Investors Reconsider the Likelihood of a Soft Landing

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

Equities finished in the red for a third straight week as minutes from July’s Federal Reserve Board meeting raised concerns that the Fed may continue to raise interest rates in response to a resilient job market and strong wage growth. While the futures market shows that investors still believe the Fed will hold rates steady at its next meeting, expectations for a rate hike at the Fed’s November meeting have crept higher, and market pricing suggests the likelihood of a rate cut by the end of the year has fallen to less than 10 percent. To be sure, Fed rate futures contracts have been notoriously volatile over the past year, but the recent trend suggests investors may be revisiting what were (until a few weeks ago) widespread expectations for a soft landing.

We have been skeptical of the likelihood of a soft landing based on the ongoing strength of the job market and wage growth that has remained above 4 percent year over year since the post-COVID recovery took hold. The Fed views 4 percent as the upper end of acceptable wage increases because it represents the sum of the historical average 2 percent growth in worker productivity (worker output per hour) and the 2 percent in annual wage increases the Fed believes the economy can absorb without sparking an economically damaging rise in inflation. While the pace of wage gains has eased from its recent high of 7 percent in March 2022, the gains remain elevated at 4.8 percent, according to the July Nonfarm Payroll report. A sustained rise in productivity could offset some of the inflationary pressures of wage gains above the Fed’s target. However, we believe the Fed sees recent productivity gains as temporary and will be sensitive to signs, such as last week’s retail sales report, that show larger paychecks are fueling increased demand for goods and services.

The latest retail sales numbers from the U.S. Census Bureau shows overall retail sales in July were up 0.7 percent from June’s upwardly revised reading and well above Wall Street estimates of a 0.4 percent increase. The latest data shows retail sales are up 3.2 percent on a year-over-year basis. While the sales numbers are not adjusted for inflation, the latest monthly reading indicates that consumer purchases outstripped price increases in July. Despite the strength of the latest sales data, the future remains less clear. The Federal Reserve Bank of San Francisco believes that excess savings that consumers stockpiled during COVID will run out this quarter. The depletion of savings along with the resumption of student loan payment requirements in September is likely to put a crimp in spending habits for millions of consumers. These headwinds have been highlighted in earnings calls of some large national retailers who have noted that consumers are resilient but budget conscious and that retail sales may slow during the remainder of the year.

As such, we believe the Fed will continue to try to drain excess liquidity from the economy through high interest rates and quantitative tightening to reduce economic growth and take the steam out of rising wages. As liquidity continues to dry up, we believe spending levels will come down, and unfortunately unemployment will potentially rise, tipping the economy into a mild recession. Fortunately, with inflation falling as it has, the Fed should have room to cut rates to soften the blow of an economic downturn.

Wall Street Wrap

Industrial production remains lower than year-ago levels: Overall Industrial production rose 1.0 percent in July, according to the latest data from the Federal Reserve. Overall, the measure has been negative in two of the past three months, including June’s decline of 0.8 percent. Manufacturing, the largest component of industrial production, rose .5 percent, offsetting June’s .5 percent decline. July’s reading received a boost from automobile manufacturing, which was up 5.2 percent. All other factory output combined was up a much smaller 0.1 percent for the month. The latest reading marked a 0.7 percent decline in industrial production on a year-over-year basis. Negative year-over-year readings of this measure have historically coincided with recessions. To date, strength from the services side of the economy has so far been able to offset the manufacturing weakness. Whether services will be able to continue to carry the load is yet to be determined, especially given the tightening macro-economic conditions.

Forward-looking indicators point down: The latest Leading Economic Indicators (LEI) report from the Conference Board continues to suggest that the economy is either in recession or on the cusp of one. The July LEI reading declined 0.4 percent. The latest measure marks the 16th consecutive month of decline. The reading is now down 7.8 percent on an annualized basis over the past six months. Weakness continues to be widespread, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering just 30 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.

While the LEI reading continues to suggest that a recession is likely in the coming months, the Coincident Economic Indicators (CEI), which measure current conditions, improved. However, the dispersion between the two (leading minus coincident indicators) remains in negative territory.

The streak of declining readings despite the favorable CEI data points to a rocky road ahead. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “In July, weak new orders, high interest rates, a dip in consumer perceptions of the outlook for business conditions, and decreasing hours worked in manufacturing fueled the leading indicator’s 0.4 percent decline. The leading index continues to suggest that economic activity is likely to decelerate and descend into mild contraction in the months ahead.”

Optimism among home builders takes a step backward: The latest sentiment reading from the National Association of Home Builders (NAHB) came in at 50, down from the prior month’s reading of 56 and the first decline in the reading since December 2022. The reading is the lowest level since May of this year. The index had moved higher during the past three months, but sentiment retreated as mortgage rates climbed above 7 percent nationally in recent weeks. In a statement accompanying the release, NAHB Chief Economist Robert Dietz noted the impact higher rates were having on the industry: “While this latest confidence reading is a reminder that housing affordability is an ongoing challenge, demand for new construction continues to be supported by a lack of resale inventory, as many homeowners elect to stay put because they are locked in at a low mortgage rate.” To offset the impact of higher interest rates, more than half of builders—55 percent—reported offering some sort of incentive to entice buyers, with 25 percent reporting they cut prices on new homes.

While builder confidence took a step back, building activity moved higher. Single-family housing starts in July rose 6.7 percent from the prior month to a seasonally adjusted annualized rate of 983,000 units, according to data from the U.S. Commerce Department. The latest estimate marks a 10 percent increase on a year-over-year basis. Meanwhile, multi-family starts were 469,00, down 1.7 percent from June’s pace of 477,00. Permits for single-family units rose by 0.6 percent from June and are up 1.3 percent on a year-over-year basis. While these numbers have stabilized in recent months, they remain well below their post COVID highs. Current high mortgage rates have made housing unaffordable, and we believe the housing sector as a whole will likely tread water during the coming quarters.

Jobless claims move lower: Weekly jobless claims were 239,000, down 11,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 234,250, up 2,750 from the previous week’s upwardly revised average. Continuing claims (those people remaining on unemployment benefits) rose to 1.716 million, up 32,000 from the prior week’s reading.

The week ahead

Tuesday: We’ll get a look at existing home sales mid-morning by the National Association of Realtors. We’ll be watching to see how the recent uptick in mortgage rates is affecting sales.

Wednesday: 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 for manufacturing continues to show weakness, while some recent data has pointed to an easing of growth on the services side. We will be watching for signs to determine whether the slowing on the services side was a temporary lull or the potential beginning of a trend. We’ll also be looking at inventory levels and readings for new orders to gauge the path forward for both industries.

Thursday: Thursday is when the Kansas City Federal Reserve’s Jackson Hole Symposium kicks off. The Symposium runs through August 26, and Federal Reserve Chairman Jerome Powell is set to speak on August 25 at 9 a.m. CT.

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.

Initial and continuing jobless claims will be announced before the market opens. Initial filings were down last week, and we will be watching to see whether last week’s decrease was a temporary blip or a sign of continued strength in the job market.

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