprisingly, given a key input for economic capacity is labor, the CBO expects the unemployment rate will move higher as the output gap turns negative. The latest CBO forecasts show unemployment climbing from its current level of 3.7 percent to 4.1 percent in the second quarter of this year and ending 2024 at 4.4 percent. As we’ve highlighted in previous commentaries, since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous low, a recession followed, and the next step in the unemployment rate was at least a 1.9 percent increase off the prior cycle low.

While we recognize the CBO estimates are subject to revision and therefore can’t be used to make conclusive calls on the economy, the fact that they support what we have been seeing in various other reports reaffirms our belief that we are late in the economic cycle. Unfortunately, with the employment picture still tight and the pace of wage growth above the 3 to 3.5 percent level the Fed believes is consistent with 2 percent inflation, we believe the Fed will likely hold rates higher for longer. The lagging and cumulative effects of higher rates will eventually bring the current economic cycle to an end. If a contraction arrives, the Fed should be able to quickly pivot to cutting rates to prevent a shallow recession from gaining momentum.

As we’ve noted—and history has proven—timing a recession is difficult. The current economic cycle could last longer; however, we believe the data shows we are late in the business cycle. As such, it is important to avoid taking unnecessary risks with your portfolio. Make sure your investment plan is updated and that you are comfortable with your asset allocation so that if tough times emerge, you won’t be tempted to sell out of the market or make rash financial decisions. The reality is that, historically, the ends of economic cycles (recessions) are temporary disruptions that lead to the beginnings of the next economic cycle. The same applies in the financial markets. Staying invested and true to your strategic asset allocation in a diversified manner during these disruptions is typically the best path to attaining and keeping financial security.

Wall Street wrap

Last week was a light week for economic data but did include potential signs of reemerging inflationary hot spots and further draining of liquidity from the economy.

Spike in prices for the services economy: The latest report from the Institute for Supply Management (ISM) shows prices paid by companies on the services side of the economy jumped to a reading of 64, up 7.3 percentage points from December’s reading of 56.7 and the highest level since February 2023. The spike in prices marked the largest one-month increase since August 2012 and, when taken in context with the ISM manufacturing price data, suggests inflationary pressures in the economy still exist. The rise in prices paid by providers coincided with an acceleration in growth for the services economy, with January’s headline reading for the sector coming in at 53.4, up from 50.5 in December (readings above 50 signal expansion).

Industries within the services economy recording growth ticked higher to 10 of 18, just above December’s level of nine of 18, which was the lowest number of groups reporting expansion during the post-COVID cycle. New orders rose to 55, up from December’s reading of 52.8. Inventory sentiment continues to suggest levels are too high, with the latest reading at 59.3, up from 55.3 the prior month. The latest results from the survey showed a rebound in the employment index, which rose to 50.5, up 6.7 points from December’s reading of 43.8. While overall business activity was unchanged at 55.8, the respondents appear to be banking on lower interest rates as a source for optimism in the year ahead. In a statement accompanying the data, Anthony Nieves, chair of the ISM Services Business Survey Committee, noted, “The majority of respondents indicate that business is steady. They are optimistic about the economy due to the potential impact of interest rate cuts; however, they are cautious due to inflation, associated cost pressures, and ongoing geopolitical conflicts.”   

More tightening by lenders: Businesses and consumers saw tightening of lending standards moderate during the fourth quarter, according to the results of the Federal Reserve’s Senior Loan Officer Opinion Survey on Lending Practices. The net percentage of lenders reporting tighter lending standards for commercial and industrial loans for large and middle-market firms came in at 14.5 percent, down from 33.9 percent in the third quarter; however, 39.7 percent of large and mid-size lenders tightened standards for commercial real estate loans. Lenders who noted an increased willingness to issue consumer installment loans remained tight at negative 17.9 percent—modestly lower than the prior quarter’s reading of negative 20.4 percent. This is further evidence that the liquidity that helped fuel economic growth over the past few years continues to dry up because of the Fed’s aggressive rate hike campaign. Additionally, the report noted that a “significant net share of banks reported weaker demand for loans from firms of all sizes.” Likewise, banks reported a decrease in the number of potential borrowers asking about new credit lines or increases in existing lines. This suggests U.S. businesses remain cautious and are reluctant to put money to work right now, with the report specifically stating that there appears to be “decreased customer investment in plant or equipment and decreased financing needs for inventories, accounts receivable, and mergers or acquisitions.”

Jobless claims remain low: Weekly initial jobless claims numbered 218,000, a decrease of 9,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 212,250, up 3,750 from the prior week. Continuing claims (those people remaining on unemployment benefits) were at 1.871 million, a decrease of 23,000 from the previous week. The four-week moving average for continuing claims rose slightly to 1.849 million, up 9,500 from last week’s revised figure.

The week ahead

Monday:  We’ll get the release of the U.S. Treasury Federal Budget Debt Summary for January. In light of Moody’s decision last fall to downgrade U.S. debt to a negative outlook due to large fiscal deficits and a decline in debt affordability, this is something we will continue to monitor.

Tuesday: The Consumer Price Index report from the Bureau of Labor Statistics (BLS) will be the big report for the week. Recent data has shown continued but uneven progress in the disinflationary process; we will be dissecting the data to see if pockets of stubborn price pressures remain.

The National Federation of Independent Business Small Business Optimism Index readings for January will be out before the opening bell. Recent readings from this survey show that price pressures and the state of the labor market are top concerns among small businesses, with many firms planning on raising wages in the coming months. We will be watching for any signs that suggest these challenges are easing.

Thursday: The U.S. Census Bureau will release the latest numbers on retail sales for January before the opening bell. Last month’s report showed final holiday sales were strong, and we will be watching to see if consumers have continued to open their wallets.

The Homebuilders Index from the National Association of Home Builders will be out mid-morning. Last month’s data showed a surge in confidence among builders in anticipation of lower rates in the year ahead. We will be watching to see if comments from the Fed that rate cuts were likely off the table for March have affected the level of optimism.

Initial and continuing jobless claims will be announced before the market opens. Initial filings declined last week, but the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The University of Michigan will release its preliminary report on February consumer sentiment and inflation expectations. We will be watching to see if a recent jump in consumer confidence and easing inflation expectations are continuing.

The latest readings from the BLS on its Producer Price Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into the direction of input costs faced by businesses and can indicate how prices may move at the consumer level in the future.

We will get January housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Thursday, will provide insights on the impact that still elevated rates are having on new home construction.

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.