Passing the Baton From Growth to Slowing Inflation

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

The markets pieced together another winning week despite some mild softening on Friday. Perhaps counterintuitively, the move higher came during a week when data showed additional slowing of the economy. The Conference Board’s Leading Economic Index (LEI) survey for June fell .8 percent from May and is down a sharp 3.7 percent on an annualized basis during the past six months. The diffusion index in the report shows that weakness during the six-month period was broad, with just 20 percent of the indicators improving. Those readings are consistent with levels generally seen at the start of past recessions.

While the data may sound alarming, the underlying numbers provide cause to believe that we are not on a path to a deep recession. Although the six-month diffusion index was anemic, the month-over-month readings paint an improving picture, climbing from a recent low of 15 percent in April to 30 percent in May and now reaching 40 percent for June. While we aren’t suggesting that the monthly improvements should be viewed as a sign that the bulk of the economic slowdown is behind us, we do believe the recent trend suggests that should the economy dip into a recession, it will be shallow.

Additional slowing of the economy, whether it reaches the technical definition of a recession or not, would provide added momentum to an already easing inflationary backdrop that is showing up in other surveys, including the most recent Business Outlook Survey released by the Federal Reserve Bank of Philadelphia. Like the LEI report, the survey showed manufacturing activity weakening significantly but also saw prices paid for goods by businesses at the lowest levels since January 2021. Similarly, the reading for prices received — what consumers paid for products — came in at 30.3, well off the recent high of 62.9 and the lowest reading since March 2021. The report offers a snapshot of what we have been seeing broadly in the data for weeks — slowing demand but, more importantly, an improving inflationary picture.

Wall Street appears to be coming around to this view of late, and we believe there remains more room for gains in the markets as price pressures ease further and investors gain clarity on just how far the Federal Reserve will need to raise rates as it seeks to right the supply/demand imbalance.

Wall Street wrap

Recent data continue to show incremental progress in righting the supply/demand imbalance that has fueled higher prices and reaffirms our belief that inflation will begin to recede.

As earnings season kicks off, we look forward to getting a front-row view of the strength of consumers and the cost pressures companies are facing as they issue their quarterly reports.

Positive news on earnings. As earnings season continues, early trends are encouraging. With 104 of the 500 companies in the S&P 500 announcing quarterly results as of late last week, 72 percent reported better than expected earnings, and 56 percent reported revenues that beat consensus estimates. The aggregate earnings beat has been 4.28 percent, and strength has been broad, with 10 of the 11 industry groups reporting better than expected earnings. Industrials was the only group to miss on earnings, with the average for the group coming in at just 0.14 percent lower than Wall Street expectations. Importantly, bottom-line forecasts for the rest of the year were largely unchanged. While earnings expectations are likely to be revised downward in the coming weeks and months, given our belief that a potential recession would be mild, we don’t think the revisions will be significant.

Demand for housing slows. Demand for existing homes fell to a 5.12 million annualized pace in June, according to the latest release form the National Association of Realtors. The pace was 5.4 percent lower than the prior month and represented a 24 percent drop from the all-time peak in January 2021. The decrease continues what has been a five-month trend in cooling demand. Similarly, mortgage applications fell to the lowest level in two years, according to data from the Mortgage Bankers Association.

The rapidly cooling housing market is in response to the surge in interest rates sparked by the Federal Reserve’s rate hikes, which have pushed mortgage rates from approximately 3.0 percent in July 2021 to now around 5.6 percent. As demand continues to slow, we believe price appreciation for homes will moderate and could recede in some pockets of the country. The taming of home prices should help consumers and have a sizeable impact on inflation readings such as the Consumer Price Index, which applies a significant weighting to housing when calculating inflation.

Mixed news in the private sector. The latest Purchasing Manufacturers Index readings released by S&P Global showed the pace of input price inflation eased again from the peak levels seen in May. The reading marked the lowest levels in six months. The improved inflationary backdrop coincided with the first contractionary reading for private-sector business activity since June 2020. The latest reading of 47.5 for July was down notably from 52.3 in June (readings above 50.0 represent a growing economy). The pace of decline was the sharpest since the initial stages of the pandemic in May 2020 and was felt by both manufacturers and service providers.

As this and other reports noted, the economy is weakening. However, the trend of inflation is improving, and the continued easing of price pressure should make a potential recession mild.

The week ahead

In addition to the key economic reports listed below, we will continue to sift through earnings reports with an eye on top-line numbers to gauge demand as well as earnings for a closer look at how cost pressures are affecting profitability.

Monday: The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures.

Wednesday: All eyes will be on the Federal Reserve as it releases its statement following its monthly meeting. The Fed has been nimble in its efforts to curb inflation, and we expect a hike of 75 basis points as base case but will be watching for a statement leaving the door open for more modest hikes of 50 basis points in the future.

Data on durable goods orders for June will be released to start the day. We’ll be watching signs that consumer appetites are continuing to transition toward services over goods.

Thursday: The Bureau of Economic Analysis will release its estimate of U.S. gross domestic product (GDP) for the second quarter. Consensus estimates suggest the economy was able to avoid producing a second straight quarter of contraction. While we don’t think it is likely, GDP could be negative for a second straight quarter, which would place the U.S. in a technical recession. Although recessions are never pleasant, our analysis shows not all contractions are the same, and we believe this one would be mild given the overall strength of the consumer and the improving inflationary trend. 

Friday: The latest Personal Consumption Expenditures (PCE) 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. The market is expecting an increase in the pace of headline inflation to 6.7 percent year over year and core readings to hold steady at 4.7 percent. We continue to believe the evidence is mounting that inflation is set to slow as we move toward year end.

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