Recession Fears Rise as Inflation Falls

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

Despite another batch of reports signaling that inflation continues to slow, the markets gave up ground last week, as investors have grown increasingly concerned that the economy is headed for a recession in the coming months. News that the Federal government may run out of options sooner than expected to pay its obligations under the current debt limit also contributed to the sense of unease.

Progress in the deflationary process was evident in the latest Consumer Price Index (CPI) release, which shows that headline inflation grew at just 0.4 percent in April. On a year-over-year basis, prices rose 4.9 percent, marking the slowest 12-month increase since April 2021. While the monthly reading was in line with Wall Street’s forecasts, the year-over-year figure came in lower than expected. Shelter was the driving force of the increase in headline readings, with an increase of 0.4 percent for the month; however, it marked an improvement from March’s level of 0.6 percent. On a year-over-year basis that category was up 8.1 percent in March, a decrease of 0.1 percent from the prior reading. While still elevated, April’s shelter reading marked the second consecutive month of slowing growth and was the smallest monthly increase since January 2022. As a reminder, shelter has a large and lagging effect on inflation readings in services (it accounts for 33 percent of the total CPI measure and has around a 12-month lag).

Given the lagging nature of the shelter reading, we believe it is telling to evaluate price pressures after stripping out this backward-looking measure. Doing so highlights the significant progress made in the disinflationary process since the surge in CPI readings that took place in May and June of 2022—a period during which shelter and commodity prices also were surging. Since then, prices excluding the shelter number are up just 0.4 percent annualized on a non-seasonally adjusted basis and up 1 percent when adjusting for seasonality. We highlight the rate following the June peak to show why we believe year-over-year CPI readings are set to tumble in the coming months as the extreme increases from May and June roll off the twelve-month total.

Core CPI, which excludes volatile food and gas prices, rose 0.4 in April, unchanged from March’s reading. On a year-over-year basis, the Core reading came in at 5.5 percent. Although still elevated, it’s important to note that the latest year-over-year reading is the slowest 12-month increase since December 2021.   

Dissecting the data further reveals that food and shelter have been the driving force of price increases over the past 12 months. When those two categories are removed, inflation is up a meager 2.3 percent, which is more in line with the Fed’s long-term target of 2 percent.

The sole blemish to what was an encouraging week of inflation data came in the form of intermediate-term inflation expectations as registered in the University of Michigan Sentiment survey. The latest release showed expectations for price increases in the next five to 10 years checking in at 3.2 percent, up from April’s reading of 3 percent. Commenting on the release, Joanne Hsu, the director of the Surveys of Consumers and a Research Associate Professor at the Institute for Social Research at the University of Michigan, noted “the rise in long-term inflation expectations did not reflect the growing influence of inflationary psychology or increased risk of a wage-price spiral.” We share Hsu’s view.

As a whole, the data last week—despite the uptick in inflation expectations in the University of Michigan survey—showed price pressures continue to wane, while the economy continues to slow. Unfortunately, we believe the slowdown will lead to a mild recession. But the contraction will snuff out any remaining hotspots in the inflation data. Interestingly, two-year breakeven inflation rates fell to 1.92 percent last week, marking the lowest level since December 2020, confirming our belief that the Fed will be able to cut later this year to keep a potential downturn from deepening.  

Wall Street Wrap

Liquidity tourniquet continues to tighten: The closing of the flow of liquidity that has taken place over the past several months through higher rates, quantitative tightening and tighter lending standards escalated during the first quarter as borrowers faced a tougher time securing loans during the period, according to the results of the Federal Reserve’s Senior Lending Officer Opinion survey. The net percentage of lenders reporting tighter lending standards for commercial and industrial loans for large and middle-market firms grew to 46.1 percent, up from 44.8 percent during the fourth quarter of 2022. The tightening standards coincided with a drop in loan demand, with 55.6 percent fewer large and middle-market banks reporting increased demand for commercial and industrial loans. Lenders who noted in the survey an increased willingness to issue consumer installment loans fell to a net 22.8 percent. Banks also reported a continued tightening of standards for commercial real estate loans alongside a drop in demand for these loans.

This is further evidence that the substantial inflow of liquidity that helped fuel inflation over the past few years continues to dry up. The level of tightening of loan availability as well as the decline in demand and M2 money supply are consistent with levels during previous recessions and help influence our outlook.

Input costs continue to trend lower: Producer input final demand costs rose 0.2 percent in April, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. On a year-over-year basis, headline PPI is up 2.3 percent, which was below market expectations and at the lowest level since January 2021. The index measures price increases for finished goods leaving the factory; it is generally a forward-looking measure of where prices for consumers are headed. As the costs producers face for finished goods continue to ease, we expect to see further price relief for consumers at the retail level.

Independent businesses optimism down: The latest data from the National Federation of Independent Business shows optimism among small business owners fell 1.1 percent in April to 89, marking the lowest level since 2013. The latest reading is the 16th consecutive monthly reading below the long-term historical average of 98. Business owners also have dim expectations going forward, with 49 percent more respondents believing conditions will get worse than that they will get better. Hiring plans remained well off from post-COVID highs at 17 percent.

The subdued optimism about the future has led to a further pullback in prices charged by businesses. Just 33 percent of respondents reported raising prices during the survey period, marking the lowest level since March 2021 and well off the recent high of 66 percent recorded in March 2022. The trend looks set to continue, as just 21 percent of businesses surveyed plan to raise prices during the next three months. For context, the latest reading marks the lowest level recorded since October 2020. This reaffirms our belief that CPI is poised to continue to moderate.

Similarly, fewer business owners reported increasing wages during the past three months (40 percent), which marked the lowest level since July 2021 and is well off a recent peak of 50 registered in January 2022. The downward trend looks likely to continue as just 21 percent of respondents expect to raise pay in the coming three months—the lowest level since April 2021 and well off the recent high of 32 recorded throughout the fourth quarter of 2021. This data shows that inflation and wage pressures are likely to ease further in the coming months but will unfortunately also lead to a mild recession.

Jobless claims rise: Weekly jobless claims rose last week with 264,000 new claims filed, up from the prior reading of 242,000 and now at the highest level since late October 2021 and well above the low of this cycle (182,00 set in September 2022). Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.813 million. We view both initial claims and continuing claims as indicative of a softening labor market as the number of people out of work is increasing, while the continuing claims number suggests those who previously lost their jobs are having a harder time finding new employment.

A word on the debt ceiling: Debt ceiling negotiations picked up last week with President Biden meeting with legislative party leaders from both sides of the aisle last Tuesday. However, a second meeting scheduled for last Friday was postponed as staff for all involved parties continued to negotiate. As of this writing, no deal has been reached. Christopher Gahan, vice president – Government Relations for Northwestern Mutual, had this to say about the standoff: “We’re entering some potentially treacherous waters, and we’re likely to get very close to the brink before a deal comes together.”

We believe the markets will likely see a spike in volatility as negotiations continue, but that will subside once a solution is reached. We continue to believe an agreement will be reached before so called “X date,” when the U.S. government runs out of extraordinary measures for funding payments and services. However, we anticipate that negotiations will be contentious, and a solution is unlikely to occur until just prior to the federal government defaulting. As a result of the uncertainty, we expect heightened volatility in the markets until a solution is reached.

The week ahead

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

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 curbing their spending habits in anticipation of a potential recession.

Wednesday: We will get March housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Tuesday, will provide insights on whether consumers can expect greater housing inventory in the months ahead.

Thursday: We’ll get a look at existing home sales mid-morning by the National Association of Realtors. This report, along with the new homes data released earlier in the week, should provide a clearer picture of whether the rapid cooling of the real estate market has stabilized. 

Initial and continuing jobless claims will be announced before the market opens. Initial filings and continuing claims rose last week, and we will be watching for signs that the employment picture is weakening.

The Conference Board’s latest Leading Economic Index 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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