Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
During the past few months, we have highlighted shifting and moderating consumer demand, rebuilt goods inventories, falling commodity prices and a rapidly cooling housing market as reasons that inflation would move lower. In essence, data over the past several months have shown an unwinding of many of the elements that drove inflation higher in the aftermath of COVID. While we continue to believe these developments will result in price pressures receding in the coming year, we also acknowledge that the lag between improvements in the supply and demand equation and a retreat in the rate of inflation has been frustratingly slow. Reports out last week highlighted that this trend is continuing.
Equities closed out the third quarter on a down note as a host of reports out last week did little to calm concerns that the Federal Reserve was poised to go too far in its rate tightening campaign. The latest jobs data from the Department of Labor showed that initial filings for unemployment fell to 193,000, down 16,000 from the previous week and now at a five-month low. The release came on the heels of an unexpectedly bullish Consumer Confidence Index report from the Conference Board that showed respondents more optimistic on everything from current economic conditions to their views on the availability of jobs.
Of note for Fed watchers was the labor market differential reading, which is based on the difference between the number of respondents who believe jobs are easy to land and those who report challenges finding work. The latest reading showed 49.4 percent of those surveyed believed it was easy to find a job, an uptick of 1.8 percentage points. Conversely, the amount of people who believe it is currently harder to find work remained largely unchanged at 11.4 percent, down just 0.2 from the prior reading. The difference between the two is important because it can be an early indicator of changes in the employment climate. While the latest differential is up slightly, to 38 percent from last month’s 36 percent gap, it is still well below the high of 47.1 percent set in March of this year.
The jobs report and labor differential were troublesome for investors because they play into one of the Fed’s areas of concern as it tries to rein in inflation — a too strong employment market that it believes will keep wage pressures high and continue to give life to elevated price pressures.
Meanwhile, the one data point out last week that is tied directly to inflation came in higher than expected and underscores the stubbornly slow progress in the battle against rising prices. The Personal Consumption Expenditures (PCE) Index from the Bureau of Economic Analysis showed a month-over-month increase of 0.3 percent. Core PCE, the Fed’s preferred measure of inflation, saw an uptick of 0.6 percent.
While not yet a consensus opinion, many investors appear to be growing more confident that the forward-looking indicators are moving in a favorable direction and that backward-looking measures of inflation, such as PCE and the Consumer Price Index, are providing a snapshot of what has already occurred, not a real-time view of the situation as it currently stands. Consumers also seem to be acknowledging the turning point in price pressures, as the final revisions to the latest University of Michigan Sentiment Survey show that forward inflation expectations (for five to 10 years in the future) fell to 2.7 percent. That figure is down from June’s reading of 3.1 percent but still modestly higher than the top of the range between 2016 and 2020, when economists and the Federal Reserve were concerned about the U.S. entering a deflationary period. For further context, the latest number is in line with readings throughout the late 1990s through 2016 and well below expectations regularly registered during the late 1970s and early 1980s.
A prime example of the lag we’ve noted between real-time data and backward-looking reports can be found in the latest PCE reading for housing prices, which shows a 6.7 percent year-over-year increase in rent and 6.3 percent rise in rental equivalent (an estimation of how much in rent homeowners would receive for renting out their homes). Contrast that against the latest readings from the S&P Core Logic Case-Shiller Index, which show that between June and July, the trajectory of housing prices on a year-over-year basis cooled at the fastest rate on record in the history of the survey. Notably, the share of homes that saw price reductions during the survey period hit 20 percent — the highest level since 2017. While housing is a high-profile sign of easing price pressures, other data suggest demand continues to ease, which should result in softening inflation readings in the coming months. Services spending is up 3 percent year over year, coinciding with a shift in demand away from goods and toward services. However, this, too, is showing signs of moderating. The PCE report shows that on an inflation-adjusted basis overall spending is up a modest 1.8 percent year over year and that the sale of goods is actually down 0.4 percent in real dollars. Taking a broader view, real spending is essentially flat over the most recent three-month period for which data is available (June through August) and is up just .28 percent since April. That pace translates to an annualized rate of just 0.88 percent. It’s worth noting that the leveling off of spending has occurred against a backdrop that has seen material improvements in inventories and an easing of supply chain backlogs. Target and Walmart were two high-profile retailers that were among the first to report a glut of inventory last quarter due to changing consumer demands. More recently, Amazon and shipping giant FedEx have warned of weakening demand, while athletic footwear and apparel maker Nike noted its plans to discount prices in an effort to reduce excess inventories. Put simply, supply is no longer scarce and demand no longer elevated. The improved supply/demand dynamic reduces pricing power throughout the economy and should result in a marked softening of the rate of inflation.
While we continue to believe that inflation is less sticky than the Fed fears, we acknowledge that the longer the lag between improvements in real-time data and a reduction in backward-looking price readings lasts, the greater the likelihood that the Fed will remain too aggressive — which could result in a deeper recession than is currently anticipated. As we noted in our most recent Asset Allocation Focus, the markets are now entering the uncomfortable “space between,” when investors are forced to juggle still high inflation readings and a hawkish Fed while also facing the reality of a potential coming recession. Throw in the uncertainty of a looming election in November, and investors are left with more questions than answers and perhaps a growing sense of unease. Here, too, our analysis shows that election-driven anxiety may be unwarranted.
We’ve long said the return to normal will be anything but smooth, and the last few weeks for investors have reaffirmed that. However, knowing there will be bumps on the road is far different than experiencing them. As such, we want to emphasize that 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. Despite the slow pace of progress, we continue to believe inflation is set to fall, and the Fed still has time to pivot to a slower pace of hikes or a potential pause in the tightening cycle.
The week ahead
- Monday: The Institute of Supply Management will release its Purchasing Manufacturers Index. In light of recent data that the economy may be on the brink of a recession, we will be scrutinizing new orders data as well as inventory levels. Additionally, we will be watching for signs that labor demand is softening.
- Tuesday: The Bureau of Labor Statistics will release its Job Openings and Labor Turnover Survey report for August. The comprehensive report will provide a clearer picture of the health of the labor market, including job openings and quits data. Federal Reserve Chairman Jerome Powell has noted the 2:1 ratio of open positions to workers seeking employment in the previous JOLTS data as a headwind to easing of wage pressures. We will be watching for signs the gap has eased as well as any uptick in the number of layoffs.
- Wednesday: Investors will get an update on demand for services in the morning when the Institute for Supply Management releases its latest data on the sector. We will be watching the report for signs that growth in demand for services is beginning to cool as well as changes in employment expectations in the sector.
- Friday: The latest employment data will be released by the Bureau of Labor Statistics. As we’ve noted recently, a significant gap has opened between the Nonfarm Payrolls report and the BLS’s other measure of employment, the so-called Household report. We will be looking for signs that the gap is tightening between the two measures.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.
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