"Further evidence required.”

It usually doesn’t make much sense to lead a weekly review of capital markets with a quote from the Fed minutes. After all, as notes from a meeting that took place weeks ago, the minutes are inherently backward-looking – if markets were prone to react to anything said or done by Federal Reserve chair Jerome Powell and his pals during the meeting, they probably would have done so in the aftermath of the meeting itself (which, for the record, was July 25-26). That’s doubly true for a meeting where the decision to boost rates another quarter-point was about as controversial as placing Alabama in the top three of the NCAA’s pre-season coach’s poll, or picking the U.S. Women’s National Team as the #1 seed in the World Cup. (Sadly, we all know how that turned out. Ugh.)

But I pulled that phrase out of the ten pages that comprise the official record of the Fed’s rate-setting committee’s late July meeting because I do think there were a few market participants who were caught off guard by it. It’s become consensus that the Fed is slowly winning the war on inflation, and the most recent readings of the Consumer Price Index and Producer Price Index did a lot to help further that belief. But in what must’ve felt like uncomfortably terse language to the soft-landing crowd, FOMC participants copped to the idea that they’re not yet satisfied that the war is over by admitting that there are still “upside risks to inflation” and that “further evidence would be required for (the Committee) to feel that inflation was clearly on a path toward 2%^[1].” Not exactly reassuring words for those who still believe the Fed will be in a position to begin cutting rates soon.

So Fed officials are on watch for evidence that the economy might be reverting to its old inflationary tendencies. They almost certainly didn’t find reassurances in last week’s retail sales report, which showed that U.S. consumers are still in a spending mood: sales at the retail level rose 0.7% in July, the fastest since February and almost twice as fast as economists predicted^[2].  

Truth be told, it’s probably unrealistic to expect retail sales to suddenly collapse just because the Fed is being aggressive. In fact, it’s not really unusual at all for consumers to continue spending at a healthy clip even while the Fed is raising rates (not least because official retail sales data as reported by the Census Bureau isn’t adjusted for inflation or for trend.) For example, during the 2008-2009 “Great Recession,” retail sales only dipped meaningfully below trend well after the Fed began cutting rates. But whatever … last week’s retail sales data still feels a little out-of-sync with the reality of the most aggressive Fed tightening campaign in recent history, if only because spending at the nation’s retail outlets remains so far above trend after a whopping 5.25% of Fed-sponsored rate hikes in a very short period of time.

Ordinarily we could look toward retailers themselves to help untangle the mess, but last week’s earnings reports also provided very little clarity. Investors seemed to like Target’s quarterly earnings report just fine, even though the retailer guided full-year results lower and grumbled that consumers have become less focused on the discretionary items that comprise a relatively large percentage of its SKUs when trying to explain why revenue trends were weak. Walmart, too, bemoaned a “choppy” retail environment and has remained cautious on consumer trends even as they saw store traffic and sales trends rise^[3]. While this could simply be evidence that consumers are becoming increasingly careful with their money and seeking lower-priced alternatives, the fact remains that Americans are still spending, self-scanning their items and plopping them into their own recyclable bags with a measure of abandon that seems misaligned with the Fed’s efforts to cool things off. Said even more plainly, as long as consumer spending continues to accelerate, fears of a nasty re-ignition of inflationary pressures will never fully fade away.

But what about the productive portion of the economy? Last week’s regional Fed manufacturing reports were equally confusing: New York’s Empire State survey reported a collapse in new order activity^[4], while the Philly Fed surprised in the opposite direction^[5]. It would be easy to blame the sad state of professional sports in New York for the difference (both the Mets and the Yankees are near the bottom of their divisions while the Phillies are second in theirs, and even the Aaron-Rodgers infused New York Jets only manage a power ranking of 8^th to the Eagle’s #2,)^[6] but the weirdness continues at the national level, too: Industrial production expanded a much better-than-expected 1.0% and capacity utilization advanced by an unusually robust 0.7% in July^[7]. Some of that can be written down to a heat wave across much of the country that significantly boosted utility output, but auto manufacturing was also up a very stout 5.2% (perhaps channel-loading in advance of contentious labor negotiations at Detroit’s “big three” next month?).

Either way, as last week’s data suggest, the sentiment “further evidence required” resonates far beyond just the inflation debate.

There are too many cross-currents in the economic environment to count right now, and unless and until the data produce a clean break in one direction or the other, trends are confusing and contradictory enough that calls for either a soft landing on one hand, or a deep recession on the other, will remain mostly a matter of faith. Said another way, exactly where you fall out on the “recession/no recession” spectrum may say a lot more about your personality than it does about your ability as an economic prognosticator.

Finally, one more tidbit before we move on: It’s getting harder and harder to ignore the giant sucking sound currently coming out of China. Suffice to say that the country’s own expectations for a powerful rebound when the last of the Zero-COVID restrictions were removed at the beginning of this year never materialized and Chinese officials are now actively looking for ways to stimulate their own economy. Last week’s news included a surprise cut in lending rates, a long-expected descent into bankruptcy for a troubled property developer, unusual currency volatility and even a suggestion that China might want to consider joining “the helicopter club” by showering citizens with direct-to-consumer stimulus checks of the same sort that contributed to all this inflationary pressure in the first place, at least among its developed-market peers.

The old cliché was “when the U.S. economy sneezes, the global economy gets the flu.” It’s looking more and more like we’ll soon have the opportunity to test whether the next logical extension is also true: If the world’s second-largest economy is really sick, can the world’s biggest avoid getting the sniffles? Looks like we’re about to find out.

What to watch this week

If last week’s data were confusing, this week might provide some clarity. On the consumer side, Friday’s mid-month update of consumer sentiment from the University of Michigan could put some much-needed context around last week’s better-than-expected retail sales figure. Was the increase in spending a reflection of increased optimism, or something more temporary? With gasoline prices on the rise again (and job markets starting to show a few preliminary signs of topping out), my vote is for the latter. Either way, hopefully the UofM’s release will shed some light.

The same goes for the industrial side of the economy. Thursday’s durable goods orders, together with two more regional Fed manufacturing reports and Wednesday’s flash Purchasing Managers’ Indices, could suggest who was when last week’s Empire State and Philly Fed surveys diverged by such a wide margin: Was it New York’s pessimism, or Philly’s optimism that captures the mindset of the nation’s manufacturers more clearly? Tune in this week to find out.

And then there’s housing. I failed to mention a fairly big setback in last week’s NAHB’s builder sentiment survey in the paragraphs above, but suffice to say that the nation’s homebuilders are suddenly feeling a little less upbeat than they were^[8]. All three indicators in the NAHB’s index were lower across each of the four regions surveyed, and while builders are still more constructive about the overall environment than they were at the beginning of the year (sorry, couldn’t resist…), a sudden and unexpected weakening in sentiment is probably not great news for the sector (or, by extension, the economy at large). Record-low affordability is almost certainly at play here, and it will tell us a lot more about the state of the housing sector when new- and existing-home sales are released this week.

Another item I neglected to mention was last week’s reading of the Conference Board’s index of leading economic indicators. That data remained deep enough in the red to allow the Conference Board to stick to its guns with its forecast that a recession remains likely in the near term. This week, the Chicago Fed will update its own National Activity Index, or “CFNAI” – designed to be a more concurrent view of the economy than the Conference Board’s LEI, but which nonetheless shares enough similarities in how its constructed and how broadly it reaches to serve as something of a rough cross-check on the LEI. If the CFNAI is signaling a downturn, then the Conference Board’s call of a pending recession will be easier to believe.