Markets Move Higher, but Economic Concerns Remain

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

Equities added to their winning streak last week as the tone of earnings season remained upbeat. Although still early (only 87 of 498 companies in the S&P 500 reporting), quarterly results have been strong, with 78 percent of companies beating earnings estimates by an aggregate 6.24 percent. The solid quarterly results and recent steady climb for the market continue to stoke investor optimism and hopes of a soft landing. The burgeoning optimism is evident in the latest reading of the American Association of Individual Investors, which showed that bullish sentiment among retail investors reached 51.4 percent, the highest level since April 2021 and well above the long-term average bullish reading of 37.5 percent. To put the level of optimism into perspective, a look at the weekly data going back to July 1987 shows that bullish sentiment has been at this level or higher only 9.4 percent of the time (178 of 1,879 weekly readings). Abnormally high readings such as these often precede negative equity returns over the following 12 months.

We acknowledge the chances of a soft landing have increased; however, we continue to believe that the economy is more likely to experience a recession in the coming quarters. We expect it will fortunately be mild, shallow and short-lived. Given the ebb and flow of the post-COVID economic recovery, the contraction may come in the form of rolling recession, as pockets of weakness and recovery play out independently. While we have seen some in the financial media speculate that a downturn may be avoided, a steady stream of data suggests otherwise.

Industrial production continues to falter, according to the latest data from the Federal Reserve, with production falling 0.5 percent in June, marking a second consecutive month of decline. On a year-over-year basis, production is down 0.4 percent. The weakness indicated by the report is consistent with other measures we follow, including the monthly S&P Global Flash Purchasing Manufacturers Index reports, which have shown manufacturing at contractionary levels seven of the past eight months—the lone exception being April.

To be sure, the services side of the economy has remained resilient. However, the overall picture from manufacturing to housing to inflation readings is of an environment showing the drag from 500 basis points in rate hikes enacted during the past 15 months. The hikes, along with rebuilt supply and the clearing of distribution bottlenecks, has brought down inflation, which was the Fed’s initial goal of its tightening effort. But the rate increases have so far been seemingly ineffective in curbing labor demand or significantly reducing wage pressures.

As we’ve noted in the past, despite all signs pointing to the disinflationary process (i.e., a decline in the rate of inflation) gaining momentum, the Fed remains worried about elevated wage pressures. It continues to view wage growth as a potential threat that could lead to the type of wage inflation spiral that defined the period of 1966–1982. Until annualized wage increases consistently register below 4 percent, we believe the Fed will be unwilling to take rate hikes off the table. As such, we believe the economy will continue to slow, and weakness will eventually reach the services sector. The good news is that given that current measures of inflation, which we view as core readings excluding lagging shelter costs, are at or nearing historic averages, which should provide room for the Fed to cut rates as needed to spur the economy should it fall into recession.

Wall Street Wrap

Forward-looking indicators point down: The latest Leading Economic Indicators (LEI) report from the Conference Board suggests that the economy is either in recession or on the cusp of one. The June LEI reading declined 0.7 percent. The latest measure marks the 15th consecutive month of decline. The reading is now down 8.1 percent on an annualized basis over the past six months. Weakness continued to be widespread, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering just 40 percent. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.2 percent or greater over the previous six months, the economy is in or on the cusp of recession. For context, the diffusion index first fell below 50 in April 2022, and the overall reading first exceeded the negative 4.2 level in June 2022.

The streak of declining readings suggests a rocky road ahead. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “The Leading Index has been in decline for fifteen months—the longest streak of consecutive decreases since 2007-08, during the runup to the Great Recession. Taken together, June’s data suggests economic activity will continue to decelerate in the months ahead. We forecast that the U.S. economy is likely to be in recession from Q3 2023 to Q1 2024. Elevated prices, tighter monetary policy, harder-to-get credit, and reduced government spending are poised to dampen economic growth further.”

Retail sales weaken: The latest retail sales numbers from the U.S. Census Bureau came in below Wall Street expectations. The report shows overall retail sales in June were up 0.2 percent from May’s upwardly revised total. It’s important to remember that retail numbers are not adjusted for inflation. The latest figure fell short of Wall Street expectations of an increase of 0.5 percent. On a year-over-year basis, sales were up 1.5 percent, well below the 7.4 percent rate in the beginning of the year and the post-COVID peak of 52 percent annualized rate recorded in March 2021.

Housing prices fall, while help with inventory may be on the way: According to data out last week from the National Association of Home Builders (NAHB), optimism among home builders continued to improve. The latest sentiment reading in its Home Builders Index came in at 56, up one point from June’s reading of 55 and marking the second reading in positive territory since July 2022. The uptick comes despite survey respondents raising concern of a recent quarter-point rise in mortgage rates. In a statement accompanying the release, NAHB Chief Economist Robert Dietz noted, “Although builders continue to remain cautiously optimistic about market conditions, the quarter-point rise in mortgage rates over the past month is a stark reminder of the stop-and-start process the market will experience as the Federal Reserve nears the end of the ongoing tightening cycle.”

While builders may be feeling more confident, the upbeat outlook did not translate to more building activity. Single-family housing starts in June fell 7 percent from the prior month and are down 8.1 percent on a year-over-year basis, according to data from the U.S. Commerce Department. The monthly and annualized declines follow a sharp rise in activity in May. We don’t believe the latest decline marks an inflection in the recent increases in new home construction, as building permits for single family units rose 2.2 percent from May’s upwardly revised level. While the continued gains in single-family permits may point to easing of some of the supply issues plaguing the housing sector, a decline in multi-family construction was discouraging. For the month, multi-family housing (two or more units) starts declined 9.9 percent from the prior month. Similarly, multi-family permits issued were down 12.8 percent from May.

The easing activity in the new construction market was mirrored in the latest existing homes data. The National Association of Realtors reported that existing home sales in the U.S. declined 3.3 percent in June to a seasonally adjusted annual rate of 4.16 million units. The decline resumes a streak of declining sales that began in January 2022 and was interrupted only in February and May of this year. On a year-over-year basis, sales were down 18.9 percent. The inventory of unsold homes was unchanged at 1.08 million units and remains below pre-pandemic levels. Prices edged higher but remained 0.9 percent lower than June 2022. Price movements continued to vary by region, with sale prices falling in the South and West but rising in the Northeast and Midwest. Given the more than 12-month lag for shelter prices to make an impact on both the Consumer Price Index and Personal Consumption Expenditures readings, we expect the year-over-year decline in home prices will provide continued momentum for the disinflationary process in the months to come.

Jobless claims fall: Weekly jobless claims fell to 228,000 from last week’s 237,000 new claims. The four-week rolling average of new jobless came in at 237,500, down 9,250 from the previous week. Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.754 million, up 33,000 from the prior reading.

The week ahead

Monday:  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 July. Activity for manufacturing continues to show weakness, while the services side has remained resilient. We will be watching for signs of tempering of growth on the services side. We’ll also be looking at inventory levels and readings for new orders to gauge the path forward for both industries.

 Tuesday: We’ll watch the S&P CoreLogic Case-Shiller index of property values. Home sales and prices overall have continued to sag over the past few months, with some regions showing stability while others have seen prices continue to fall. We will be watching to see if modest declines in mortgage rates have slowed the year-over-year decline in home values.

The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work.

Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following its monthly meeting. We expect the Fed will raise rates by 25 basis points, and we will be listening for indications of whether the Fed believes it will be necessary to continue to hike given the still strong employment picture.

Data on durable goods orders for June will be released to start the day. We’ll be watching for signs that consumer appetite for big-ticket purchases remains tepid despite recent increases in consumer sentiment.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings and continuing claims fell last week, and we will be watching to see whether the uptick was a temporary blip.

Friday: The June Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions. We will be scrutinizing this report with a particular focus on the services side of the reading, including shelter costs.

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