Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
The past couple days have clearly been difficult for investors, as markets have turned sharply lower amid uncertainty over the path of inflation, economic growth and how aggressively the Fed may need to tighten rates. Wednesday’s 1,100-point drop may feel anything but normal. But recent data, including more out this week, continue to give us comfort that the economy has room to grind higher and that inflation will come off the boil as we move forward.
As we think about the path forward, we’re looking at several variables.
COVID-19 changed consumer behavior. Shutdowns and initial uncertainty caused consumer spending to plummet, and government stimulus and Fed action were unleashed to fill the hole in economic growth. As liquidity poured in, consumers (who were still largely hunkered down at home) shifted spending from services like hotels and restaurants to goods like furniture, electronics and appliances. The result was a sharp consumer-driven rebound that pulled forward future economic growth at an unsustainable clip and caused much of the initial price pressure. Now, consumer demand is shifting back to a pre-COVID trajectory, which, while still growing, is doing so at a slower pace than at the height of fiscal and monetary stimulus. Additionally, spending habits are shifting back to services and away from goods. The return to a more measured pace of growth has been uncomfortable for some and downright painful for areas of the market and economy that were beneficiaries of COVID.
While some of Wednesday’s rout in the market was sparked by disappointing comments from big retailer Target, details from the company along with broader data point to a consumer still willing to spend — maybe just differently. According to Target, sales of big-ticket items, such as TVs and kitchen appliances, were down. On the flipside, experience-related items grew. Luggage was up 50 percent. While this is a snapshot from one company, it is backed by broader measures.
Consumer spending remained strong during the month of April, with retail sales up 0.9 percent overall. Meanwhile, the March figure was revised up from 0.5 percent to 1.4 percent. While consumer demand remains strong, supply challenges that have fueled some of the recent inflation are showing signs of receding.
While the cost of food and energy is likely to stay elevated, signs point to inflationary pressures for other goods easing. For example, furniture and home furnishings inventories are starting to normalize. Inventory-to-sales figures hit a low last year of 1.25 but have since recovered to 1.64 — the highest level since 2014. The improving inventory levels are welcomed news as the latest Personal Consumption Expenditure index shows the prices in the furnishings and durable household equipment category are up 12.1 percent year-over-year. For context, for the 25-year period from 1994 to 2019, prices in the group depreciated a cumulative 27 percent.
Similarly, the much-publicized lack of inventory on car lots is easing. The latest industrial production report for the month of April shows manufacturers pumped out vehicles at a pace of 10.3 million units per year in April, the highest rate since March 2021. While the rate is shy of the 10.7 million annual rate of 2019, it is still a significant sign of improvement from the rate of 7.5 million in September 2021. As production continues to ramp up, price increases should begin to slow. We’ve already seen an improvement in vehicle prices in the latest Personal Consumption Expenditure report. The latest release shows vehicle and parts prices were up 19.6 percent year over year, but that is down from the 23.6 percent year-over-year increase reported in January. Contrast that against the 25-year period ending in 2019 when prices rose just 5 percent in total during the period.
Inflation, the Fed and markets
The fact that consumer habits are returning to more normal patterns and manufacturers are catching up to demand should be welcome news for a Federal Reserve tasked with reining in inflation. Put simply, the supply-demand equation is improving, which should ease some of the recent growth in prices.
While the Fed has been vocal about its willingness to aggressively battle rising prices, its rhetoric has already taken on some of the heavy lifting. Keep in mind, the Fed has increased only 0.75 percent since the current hiking cycle began. Yet financial conditions have tightened significantly in anticipation of aggressive hikes going forward. Yields on the 10-year Treasury have returned to levels last seen in late 2018. This has caused a repricing of the bond market, which has had a carryover to the equities markets, where growth stocks in particular have undergone dramatic price shifts in response to the fear of higher rates.
The upshot is that the fear of future Fed action is already siphoning some of the excesses brought on from historically low interest rates. For instance, mortgage rates have jumped to more than 5 percent after years of languishing at 3 percent or less. Rising interest costs are taking a toll on affordability and having a cooling effect on housing demand. Mortgage applications fell 11 percent from the previous week, according to the Mortgage Bankers Association’s weekly survey, which dovetails with a sentiment survey out by the National Association of Home Builders that shows that builder sentiment has fallen to 69 — down from its 84 reading at the end of 2021 and well off its record of 90 in late 2020.
Pulling it together
Not only have investors gotten ahead of the Fed raising rates, but markets have raced to a dour conclusion about how it ultimately plays out. According to the latest American Association of Individual Investors (AAII) Investor Sentiment Survey, just 26 percent of investors surveyed thought the market would be higher six months from now. That continues a pessimistic trend that began in mid-February after Russia invaded Ukraine, and the poll recorded its first reading below 20 in mid-February. Since then, there have been three additional readings in the teens. However, the survey has a remarkable track record as a contrarian indicator. In 97 percent of the cases when bullish sentiment has fallen below 20 percent, 52-week forward returns for equities have been positive.
While the markets continue to gyrate as the economy lurches back to normal, we believe economic growth will continue, just at a more tempered pace. That, in turn, will lower the heat on inflation and give the Fed room to surprise on the dovish side in this rate hiking cycle. The result for investors could be a market that is propelled higher in the coming months, albeit in a volatile manner. The prospects of a recession this year remain low in our view, although we recognize the possibility exists and wouldn’t be surprised to see a contraction in the next two to three years. The good news is if the economy is pulled into a recession, we expect it will be relatively mild and short-lived, and the market may already reflect it.
This is the time to lean on your financial plan. Good planning anticipates market downturns like this. It anticipates recessions. Staying invested through downturns is what positions investors to participate in the growth that has historically always followed. We have no reason to believe this time will be any different.