Economic and Financial Markets Review, June 2023
At the risk of mixing metaphors, we continue to wait for Godot’s other shoe to drop. Whether it is the long-anticipated recession, more bank failures (or something else in the financial system breaking as the Federal Reserve tightens monetary policy), a return to the stock market lows of last October (or lower), or a move back up to 4-percent-plus yields on 10-year Treasury notes, none of these bad events has occurred (yet). And a new geopolitical risk has suddenly emerged with the (apparently) short-lived mutiny in Russia from the Wagner Group. But despite the economy and financial markets continuing to move upward, do we see Godot emerging through the fog? Or is that just the echo of another shoe dropping well over the horizon?
The job market continued to be solid over the past couple of months, and that is ultimately the most important bellwether for the economy. As we reported here last month, nonfarm payrolls (NFP) jumped by 339,000 for May (with large upward revisions for the prior two months). This is strong growth for any period, but it is especially solid (and unusual) given that payrolls are nearly four million above the previous peak and we are more than three years past the end of the Covid recession. The U-3 unemployment rate moved up to 3.7 percent, a historically low figure but a big jump from the prior month’s level (3.4 percent, a figure not bettered since 1953). Monthly increases of that magnitude occur only rarely outside of economic downturns. And, as noted in our last report, the pace of job gains and the low level of unemployment are not sustainable without causing wages to rise – and ultimately prices to rise further with anemic productivity gains. Strength was also shown in the April Job Openings and Labor Turnover Survey (JOLTS) with a substantial increase in job openings. Moreover, the ratio of job openings to the number of unemployed persons (perhaps the best measure of slack in the job market) rose to 1.79 for the month, more than three times its long-run median. More recently released job market indicators also show strength, with the jobs gap (jobs plentiful less jobs hard to get) in the May Consumer Confidence Survey moving higher again. But there may be an early sign that the job market is becoming less heated. The four-week average of weekly unemployment claims moved up modestly in June, although the level remains low. Until the labor market cools significantly, it will be hard for the economy to slip into a downturn.
The ongoing strength in the job market continues to push consumer spending upward in nominal terms. Retail sales for May rose by 0.3 percent, despite a drop of 6.5 percent in unit light vehicle sales. Core retail sales (excluding autos, gasoline, and building supplies) increased by a modest 0.2 percent – barely beating the monthly increase in inflation. The broader measure of personal consumption expenditures (PCE) increased by only 0.1 percent for June and was little changed when adjusted for inflation – as has been the case for the past four months (after a surge in January). On an annualized basis, real PCE growth over the most recent four-month period has averaged only 0.4 percent. With consumer spending roughly two-thirds of all GDP, is this a sign that overall economic growth is poised to slow? It seems so, although it would be useful to see several additional months’ worth of data before having confidence in that view. For example, the Conference Board’s Consumer Confidence Index jumped in June to the highest level since the start of 2022, hardly the stuff of a major cutback on the part of consumers. Still, financing rates have increased significantly since the Fed started tightening monetary policy, and this is making it more difficult for consumers to purchase items on credit. New 48-month bank auto loan rates, for example, have moved to their highest levels since at least 2004.
Housing activity remained mixed over the past month, with the new side of the market showing renewed strength and the existing side remaining supply-constrained. New home sales soared by 12.2 percent in May to reach their highest annualized pace since the start of 2022. Builders are responding to the pickup in demand by increasing construction activity. As a result, housing starts jumped, rising to the highest annualized pace in a year, with both single- and multifamily starts up sharply. On the other hand, existing home sales were little changed in May at low levels. Moreover, pending home sales (existing sales counted at contract signing, as are new sales) dropped by 2.7 percent in May and are at their lowest level this year, signaling a drop in existing sales for June. Despite higher prices and mortgage rates, solid job growth and positive demographics are boosting housing demand – but this is showing up primarily in the new home market as homebuilders can respond by increasing housing starts. Most existing homeowners have historically low mortgage rates, and they appear to be wedded to them. Even if a current homeowner was able to find an acceptable house today at the same price as the median-priced home of two years ago, the jump in mortgage rates (from approximately 3.00 percent to around 6.50 percent) would mean that the monthly payment (assuming a 20 percent downpayment) would be nearly 50 percent higher. More existing homes will come on the market over time, but on a seasonally adjusted basis the number of single-family existing homes for sale in May was the fewest all the way back to 1982 (except for two months at the start of last year). For the foreseeable future, growth in the housing market will remain with new construction.
Measures of business activity have been mixed for a while. The overall index from the Institute for Supply Management (ISM) manufacturing survey for May was below 50, indicating contraction, for the seventh consecutive month. (Note that as this report was being finished, the June survey showed that this measure declined for an eighth consecutive month). The Small Business Optimism Index from the National Federation of Independent Business (NFIB) edged higher in May, but remains at historically low levels. The services side of the economy continues to expand, with the ISM services survey remaining barely above the breakeven level of 50 for May.
Leading indicators of recession continue to point strongly toward a downturn, even if it hasn’t started yet. The Conference Board’s Index of Leading Economic Indicators (LEI) has now declined for 14 consecutive months, and May’s 12-month change of -7.9 percent is at a level that has always preceded recessions (although it was marginally better than April’s -8.0 percent). Additionally, the yield curve continues to be significantly inverted, with short-term rates above long-term rates. This inversion is slightly less steep than at the beginning of May, but it is still close to the steepest it has been since at least 1981. The lags involved with monetary policy changes are long and variable, suggesting that it is difficult to determine when a recession will begin after these indicators turn negative. But they have been reliable guides in the past, and they are likely to be correct in their signaling this time, too.
Inflation and the Federal Reserve
Inflation has undeniably slowed over this year, but the 12-month trend rates continue to be well above the Fed’s long-term goal of 2.0 percent. The trend rate for the Fed’s preferred inflation measure, the Personal Consumption Expenditure (PCE) Price Index (a much broader measure of inflation than the more commonly viewed Consumer Price Index, CPI), dropped to 3.8 percent for May, the slowest in about two years. But the core rate (removing the volatile food and energy components) was little changed at just above 4.6 percent. Additionally, the “super core” inflation rate (PCE services less energy and housing), slipped only slightly to 4.5 percent – not significantly different from the pace at the start of the year. The Zillow Observed Rent Index continued to show slower trend increases, down to just under 5.0 percent in May (compared with 7.0 percent in June and 17.2 percent at its peak in February 2022). As with Godot and the other shoe, we continue to wait for slower rent gains to have a meaningful impact on slowing the broader inflation figures.
The overall picture – declines in overall inflation, but not much in core inflation and still at trend rates well above its longer-term goal – places the Fed in a difficult position. Should it continue to pause its ongoing tightening (as it did at the June FOMC meeting), waiting to see if inflation continues to slow, and eventually move back within bounds? If successful, this approach might be able to engineer a soft landing – bringing inflation back to the Fed’s goal without a recession. But if unsuccessful, inflation would continue above the Fed’s goal, raising the risk that higher inflation would become embedded in wage- and price-setting behavior, resulting in even more tightening later on – and thus creating the basis for an even more severe recession down the road. Or should the Fed tighten further now, responding to trend core inflation that hasn’t budged much this year? This course of action would almost certainly result in inflation moving back to the Fed’s goal sooner but with a heightened risk of a near-term recession (perhaps already unavoidable at this point).
Listening to recent statements from Fed Chair Powell, the majority of FOMC members have decided on the latter course for now. The median of projections from the FOMC members after the June meeting showed another 50 basis points of tightening this year. How much the Fed actually tightens before stopping in this cycle will depend on when and how quickly core inflation moves back toward the Fed’s 2.0 percent goal, as well as on whether the economy falls into recession. The longer inflation remains above the goal, the more the Fed will tighten, especially if the economy continues to expand. As difficult as the Fed’s decisions are today on tightening, they will be even more difficult if the economy stumbles with inflation still high.
It’s been two months since the last bank failure, despite pressure on bank net-interest margins from the inverted yield curve. Moreover, the debt limit agreement has taken federal default concerns away from financial markets. Still, there are lots of things to be concerned about, including more Fed tightening, recession risks, earnings, and geopolitics (not to mention US politics as the country gears-up for the 2024 elections).
With the Fed passing on tightening at the June FOMC meeting, short-term rates were little changed over the month. At the end of May, the yield on the 1-month Treasury note was 5.28 percent (down from 6.02 percent the Friday before, when a default of some sort seemed probable). At the end of June, the yield was lower by 4 basis points. Longer-term rates edged higher over the month, with the 10-year Treasury yield climbing by 17 basis points to 3.81 percent (and 3.86 percent at the start of July, toward the upper end of its recent range). At least some of this increase in longer-term rates likely stems from modestly higher inflation expectations, with the implied 5-year inflation rate rising to the highest level since early May. Credit spreads on investment-grade corporate bonds edged a bit higher over the month, but spreads on non-investment-grade (junk) bonds dropped over the month to the lowest levels since last March. So much for recession fears.
And speaking of shrugging off concerns about recession (and earnings), broad equity market averages moved solidly higher over the month. From the end of May to the end of June, the S&P 500 Index climbed by 6.5 percent. It is now up by 15.9 percent thus far in 2023 (and by 16.3 percent from a year ago). The Dow Jones Industrial Average rose by 4.6 percent last month (and by 3.8 percent this year), while the NASDAQ Composite jumped by 6.6 percent in June (and is up by a cool 31.7 percent so far this year). Mid- and small-cap averages finally joined the romp upwards, with gains of 9.0 and 8.0 percent, respectively, for June (and by 7.9 and 5.1 percent for the year).
Equity market averages are clearly not terribly concerned about a recession (and the resulting impact on earnings), while fixed-income markets are more concerned about Fed tightening and inflation than they are about a downturn in the economy. Financial markets are not waiting for Godot, nor are they concerned about other shoes dropping. Still, the Fed is likely to tighten further, inflation-adjusted consumer spending is slowing, and leading indicators of a downturn continue to signal caution.
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