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Saturday, May 18, 2024

Capital markets perspective: Soft landing or economic doom?

Capital markets perspective: Soft landing or economic doom?

07.31.2023

Agree to disagree.

According to Federal Reserve Chairman Jerome Powell, the U.S. economy has been resilient enough in recent weeks to convince the army of staff economists at the Federal Reserve to back down from their previous view that a recession is looming1. On the other hand, economists at the Conference Board – a non-profit think-tank that publishes a closely-watched survey of consumer confidence– still anticipate that a recession will probably arrive before year-end2.

The Conference Board’s assessment came despite a big improvement in consumer confidence that included a reading above 80 on the so-called expectations index: that’s significant because a reading below 80 – where the expectations index has spent much of the last 18 months – typically suggests recession. In other words, consumer expectations improved enough this month to allow Conference Board economists to haul down the red flag recession warning that their data had been indicating for more than a year, but they chose not to. The Conference Board, it seems, is disagreeing not only with Powell and his team of economic forecasters, but also with respondents to their own survey.

I admit to being sympathetic to the Conference Board’s view. Call it stubbornness, misguided risk aversion or just a generally grumpy disposition when it comes to all things economic, but it’s still hard for me to believe that the economy can entirely sidestep 5.25% of very aggressive Fed tightening without enduring at least a mild recession, even if data like consumer confidence and last week’s PMIs might suggest otherwise (for the record, manufacturing PMIs – which have been signaling contraction pretty consistently since last October – inched surprisingly close to neutral in July3.)  It just feels like something’s out there – something potentially bad – that all the upbeat labor market data, improving consumer sentiment and equity market strength that we’ve enjoyed so far this summer may not fully account for.

I get it, there are plenty of reasons to embrace the view that Powell and his Fed have successfully engineered what was once thought to be almost impossible: a soft landing. Beyond last week’s above-mentioned PMI and consumer confidence data, we also learned that GDP grew a better-than-expected 2.4% in the second quarter4 and that consumers continued to spend at a faster-than-expected rate even though incomes seem to be stabilizing a bit5. Moreover, last week’s read of both inflation and wage growth were notably tame, confirming recent data that suggests inflation is successfully being brought under control6. That’s all very good news that clearly supports the soft landing narrative.

But even Powell, who has perhaps the biggest dog in this fight, admits that it might take until 2025 before inflation is back at the Fed’s 2% target – an admission that caused equity markets to belch up pretty much all of their gains following Wednesday’s Fed decision. Moreover, core inflation remains sticky enough that nobody (including Powell) can completely rule out renewed Fed aggression, not to mention that the last version of those staff projections that have apparently now moved away from recession as their base-case said that risks were still weighted decidedly to the downside7.

And it goes without saying that unexpected shocks could easily derail the accuracy of any forecast, including the Fed’s. For example, will the pending resumption of student loan payments in October be enough to derail recent gains in consumer confidence and finally cause consumption to tip over once and for all? Or, could Russia’s recent decision to pull out of the UN-brokered deal, allowing Ukrainian grain to continue to exit the Black Sea, reignite headline inflation in a way that the Fed simply can’t ignore? (Ditto for an unexpectedly cold winter, which could put renewed pressure on energy prices.) And then there’s the corporate sector, which has so far escaped too much damage from the Fed’s relentless campaign but now stands accused of post-pandemic “employee hoarding” that might eventually prove too expensive if the economy softens further. Who knows, but these are the types of things that the U.S. recession debate now hinges on.

Either way, it’s pretty clear that a philosophical disagreement about the future path of U.S. growth has sprung up between two groups — those who view a recession as unlikely and those who hold onto an apocalyptic prediction. At least one thing is certain: This is the debate that’s currently driving markets.

And oh, yeah, before I forget: The Fed boosted rates another 0.25% last week. (I guess it tells you something about where the market’s head is at that it took eight whole paragraphs of mixed metaphors and split infinitives for me to finally mention that…) Have a great week.

What to watch this week

Economic Events

July 31 – August 4              

Monday: Senior Loan Officer Survey; earnings: ON, WDC, n=150

Tuesday: JOLTS, ISM/PMI manufacturing; earnings: AMD, CAT, BP, big pharma, SBUX, n=260

Wednesday: ADP payrolls; earnings: n=480

Thursday: Challenger job cuts, productivity/ULCs, ISM/PMI services, jobless claims; earnings: AAPL, AMZN, n=600

Friday: Payrolls; earnings: XOM, CVX, PG; earnings: BRK, n=170

In discussing last week’s decision to boost rates, Powell singled out the fact that he and his pals will get two more reads on both inflation and payroll growth before they have to make their next decision in September. The first of these reports appears on Friday, when the Bureau of Labor Statistics releases its latest look at unemployment, labor force participation and payroll growth. But at least as important will be Tuesday’s JOLTS report (which, among other things, details how many job openings exist in the U.S. and how comfortable people are leaving their existing employer for greener pastures). JOLTS has been one of the most obvious signs of excessive labor market tightness, and if the real trick to achieving a soft landing will be letting the air out of an over-inflated jobs market without causing it to pop, then things like payroll growth, JOLTS and Thursday’s Challenger job cuts report will be a good test to see how likely that really is.

This week will also feature our final PMIs for July – manufacturing on Tuesday and services/non-manufacturing on Thursday. As mentioned above, manufacturing activity seems to be inching back toward the line dividing expansion and contraction after almost a year in the red. Services activity, on the other hand, has been downright robust but is now starting to ease. Look for these two readings to continue to converge this week; which side of the 50-yard line that conversion takes place will eventually tell us a lot about whether the U.S. economy can continue to gather momentum.

Those two big events – payrolls and PMIs – would ordinarily be more than enough to keep anyone concerned about the economy busy all week long. Add to that the continued ramping up of earnings season (more than 1,000 companies are scheduled to release results on Wednesday and Thursday alone), and there’s more than enough for even the most data-driven economist to chew on. But given where we currently find ourselves, I’d be remiss if I didn’t point out two other economic releases that ordinarily don’t get a whole lot of attention.

The first of these is Monday’s Senior Loan Officer’s Survey (“SLOOS” for short.) SLOOS is a survey of bank officials conducted every three months by the Federal Reserve that seeks to gather information on loan demand, lending standards and whether bankers are becoming more or less willing to embrace risk. Before the regional banking crisis in March, these bankers were already becoming more sheepish – an attitude that became even more entrenched after Silicon Valley Bank went belly-up. If that trend continues, or if loan demand continues to fall, it would be another important sign that the Fed’s relentless rate-raising campaign is effectively cooling off economic activity. As with the jobs market, the trick will be to get this just right: weak enough to suggest a much-needed cooling, but not so weak that it risks creating an economic shock.

And then there’s productivity. In an academic sense, productivity is pretty much the Holy Grail for economists because economic growth built on a strong foundation of rising productivity can create higher living standards across the economy. But productivity releases themselves don’t tend to get a whole lot of attention because the line connecting productivity to actual trends in the here-and-now is so long and obscure that markets have little incentive to care. Once in a while, though, productivity can tell you a lot about the current environment: for example, if the concept of “job hoarding” is real, then we should eventually see productivity begin to decline as companies use more and more workers to produce less and less output. If that trend becomes pronounced, the next question will ultimately be how long firms are willing to endure the costs associated with payroll bloat before beginning to shed excess workers. That’s a lot to ask of a productivity report that ordinarily gets only a very small share of the spotlight, but Thursday’s report might nonetheless be worth a quick read.

 

1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20230726.pdf

2 https://www.conference-board.org/topics/consumer-confidence

4 https://www.bea.gov/sites/default/files/2023-07/gdp2q23_adv.pdf

5 https://www.bea.gov/sites/default/files/2023-07/pi0623_fax.pdf

6 https://www.bls.gov/news.release/eci.t01.htm

7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230614.pdf

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Tom Nun, CFA

Contributor

Tom Nun, CFA, Portfolio Strategist at Empower, works alongside teams overseeing portfolio construction, advice solutions, portfolio management, and investment products and consulting.

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