Signs of Easing Strength in the Job Market May Not Be Enough for the Fed

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

The major indices all finished down for the week as investors locked in gains from the recent rally in equities and took a more cautious approach as they began to look beyond recent earnings announcements.

A slew of employment numbers out last week hinted at some slight softening of the still resilient job market. However, the recent figures may not be enough to alleviate the Federal Reserve Board’s concerns that the high demand for workers presents an ongoing threat to its stated long-term goal of bringing inflation down to 2 percent.

To be sure, the latest numbers were overall consistent with a robust employment picture, but they also suggest that the economy is moving past the peak in hiring it experienced late last year. For instance, the latest Jobs Openings and Labor Turnover Survey (JOLTS) showed the number of new positions created in June declined by 34,000 from May’s downwardly revised reading, resulting in 9.582 million unfilled positions. The latest reading marks the lowest level of monthly openings since April 2021 and came in below consensus Wall Street estimates. The so-called “quits” rate, which is viewed as a proxy for the level of confidence employees feel about the job market, came in at 2.4 percent, down from May’s reading of 2.6 percent and the lowest reading since February 2021. Once again, the industries that saw the greatest increases in quits were on the services side of the economy, including arts, entertainment and recreation.

Similarly, the Nonfarm payroll report for July released late last week showed 187,000 new hires, slightly above the 185,000 downwardly revised figure for June and a 67 percent decline from the July 2022 reading of 568,000 new hires. Previous estimates for new hires for May and June were revised downward by a total of 49,000 positions. The latest monthly figure is well below the average of 312,000 monthly new hires recorded during the past 12 months. Of the July new hires, the majority (63,000) were in non-cyclical health care. Average hours worked declined by 0.1 hours to 34.3, which may also be signaling an easing in labor demand, as employers often cut hours as a first step as they evaluate whether slowing demand is temporary or an emerging trend.

While the latest data suggests the employment picture remains strong by historic standards, the trend appears to be pointing toward a downshift in the pace of hiring. Despite the gradual weakening, details in the data are unlikely to ease concerns from Fed Chair Powell that wage pressures could reignite inflation. The Nonfarm report showed wages for production and non-supervisory employees grew by 0.45 percent from the previous month and are now up 4.77 percent on a year-over-year basis. The latest figure is well below the post-COVID year-over-year peak of 5.9 percent recorded in March 2022; however, as we noted in our most recent quarterly market commentary, the Fed views 4 percent as the upper end of tolerable wage increases because it represents the sum of the historical average 2 percent growth in worker productivity (worker output per hour) and the 2 percent in annual wage increases the Fed believes the economy can absorb without sparking an economically damaging rise in inflation. While the latest data showed productivity rose by a 3.7 percent annualized rate in the second quarter, we don’t believe the Fed will see a one-quarter jump in productivity as a compelling counter to still too high wages.

Given the still strong wage growth, we believe the Fed will be unwilling to take rate hikes off the table. As such, we believe the economy will continue to slow, and recent signs of weakness in the services sector will eventually take root. The good news is that given that considerable progress in bringing down current measures of inflation, which we view as core readings excluding lagging shelter costs, should provide room for the Fed to cut rates as needed to spur the economy should it fall into recession.

Wall Street Wrap

Jobless claims move higher: Weekly jobless claims rose to 227,000 from last week’s 221,000 new claims. The four-week rolling average of new jobless came in at 228,250, down 5,550 from the previous week. Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.7 million, up 11,000 from the prior week’s revised reading.

Manufacturing continues to contract: The latest data from the Institute of Supply Management (ISM) shows the manufacturing sector notched a ninth consecutive month in contraction territory with a reading of 46.4, up a modest 0.4 from June’s reading (readings below 50 signal contraction). Weakness was widespread, with only one of the six largest manufacturing industries—petroleum and coal products—showing growth and only two of the total 18 industries reporting growth. New orders remained in contraction territory at 47.3; however, this marked a second consecutive month of improvement, building on May’s reading of 45.6. The continued weakness in manufacturing continues to keep a lid on price pressures for the industry as reflected in the latest contractionary reading of 42.6, which remains near levels not seen since the beginning of COVID.

While the weakness in new orders and activity appears to be stabilizing based on the latest report, it’s worth noting that staffing continued to contract, with the latest employment reading coming in at 44.4, 3.7 points lower than June’s level. In a statement accompanying the latest data, Tim Fiore, chair of the ISM, noted, “Demand remains weak but marginally better compared to June, production slowed due to lack of work, and suppliers continue to have capacity. There are signs of more employment reduction actions in the near term to better match production output.”

While the report continued to paint a weak picture for manufacturing, the recent stabilization of production and new orders coupled with still low inventory levels for both manufacturers and customers could result in a quick recovery for the sector should demand continue to move higher.

Growth in services sector slows: ISM data for the services side of the economy showed that the pace of expansion slowed, with the latest headline reading for the sector coming in at 52.7, down from June’s reading 53.9 (readings above 50 signal expansion). New orders ticked down to 55 from the prior month’s readding of 55.5. Supply chains continue to keep pace with demand, with the latest survey showing delivery times slowing modestly but still at a level consistent with meeting demand.

Notably, while the sector remains in expansion, hiring has eased; the latest survey shows a reading of 50.7, down from June’s level of 53.1.

Liquidity continues to dry up: Businesses and consumers saw a continuation of increasingly stringent lending standards during the second quarter, according to the results of the Federal Reserve’s Senior Lending Officer survey. The net percentage of lenders reporting tighter lending standards for commercial and industrial loans for large and middle-market firms grew to 50.8 percent. Lenders who noted an increased willingness to issue consumer installment loans fell to a net -21.8 percent—similar to the prior quarter’s reading of negative 22.8 percent. The latest report also suggests that it will become even more challenging to get loans during the second half of the year, with 40.3 percent of large and middle-market lenders expecting to tighten standards for commercial and industrial loans.

This is further evidence that the liquidity spigot that helped fuel inflation over the past few years continues to shut off as a result of the Fed’s aggressive rate hike campaign. The level of tightening loan availability as well as the decline in demand are consistent with levels during previous recessions and continue to influence our outlook.

A word on the U.S. credit rating: On August 1, 2023, Fitch Ratings, one of the three major commercial credit rating agencies in the U.S., downgraded its rating for U.S. government credit to AA+.  We don’t see the downgrade having an impact on the view the global investment markets hold for U.S. Treasurys. However, it’s important to remember that the country’s annual interest costs on servicing its debt are rising. With interest payments taking up more resources in the budget, it is likely borrowing costs will become an issue that restricts future government spending. This could mean that we may see an erosion of the ultra-favorable backdrop for risk-taking that has existed over much of the prior decade. This does not mean we will not overweight risk but could mean that our positioning may become a bit more dynamic given the threat of smaller and slower fiscal and monetary policy interventions going forward.

The week ahead

Monday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers have begun to take on more credit card debt in recent months, but overall balance sheets have remained strong. We will be watching for changes in debt levels in light of recent data showing increased spending.

Tuesday: The NFIB Small Business Optimism Index readings for July will be out before the opening bell. The report should provide insights about the state of the labor market for small companies and expectations related to price increases at the consumer level in the months ahead.

Final wholesale inventory numbers for June will be released after the market opens. Of interest will be any revisions to the direction of inventories from initial readings.

Thursday: The Consumer Price Index report from the U.S. Bureau of Labor Statistics (BLS) will be the big report for the week. Data continues to show progress in the disinflationary process, and we will be dissecting the data to see if the pace of disinflation has changed, with a particular focus on the services side of the equation.

Initial and continuing jobless claims will be announced before the market opens. Initial filings were up last week, and we will be watching to see if there are additional signs of softening in the labor market.

Friday: The latest readings from the BLS on its Producer Prices Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into how easing input costs, such as raw materials and wages, are impacting the prices of goods bought by end consumers.

The University of Michigan will release its preliminary report on August consumer sentiment and inflation expectations. We will be watching the report for signs that respondents’ expectations in the coming year and, more importantly, five- to 10-year period continue to ease.

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