Taking a Longer View Amid Short-Term Market Turmoil

Brent Schutte, CFA, is Chief Investment Officer of the Northwestern Mutual Wealth Management Company.

After a week of troubling news on inflation, concerns over likely Fed moves and a market pullback, it’s time to take a deep breath, relax and look ahead calmly. Without a doubt, the current environment is marked by confusion and even outright fear. Everyone is trying to figure out the direction and possible severity of inflation, how that will affect economic growth, and the extent of the Federal Reserve’s rate hikes.

In the face of this turmoil — roiled even more by the Russian invasion of Ukraine, subsequent commodity price spikes and rising global geopolitical tensions — our underlying forecasts remain consistent. We continue to believe that recession calls are premature, that inflation is peaking and will begin rolling over in the coming months and that the Fed will continue to raise rates but will be extremely careful not to tighten us into a recession.

At some point, we will have a recession. But we think it’s likely that’s still years — not months — away. What’s more, when one does come, it is apt to be less severe than many anticipate given the strength of consumer and corporate balance sheets. In the meantime, we still believe we will see another leg up in equity markets, particularly certain parts of the market. Let’s look at some of the key things we’ve been watching over the past week.

Wall Street wrap

Several widely watched markers of economic activity were released last week, offering views on the economy’s direction, activity in manufacturing and services, the housing market and inflation. The dispiriting news on several fronts also contained bright spots amid the gloom — and some of the gloom even contained a silver lining.

Projections of slower growth. Last week’s release of the Conference Board’s Leading Economic Index (LEI), a composite of leading indicators, showed a March rise despite headwinds from the war in Ukraine. This puts the index up 6.4 percent year over year, which is consistent with continued economic growth. The Conference Board projects that growth at 3 percent for 2022, which includes a 0.5 percent downgrade due to the Russia-Ukraine war. That is slower than the 5.6 percent pace of 2021 but still above the pre-Covid trend.

Current conditions remain strong. The S&P Global flash U.S. Composite PMI Output Index, which tracks the manufacturing and services sectors, fell to 55.1 in April from March’s 57.7, with the manufacturing component ticking up to 59.7 from 58.8 and services taking a dip to 54.7 from 58. The manufacturing increase was helped by a spike in new-order growth, which was the highest in seven months and spurred by foreign demand. We believe the decline in services is likely to be reversed as spending shifts to the services sector.

In Europe, despite fears of an imminent recession, the region’s headline composite PMI rose to 55.8 from 54.9 on the back of a surge in tourism and recreation, while the manufacturing index dipped to 55.3 from 56.5.

A normalizing housing market. Housing starts, at a 1.79 million annualized rate, are at their highest level since 2006. Building permits, now at 1.873 million, are near their recent high. The reason for the strength in new homes is that sales of existing homes have been strong against a backdrop of low supply. The result is a current pace in which it would take only two months, not the typical five, to clear the nation’s inventory of housing, which is a sign of tightness. That tightness is also reflected in the price of existing home sales, which rose to a record average of $375,300. But the pace of gains is slipping, as is the confidence of home builders. Those declines, along with the likely slowing in housing, reflect higher mortgage interest rates, which will erode home affordability and put downward pressure on home prices. This does not spell doom, as in 2005 or 2006, but more a cooling off from the current fever pitch and a return to more normal conditions with mortgage rates that would seem reasonable by historical measures.

Federal Reserve fears. Expectations that the Fed will be more aggressive in hiking rates in the near term drove equities lower over the past week. To keep its inflation-fighting credibility intact, we believe the Fed is likely to front-load its hikes in the coming months with a series of 0.5 percent increases. However, toward the end of the year and into 2023, we believe the Fed will slow the pace of hikes to assess the impact of its actions as it pushes closer toward the neutral rate, which is the rate at which policy is neither stimulative nor restrictive. Should a trade-off become necessary between higher-than-desired inflation or a politically and societally unpalatable recession, the Fed will lean to the former.

A last word on sentiment. Last week, we noted that bullish sentiment in the weekly American Association of Individual Investors’ survey slid 8.9 percentage points to 15.8 percent — a level not seen in nearly 30 years. This week, bullishness inched upward to 18.9 percent, but this number remains historically depressed. Indeed, only 23 other times has this survey been at this level or lower since 1987, and in each of the prior 22 instances the market was higher 12 months later. (We can’t judge the predictive value of last week’s number because the outcome won’t be known for another 51 weeks.) This is just one piece of a bigger economic and market picture, but it’s one that we see as a continuing bullish contrarian indicator.

The week ahead

More readings on the housing and real estate markets are due this week, but the big news will come at the end of the week, when much-watched data on inflation (PCE), consumer spending and income and consumer sentiment will be released. Don’t be surprised by volatility as markets head into the weekend.

• Tuesday: Data on durable goods orders in March will start the day, along with data on home prices in February and new-home sales in March. Also due is the Conference Board’s consumer confidence reading for April.
• Wednesday: Pending home sales in March and the first quarter’s home ownership rate are due out just after the market opens.
• Thursday: Weekly figures on initial and continuing jobless claims will be released as well as an estimate of first-quarter GDP.
• Friday: The heaviest day on this week’s economic calendar will reveal March numbers for the PCE Index, nominal income, nominal consumer spending and real disposable income. Also due are April figures for the Chicago PMI and consumer sentiment and five-year inflation expectations as measured by the University of Michigan.

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