Two Burning Questions That Are Driving Market Volatility

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

While investors remain fixated on inflation, Federal Reserve tightening and economic growth, the volatility we’ve seen in the markets recently, including this past week, is being driven primarily by two questions on investors’ minds: 1) How quickly will inflation ease? 2) Will pressures subside fast enough that the Fed can be patient and not tighten the U.S. economy into a recession?

The uncertainty around these two questions has fueled pessimism and caused investors to regard much of the economic data coming out — good or bad — as another sign that a recession is on its way. For example, the surprisingly strong employment report on Friday was greeted with selling on Wall Street, as investors saw it as another sign that the Fed would be forced to ratchet up rates to starve too-hot economic growth. Similarly, investors blanched at the latest ISM Manufacturing and Services data despite it showing the 24^th consecutive month of growth. The concern in the markets was that the growth was a little slower than expected. But remember, if the economy expands too fast, it will add fuel to the inflation fire. Slower growth should allow supply chain bottlenecks to improve, reduce wage inflation and tamp down rising input costs driven by supply constraints.

Highlighting the extreme pessimism on Wall Street isn’t meant to distract from the unique challenges the Fed is facing in its effort to stick a soft landing. The task is clearly made more difficult by the Russia-Ukraine war and its impact on energy and other commodity supplies as well as the unwinding of numerous factors related to COVID. However, the data are largely consistent in showing that progress is being made on the inflation front, and we believe the economy remains on track to edge higher in the second half of the year and equities will follow.

Wall Street wrap

Recent data continue to point to resilient growth in the economy and suggest inflation is slowly rolling over. We will be closely monitoring the inputs that are driving price pressures and expect to see more improvement in the coming weeks and months.

Employment numbers strong but slowing. Employment growth remains strong, with 390,000 jobs added in May, including 333,000 in the private sector, according to the latest report from the Bureau of Labor Statistics. The report surprised Wall Street and was stronger than a more tepid number issued in the ADP National Employment Report earlier in the week. Important to note is that the pace of hiring slowed and dipped below 400,000 jobs for the first time in 12 months and is the slowest pace since April 2021.

Importantly, the unemployment rate stayed steady at 3.6 percent despite the new hires because there was an uptick in the number of people rejoining the labor market. Labor participation grew by 330,000, bringing the total to 2.1 million new entrants year to date. This is significant because, as the number of people entering the workforce continues to grow, it will ease competition for employees and should slow the growth of labor costs for businesses. Going forward, we would like to see an acceleration of adults entering the workforce and a further reduction in the pace of hiring so supply and demand grow closer to balanced.

In the interim, wage growth is starting to slow, with average hourly earnings up .3 percent compared to expectations of .4 percent growth. This puts year-over-year increases at 5.2 percent — off the 5.5 percent rate in April — and we expect slower numbers are on the way. The six-month annualized rate of wage increases is 4.6 percent, and the four-month annualized pace is 3.8 percent.

Positive news from manufacturers and service providers. Growth in the services sector continued, with the latest reading clocking in at 55.9, down from 57.1 the previous month (readings above 50 signal an expansion). New orders increased, while customer inventories shrank. The result is a pipeline of continued demand for future production.

Noteworthy in the report was a decrease in the reading of backlogs to 52 from 59.4, which should alleviate some bottlenecks. Likewise, supplier delivery times are improving, which should lead to a further reduction in manufacturing constraints. Both order backlogs and delivery times are at the lowest levels since March 2021.

Growth in the manufacturing sector edged higher in May as the latest ISM Manufacturing PMI data showed an increase to 56.1, up from April’s reading of 55.4. New orders also increased, while customer inventories shrank. We believe some of the manufacturer data may be impacted by the ongoing challenges caused by China’s efforts to fight COVID outbreaks domestically. Note that we are beginning to see easing of COVID-related lockdowns in China. Last week we saw a two-month lockdown lifted in Shanghai, China’s largest city.

Noteworthy in the report was a modest decrease in readings for costs for companies producing goods. Delivery times from suppliers remain elevated but showed signs of peaking. Respondents also reported making progress in addressing labor shortages. While the growth in production and new orders is welcome, the improvements in delivery time readings, costs and labor are an important element in slowing goods inflation.

The week ahead

It’s a light week for data ahead, but here are some of the things we’ll be watching.

Tuesday: The Federal Reserve will release its latest Consumer Credit report. Consumers’ balance sheets have been an area of strength, and we will be looking to see if consumers have been taking on more debt in response to rising prices.

The Bureau of Economic Analysis releases its report on the U.S. trade balance as of April. Changes in the data could shed some light on the ripple effects of China’s efforts to battle domestic COVID cases as well as the ongoing impact of the Russia-Ukraine war on the global economy.

Wednesday: Final wholesale inventory numbers for April will be released after market open. Of interest will be any revisions to the direction of inventories from initial readings.

Friday: The U.S. Bureau of Labor Statistics will release its Consumer Price Index for May. This report, while not as heavily relied upon by the Fed as the Personal Consumption Expenditure price index is, will give an early read on whether inflation is continuing to ebb for consumers.

The University of Michigan will release its preliminary report on May consumer sentiment as well as five-year economic expectations. Sentiment showed signs of eroding in the last report, and we’ll be watching for changes that could affect consumer spending decisions in the near term.

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