The Economy Picks Up Where It Left Off Pre-COVID

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

The back-and-forth debate about the prospects of a soft landing, which has driven the markets so far this year, continued over the past week with renewed concerns that the economy is still too strong and that the Federal Reserve will need to continue to tighten rates to get inflation fully under control. The angst is a carryover from the Feb. 3 jobs report that showed 517,000 new hires in January. However, as we’ve cautioned in the past, each economic report provides just a small sliver of a much larger picture. As such, basing buy or sell decisions on a narrative in which the latest data has an outsized influence is fraught with risk. 

To be sure, the January jobs number caught the attention of members of the Federal Open Markets Committee and likely strengthened their resolve to see the employment picture weaken before the board will put an end to rate hikes. However, we do not interpret the stubbornly tight labor market as a sign of a still-robust economy. Instead, we remain steadfast in our view that the economy is weakening and will give way to a shallow, short and rolling recession in the coming months. We also continue to believe that as economic growth stalls, the labor market is likely to show cracks, and because of the already considerable progress made in curbing inflation, the Fed will be able to pivot to holding rates steady and cut them later in the year should the potential recession deepen. 

In our view, a mild recession would mark the completion of the U.S. economy’s long return to where it was just prior to the arrival of COVID. Recall that in late 2019/early 2020, the U.S. was in the late stages of a 10-year economic expansion. The labor market was tight, with unemployment at 3.5 percent; wage pressures were building, with (production and non-supervisory worker) wages peaking at 3.7 percent year over year in the fourth quarter of 2019; and the yield curve was flattening. Fast-forward to today, when unemployment is at 3.4 percent, non-supervisory and production wages are up 5.1 percent year over year (but still coming down from a COVID-driven high of 7 percent in March 2022), and the yield curve is now inverted. Put simply, it is reasonable to conclude the domestic economy has come full circle and is where it would have likely been in early 2020 had the global pandemic not happened. We highlight this to make the case that the economy is largely back to normal, and as such, it is reasonable to expect normal business cycle patterns to reemerge. And while past performance doesn’t guarantee future results, a look at past economic cycles may provide insights into why we believe the economy is late in an economic cycle.  

As we’ve detailed in previous commentaries, the persistent high inflation of the late 1970s and early ’80s was fueled by wage and price spiral that saw wage growth continually push higher in the upper single digits for most of the decade, reaching a peak of 9.4 percent in early 1981. The ever-increasing paychecks allowed consumers to pay higher prices for longer. However, following former Fed Chair Paul Volker’s success in breaking the inflation cycle in the early 1980s, wage pressures have largely been kept in check. Since then, every economic cycle over the past four decades has ended with the economy running out of production slack, a condition in which employers are unable to find additional workers to hire. The scarcity of workers causes wages to rise as employers compete for labor.  In each cycle this has led to wages rising slightly above 4 percent. Once the 4 percent level was met or eclipsed, a recession ensued in each instance.   

The January 2023 jobs report showed the U.S. unemployment rate at 3.4 percent, now below the pre-COVID low of 3.5 percent, and suggests that the economy is at a place where it is running low on workers to hire. The only caveat is that the unemployment figure is measured based on those already employed or actively looking for work. Today, 62.4 percent of the working-age population is either employed or looking for a job, compared to 63.3 percent pre-COVID. If the participation rate climbs back to pre-COVID levels, there will be additional labor market slack, wages will continue to push lower, and the economic cycle could continue. This is the path to a soft landing; however, it appears the Fed believes this is unlikely and will therefore continue to tighten to slow the economy further in pursuit of creating “labor market slack.” Unfortunately, this implies job losses and a rising unemployment rate. This is why we believe that a recession is the base case for the economy in the coming months. The silver lining is that we don’t believe the contraction will be deep but rather shallow and short given the overall still-strong condition of consumers and business. With inflation continuing to fall and wage/inflation expectations anchored, we believe the Fed will be able to pivot to rate cuts later in the year if needed to keep any such recession from deepening. As we’ve noted in the past, we also believe the markets have discounted a majority of any such economic decline. 

Wall Street Wrap 

While January’s jobs report renewed talk of an economy that’s running too hot, data out last week suggests that a slowdown continues. 

Wholesale inventories climb: The latest data from the U.S. Census bureau shows wholesale inventories rose 0.1 percent in December from the prior month and were up 17.6 percent compared to December 2021. Inventory-to-sales levels were at 1.36 compared to 1.24 a year prior. Coincidently, this 1.36 ratio is in line with levels seen in late 2019 and early 2020, a period when a trade war was slowing economic growth and inflation was low. With inventories growing relative to sales, wholesalers are likely to lack pricing power in the coming months, which should contribute to disinflationary pressures.  

Liquidity drying up: Businesses and consumers had a tougher time getting loans in the fourth quarter of last year, 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 44.8 percent. Lenders who noted an increased willingness to issue consumer installment loans fell to a net -12.5 percent. Banks also reported a drop in demand for real estate 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 of loan availability as well as the decline in demand are consistent with levels during previous recessions and help influence our outlook. 

Consumer sentiment remains weak: Concerns about the direction of the economy continue to weigh on consumer expectations, according to the latest data from the University of Michigan Sentiment survey. The gauge of economic expectations for the next six months came in at 66.4, up modestly from January’s reading of 64.9 but still low by historical standards. Sentiment on the current state of the economy rose to 72.6 from the prior month’s reading of 68.4. This measure is sensitive to prices paid at the fuel pump, which fell during the month. Of note on the inflation front, expectations for price increases in the next five to 10 years came in at 2.9 percent. As a reminder, inflation expectation is one of the things the Fed watches as it strives to control price pressures.   

Despite the seemingly strong labor market, consumers expect rising unemployment in the next year. Indeed, this measure is also at a level consistent with conditions before previous recessions and will likely lead consumers to spend cautiously. We also note that despite current strong wages, consumers’ median expectations are for 2.5 percent growth in income (wages) over the coming year. This remains “normal” and well below the 5 to 6 percent expectations that existed in the wage and price spiral of the late 1970s and early ’80s.  

The week ahead 

Tuesday: The big release for the day will be the Consumer Price Index report from the Bureau of Labor Statistics. Recent data has indicated disinflationary progress has been gaining momentum, and we will be dissecting the data to see if easing price pressures are beginning to take hold in the services side of the economy. 

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

Wednesday: 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 continuing to pull back on discretionary spending in the face of rising costs. We will also be watching for changes in the trend of consumers turning away from buying goods. 

A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders.   

Thursday: The latest readings from the U.S. Bureau of Labor Statistics 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.  

Initial and continuing jobless claims will be announced before the market opens. Initial filings crept up modestly last week, and we will be watching for signs of a cooling job market.  

We will get January housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Wednesday, will provide a clearer picture on demand for housing as mortgage rates have retreated modestly in recent weeks. 

Friday: The Conference Board’s latest Leading Economic Index (LEI) survey will be a key release during the week. Recent reports have suggested the U.S. economy may be on the cusp of a recession. We will be scrutinizing the data for any indications of a change in the pace of softening. 

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