Strong Economic Data Casts Doubts on Prospects for a Soft Landing

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

Stocks finished lower for the week as new jobless claims came in below forecasts and stronger than expected growth on the services side of the economy raised investors’ concerns that the Federal Reserve may need to raise rates further to keep inflation heading lower. The frequent rotation during the past few months between investors cheering a potential soft landing and fearing a still too strong economy highlights the unusual path the economy has been on during its recovery from damage inflicted by COVID.  

While parts of the economy (such as services) have remained strong and continue to prop up the overall business climate, manufacturing has been weak, and forward-looking measures, such as the Conference Board’s Leading Economic Indicators, have been suggesting for months that we are either in recession or approaching one in the near future.  

The crosscurrents that have continued to buffet investors for much of this year have been closely monitored by the Fed and have prompted Fed Chair Jerome Powell to studiously stick to his script that the Fed will continue to take a data-driven approach when making future rate decisions. While we have every reason to believe the Fed will be mindful of the data, we believe it will continue to be particularly sensitive to wage growth above all else as it plots the path forward. As we discussed in our latest Asset Allocation Focus, the employment picture—more specifically, wages—is the final battlefront in the Fed’s fight against inflation. The Fed is concerned that elevated wages could lead to a repeat of the period of embedded high inflation that occurred from 1966 to 1982. That time frame was characterized by a wage–price spiral in which rising wages were used to pay ever-rising prices. A return to the dynamic of the 1970s and early ’80s is the paramount concern and why the Fed is intently focused on the tight labor market. Indeed, when asked during an interview last week what level of wage growth he believed is compatible with the Fed’s goal of 2 percent annual inflation, New York Fed President John Williams put the figure at 3.25 percent to 3.5 percent—well below the latest reading of 4.5 percent from the Bureau of Labor Statistics. 

While Williams expressed optimism that wage growth was heading lower and would reach what he believed was a rate consistent with 2 percent inflation, he also acknowledged that unemployment would likely climb in the coming quarters and eventually top 4 percent as wage pressures receded.  

A sustained uptick in productivity or a sharp increase in the number of available workers could alleviate wage pressures; however, we have yet to see evidence to suggest a lasting improvement in either measure is likely to occur. That leaves a decrease in the demand for employment as the most likely lever to bring wage pressures down. And to achieve that, we believe the Fed is likely to keep rates high and may raise them further in the coming months. While 525 basis points in hikes over the past 18 months have affected parts of the economy, such as real estate, we believe the full impact has yet to be felt. Additionally, the longer interest rates are at their current levels or higher, the greater the cumulative effect on the economy. That’s because at their current range of 5.25–5.5 percent, interest rates are well in excess of the so-called “r*,” or natural rate—which is defined as the interest rate that is neither restrictive or expansive and is expected to prevail when an economy is at full strength and inflation is stable (estimated at 2 percent). Current estimates of the r* rate peg the level at around 2.5 percent, meaning at their existing levels, rates are acting as a drag on the economy. 

Fortunately, the COVID-fueled spike in prices has largely subsided, which should provide the Federal Reserve with room to cut rates to soften the blow if an economic downturn begins to gain momentum. 

Wall Street Wrap 

Beige book paints a muted picture: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that in aggregate economic growth was modest and job growth was subdued. Tourism spending was stronger than expected; however, most respondents believed that the uptick represented the final surge of pent-up travel demand stemming from COVID. Additionally, contacts in some Fed districts reported retail spending is showing signs of slowing, as it appeared excess savings were being depleted. The bulk of the decrease was in non-essential spending. The majority of districts reported wages remained elevated despite previous expectations that pressures to raise wages would subside. Still, the report noted “nearly all districts indicated businesses renewed their previously unfulfilled expectations that wage growth will slow broadly in the near term.” 

As it pertains directly to inflation, most districts reported price growth slowed, with manufacturing and consumer-goods sectors seeing the greatest decrease. It’s worth noting that respondents in several districts noted that they were having difficulties passing higher input costs onto consumers and instead had to absorb the higher costs, thereby reducing their profit margins.  

Growth in services sector ticks higher: Institute for Supply Management data for the services side of the economy showed that the pace of expansion increased, with the latest headline reading for the sector coming in at 54.5, up from a reading of 52.7 in July (readings above 50 signal expansion). New orders increased to 57.5 from the prior month’s reading of 55. However, inventories grew 7.3 points to 57.7, and inventory sentiment moved higher, suggesting inventory levels were too high. The inventory data coupled with a 10.3-point decline in backlog orders—the largest decline on record—suggests that future production needs could be muted going forward.  

The latest measure of prices also increased to 58.9, up from July’s 56.8. Similarly, hiring rebounded to 54.7, up four points during the past month. 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. 

Capital spending inches higher: While much of the data out last week provided an updated picture of consumer spending, we also received some insights into business spending; here, too, the data shows waning demand. Final data shows U.S. core capital goods orders, which exclude aircraft and defense spending, are up just 0.5 percent in July on a year-over-year basis and are essentially flat since October 2022. For context, capital goods orders were up 6.3 percent year over year in July 2022. While capital goods make up a much smaller portion of gross domestic product than consumer spending, the tepid level of the past year suggests businesses remain cautious with their dollars and provides another warning sign of a potential recession. 

Jobless claims move lower: Weekly jobless claims were 216,000, down 13,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 229,000, decreasing 8,500 from the previous week’s upwardly revised average. Continuing claims (those people remaining on unemployment benefits) fell to 1.679 million from the previous revised reading of 1.719 million.  

The week ahead 

Tuesday: The NFIB Small Business Optimism Index readings for August 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. 

Wednesday: 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.  

Thursday: 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 the direction of input costs faced by business and can indicate how prices may move at the consumer level in the future.  

The U.S. Census Bureau will release the latest numbers on retail sales before the opening bell. The data should yield insights into whether consumers are adjusting their spending habits as a reflection of their expectations for the economy going forward. 

Initial and continuing jobless claims will be announced before the market opens. Initial filings were down last week, and we will be watching to see whether last week’s decrease was a temporary blip or a sign of continued strength in the job market. 

Friday: The University of Michigan will release its preliminary report on September 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. 

The Empire State Manufacturing Index, released before the opening bell, will offer a look at the health of manufacturing and general business conditions in the influential New York state region. 

Follow Brent Schutte on 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.