Why Not Too Hot nor Too Cold May Not Be Just Right

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

Equities soared last week, completing a comeback from an early August swoon driven by signs of a slowing economy that reignited fears of a coming recession. The surge higher for the major indices was fueled by further signs that inflation is headed in the right direction and that the economy, at least based on headline data, remains relatively strong despite current elevated interest rates.

While some in the financial media labeled last week’s data as a perfect mix of being neither too hot nor too cold, we believe that take ignores the fact that the longer monetary policy is restrictive (i.e., rates remain high and act as a drag on the economy), the deeper the higher rates will seep into the economy and the chances of a recession will increase. Put simply, economic data that is neither too hot nor too cold gives the Fed little incentive to make meaningful cuts to interest rates.

We believe the risk of reigniting price pressures by stoking growth in an economy that doesn’t show obvious signs of faltering is too great for the Fed to aggressively cut rates. The risk is heightened further by the fact that while inflation readings are improving, longer-term trends still show lingering price pressures that could reawaken if the economy heats up. As such, barring much worse than expected employment numbers later this month, we continue to believe the more likely path the Fed will take is for a modest 25-basis-point cut in September and a gradual unwinding of rates after that as data warrants. Unfortunately, the longer rates remain in restrictive territory, the more downward pressure they will exert on the economy—and consequently, the risk of a recession will rise.

While it remains possible that the economy could avoid a recession in the near term even if the Fed is slow to make meaningful reductions in rates, trends in the data suggest it is unlikely. For example, unemployment has been trending higher and has risen by 0.9 percent from its post-COVID low. Looking back, every time the U.S. has experienced a rise in the unemployment rate, as we are seeing now, a recession has followed.

To be sure, there are occasional signs that the economy continues to defy gravity—last week’s retail sales being the most recent. But while sales beat Wall Street expectations, as we detail below, the results were just a single data point, and the trend has been middling at best. Additionally, while consumer spending fuels the bulk of the economy, there have been instances when retail sales grew even as the economy stumbled. In November 2007, one month prior to the start of the Great Financial Crisis, retail sales grew by 1 percent month over month and were up 5.5 percent year over year. Similarly, in January 2001, just before the dotcom recession began in March that year, retail sales climbed 1.1 percent for the month and were up 4 percent over the previous 12 months.

We point out the above anomalies because they underscore the importance of not anchoring expectations for the economy and markets on any single data point. Instead, we believe the best approach is to look at trends and the weight of a diverse set of data as you draw your conclusions about the path forward. Similarly, we believe investors are best served by taking a diversified approach to investing. We believe owning a variety of asset classes is the best way to deal with that volatility because it acknowledges that no one knows for certain what will happen. And while diversification is often viewed as a defensive tool, we believe it should be considered an all-weather approach that allows investors to have exposure to asset classes that typically perform well even as others lag. At Northwestern Mutual, our advisors have tools to help you prepare for all of life’s challenging events and uncertainties.

Wall Street wrap

Headline data out last week gave hope to investors who want to believe the economy and markets can continue to grow for the foreseeable future. Unfortunately, details of many of the reports suggest that things aren’t as strong as they appear at first glance.

Inflation slows (sort of): The latest Consumer Price Index (CPI) reading from the Bureau of Labor Statistics (BLS) showed prices rose 0.2 percent in July after declining 0.1 percent in June. On a year-over-year basis, the headline figure was up 2.9 percent, marking the lowest annualized reading since March 2021. Core inflation, which excludes volatile food and energy costs, rose 0.2 percent in July and is now up 3.2 percent year over year, marking the smallest 12-month growth since April 2021. Prices for gasoline were flat, while food costs rose 0.2 percent.

Goods prices declined 0.3 percent for the month and are now down 1.9 percent on a year-over-year basis. Services prices increased 0.3 percent in July, up from a 0.1 percent increase in June. On a year-over-year basis, prices for services are up 4.9 percent. Shelter costs rose 0.4 percent, up from 0.2 percent the prior month.

A more detailed look shows that so-called “super core” services inflation, excluding shelter inflation (often mentioned by Chair Powell), rose 0.2 percent for the month and is still up 4.5 percent over the past 12 months.

This marks the third consecutive encouraging CPI reading, but a look at longer-term trends tempers some of our enthusiasm. While headline inflation is moving in the right direction from the uptick we saw earlier in the year, the current 12-month rate is just 0.1 percent lower than it was in June 2023. Additionally, while near-term trends are encouraging, a look over longer periods suggests the Fed is likely to be wary of being too aggressive with rate cuts at the risk of reigniting inflation. For example, services inflation on a six-month annualized basis is still up 4.19 percent. Excluding the lagging shelter category, services inflation is running at a 3.61 percent six-month annualized pace.

Finally, another inflation measure calculated by the Cleveland Federal Reserve, called the Cleveland Median CPI, came in at 0.31 percent in July, up from 0.19 percent in June and 0.24 percent in May. The latest reading translates to a 12-month annualized pace of 3.8 percent, up from June’s reading of 2.4 percent. For further context, the one-month annualized pace of this measure was 2.5 percent in July 2023.

We highlight the longer trends and the marginal movement over the past 12 months not to take away from the encouraging progress made over the past few months but as a reminder as to why the Fed may not be as aggressive in cutting rates as many investors may hope.

Consumers back to spending: The latest retail sales numbers from the U.S. Census Bureau show overall retail and food service sales grew 1 percent in July, up from June’s decline of 0.2 percent and stronger than Wall Street expectations. Details were also solid, with sales excluding autos and gas up 0.4 percent in July, off from May’s rise of 0.8 percent. The latest report shows retail sales are up 2.7 percent on a year-over-year basis, up from June’s pace of 2.0 percent. Sales figures are adjusted for seasonal variation and holidays but not for price changes. That means that year-over-year sales have risen slower than inflation. Ten of 13 categories measured saw month-over-month increases, but the overwhelming majority of the 1 percent growth was driven by two categories—motor vehicles and parts (0.67 percent) and food and beverage (0.11 percent).

Consumer sentiment split: Consumer sentiment rose to 67.8 in August, up 1.4 points from July’s final reading of 66.4, according to the latest consumer sentiment survey released by the University of Michigan. Views of current economic conditions continued to decline, with the latest reading at 60.9, down from July’s level of 62.7, The latest reading is well off the recent high of 82.5 recorded in March of this year. The speed and size of the decline is typically seen during periods where consumers are stretched and demand begins to wane. The depressed reading of current conditions is also now at a level typically seen during economic contractions.

While consumers may feel down about current conditions, expectations for the future did improve, coming in at 72.1, up from July’s reading of 68.8 and the highest level in four months.

Inflation expectations for the year ahead are at 2.9 percent, near the high end of the 2.3 to 3 percent range in the two years before COVID. Long-run inflation expectations came in at 3 percent, unchanged from June’s final reading. While inflation expectations remain anchored, consumer expectations of income have weakened. The latest survey results show respondents expect household income to increase by just 0.8 percent in the coming year. Similarly, the real household income (after inflation) expectation during the next one to two years from the survey has tumbled to 52 from its recent high of 81 in January of this year and 78 in March. The current level is the lowest recorded since March 1980. Declining income expectations against still elevated prices are pressuring low- and middle-income consumers, which could lead to a pullback in spending in the coming quarters.

Small business owner optimism improves: The latest data from the National Federation of Independent Businesses shows that optimism among small businesses climbed to 93.7, up 2.2 points from June’s reading and marking the highest reading this year. Despite the improvement, the latest measure marks the 31st consecutive month of readings below the 50-year average of 98.

While optimism has edged higher in recent reports, price pressures continue to weigh on the minds of business owners. Inflation was once again the top concern for survey respondents with 25 percent listing it as the most pressing challenge, up four points from the prior month. However, fewer companies are raising prices to offset inflation pressures. The latest results show that the portion of businesses raising prices fell by five points to a net 22 percent of respondents. Additionally, 24 percent expect to raise prices, marking the lowest reading since April 2023.

Demand showed signs of weakening, with 16 percent fewer companies reporting an increase in nominal sales versus those that saw flat or declining sales. That number is up from June’s level of 12 percent fewer companies reporting increased nominal sales versus flat or declining sales. Business owners are somewhat less pessimistic about prospects going forward, with a net negative 9 percent of all owners expecting higher inflation-adjusted sales in the next three months, down from June’s negative 13 percent. Still, these two readings are at the historically low levels that have typically occurred in or near recessions.

Perhaps as an effort to maintain margins in the face of sticky cost pressures, the percentage of businesses raising compensation fell five points to 33 percent. Similarly, a seasonally adjusted 18 percent expect to raise wages in the coming three months, down four points from June and at the low end of a range that has been in place during the past 18 months. While compensation has come down some in the latest survey, it is still elevated on a historical basis.

Manufacturing production tumbles: Industrial production fell 0.6 percent in July after increasing by 0.3 percent in June. Half of the decline was tied to the shuttering of petrochemical industries in response to Hurricane Beryl. On a year-over-year basis, industrial production is down 0.2 percent. Manufacturing (the largest component of industrial production) fell 0.3 percent for the month. Year over year, manufacturing was up just 0.1 percent. Durable goods manufacturing fell 0.4 percent in December but was offset by a 0.6 percent gain for nondurable products. The latest report is consistent with other measures of manufacturing we follow and suggests that a rebound in that side of the economy has yet to materialize.

Continuing jobless claims inch lower: Initial jobless claims were 227,000, down 7,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 236,500, a decrease of 4,500 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.864 million, down 7,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.862 million, an increase of 1,000 from last week’s revised number and the highest level since November 2021. We view continuing claims as a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data.

Homebuilders’ confidence declines: Persistent high interest rates and housing affordability issues weighed on builder optimism in August. The latest sentiment reading from the National Association of Home Builders came in at 20, down two points from July’s final reading and the lowest level since December 2023. Weak customer traffic and current sales contributed to the lack of enthusiasm among builders.

The impact of high interest rates can also be seen in the latest housing starts data from the U.S. Census Bureau, which shows residential starts fell 6.8 percent in July to a seasonally adjusted annualized rate of 1.238 million, the slowest pace since May 2020. On a year-over-year basis, starts were down 4.4 percent. Single-family housing starts declined by 14.1 percent from June’s revised pace to a seasonally adjusted annualized rate of 851,000 units. For further context, single-family starts were at a seasonally adjusted annualized pace of 1.12 million units just 10 months ago. Meanwhile, multifamily starts (buildings with five or more units) were at 363,000, up 11.7 percent from June’s revised pace but down 21.8 percent year over year.

Total building permits also declined in July by 4 percent to 1.39 million. Single-family permits were little changed from the prior month at 938,000. Multifamily permits came in at 408,000, a decline of 12.4 percent.

The week ahead

Monday: The Conference Board’s latest Leading Economic Index Survey for July will be out midmorning. Recent reports have shown modest improvement but still point to weak economic growth ahead for the U.S. economy. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.

Wednesday: The Kansas City Federal Reserve’s Jackson Hole Symposium kicks off. The Symposium runs through August 23, and Federal Reserve Chairman Jerome Powell is set to speak on the final day of the event.

The day offers a look at the minutes from the most recent meeting of the Federal Reserve Board. We’ll be looking for board members’ thoughts on the employment picture and wages. While there seems to be a consensus that rate cuts are likely to begin soon, we will watch to see if there was discussion about the possible size and cadence of future rate cuts.

We’ll get preliminary annual revisions for Nonfarm payroll data midmorning from the Bureau of Labor Statistics. As we’ve noted in the past, the Nonfarm payroll data has shown significantly more hiring than that captured by the BLS’ Household report. We will be examining the data to see if adjustments close the gap between the two reports.

Thursday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for August. Activity rose last month, and while prices continued to climb, it was at the slowest pace since January. We will be watching for signs to determine whether the uptick in hiring last month has continued or was simply a one-month blip. Prices paid will also be a point of interest for us.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have varied from week to week but overall have been trending higher, and we’ll continue to monitor this report for further signs of eroding strength of the employment picture.

Friday: The U.S. Census Bureau will release data on new home sales for July. We’ll be looking at this data to assess the impact that fluctuations in mortgage rates have had on demand for newly built homes.

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