The Weekly Five

A Skip and Then a Jump?

June 2, 2023

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

Relief from the debt-ceiling impasse allowed economy-watchers’ attention to return to the usual suspects: inflation, jobs and what monetary policymakers will do. Disjointed labor data and more signs of wide variation in the health of different parts of the economy do nothing to make forming conclusions easy. Here are five takeaways from the week:

What are the most important consequences of the debt-ceiling deal?

The Fiscal Responsibility Act passed both houses of Congress and was on its way to becoming law on Friday, just days ahead of the U.S. facing default. The deal suspends the debt ceiling until after the next presidential election and includes modest spending cuts, including federal spending caps, clawing back unspent pandemic funds and eliminating and reallocating funds destined for the Internal Revenue Service.

We don’t see this as being impactful to the U.S. economic growth outlook and markets have greeted the deal constructively. While stress in the shortest tenors of the U.S. Treasury bill market relaxed, we can anticipate volatility later this summer as the government resumes issuing debt to refill its bare coffers. We will monitor the additional liquidity drain this represents, along with continued quantitative tightening; we anticipate that there will be ample demand for the shorter-dated bills in particular amid extremely high levels of money market fund balances.

Is labor market tightness showing any signs of relaxing?

The highly anticipated May nonfarm payroll report and other jobs data represent a bit of a confusing signal on strength in the labor market. According to the establishment survey, the U.S. economy created 339,000 jobs last month, roundly beating the consensus estimate for 195,000 new jobs. Further, last month’s report was revised upward to 294,000.

Beyond this strong headline, the unemployment rate rose to 3.7% from 3.4% as prime age workers, particularly older prime aged 45 to 55, continue to re-enter the workforce. Overall prime-age labor force participation sits above pre -pandemic levels. And the household survey painted yet a different picture, with a loss of more than 300,000 jobs, following two months of increase. The two monthly surveys the Bureau of Labor Statistics conducts often diverge month to month but tend to mean revert over time.

Differences between household and establishment measures for May notwithstanding, the overall picture is still strong — the weekly ADP data, monthly JOLTS data, and today’s payroll report point to tight conditions persisting in the labor market. We do see some fraying around these strong edges, with hours worked falling — which can presage job losses as companies typically cut hours before reducing headcount. As for earnings, wage inflation persisted, with average hourly earnings rising 0.3% month over month, a nearly 4% six-month annualized change. Our takeaway from this disjointed data is for continued strong labor markets supporting the U.S. economy, which supports our base case that the U.S. is likely to avoid a recession in 2023.

A skip and then a jump?

Expectations for the next policy move from the Federal Reserve have ebbed and flowed with the data, which the Fed has consistently cited as its guide. By that measure, there is certainly room for a rate hike at the mid-June meeting of the Federal Open Market Committee. The service sector continues to support economic growth, while strong labor markets continue to support consumer spending at trends incompatible with a 2% inflation target. That said, we have heard a more moderate message from Fed Chair Jerome Powell and others, suggesting that a pause to reflect on the cumulative impacts of the already aggressive policy stance may be in order.

In considering the long and variable lags between tighter policy and impact to the real economy, we see a logical sequence of events. The most interest-rate sensitive parts of the economy will be impacted first. Housing and manufacturing are both weak, reflecting the burden of a higher cost of capital. The services side of the economy — the dominant side — will be impacted with a much longer lag. We have started to see an increase in layoffs that have yet to be reflected in the overall jobs data, and we are beginning to see some fraying around the edges of the resilient consumer. Consumer credit data, along with some commentary from retail-sector earnings, seem to point to emerging stress, particularly at lower incomes. More spending on needs than wants, a pop in spending around payroll periods, and a higher consumer credit delinquency rate are all areas worth watching.

Market expectations for a June rate hike had risen to roughly 70% earlier this week, only to drop to 30% in response to muted manufacturing data reflecting weak activity and lower price pressures. The Institute for Supply Management’s index of manufacturing prices paid fell to 44.2 in May from above 53 in April, with 85% of respondents to the survey indicating that prices have either fallen or remained stable. We see outright deflation in certain areas of manufacturing, particularly in logistics and shipping, where rates have fallen significantly. We anticipate that the Fed will take a pause this month, but perhaps a hawkish pause, insofar as Powell will doubtless point to the job not being complete.

Is the concentration of recent equity gains worrisome?

More market observers are catching onto and commenting on the narrowness of the U.S. market advance, which we have noted. Large technology and technology-adjacent stocks represent nearly all of the market advance this year. Bank of America has dubbed the leadership the “magnificent seven:” Apple, Microsoft, Google, Meta, Nvidia, Tesla and Amazon. These stocks have dominated returns year to date and represent nearly 28% of the market capitalization of the Standard & Poor’s 500 Index.

Given the common narrative that these growth stocks are uniquely vulnerable to interest rate increases as they tend to sell at above market valuations, this performance and concentration is more perplexing: The last time the market was as concentrated in these large growth stocks, the 10-year Treasury rate was 1.5% compared with the current rate of 3.68%, according to BofA. While this concentration does leave the index vulnerable to the very specific dynamics of a small group of stocks, the research on how concentration impacts returns is inconclusive. There is no empirical evidence to suggest definitively that concentration is a precursor to market declines, with some scant evidence that narrow breadth may lead to bouts of market volatility.

That said, we do know that valuation ultimately does matter, and starting valuation has an impact on longer-term returns. With that empirically supported foundation, we can observe that these large growth stocks are selling at elevated valuations relative to history, signaling lower longer-term returns. It is worth noting that the market as a whole, certainly influenced by these large expensive stocks, is selling at an elevated valuation. In a year with negative earnings growth, all the returns so far in 2023 have been a function of higher valuations; that is, investors’ willingness to pay more for each dollar of earnings.

How are European policymakers grappling with similar dynamics to the U.S.?

European economies are facing the same inflationary pressures as the U.S. economy, if not even more.

The continent’s economies are also facing similar potential headwinds from tighter monetary policy, as the European Central Bank has followed in the Federal Reserve’s footsteps in hiking rates.

Similarly, the ECB is facing the same conundrum as the U.S. central bank: depending on data, while remaining sensitive to the cumulative impacts of the policy tightening that has already taken place, particularly in light of the more acute economic fragility of the Eurozone economies compared with the U.S.

This puts the ECB at a crossroads heading up to its June meeting, according to Wouter Sturkenboom, our chief investment strategist for Europe, the Middle East and Africa and the Asia-Pacific region. He is concerned not with the concept of data dependency per se, but rather with which set of data will dominate, lagging or leading? Some of the lagging data suggests more stress on the consumer, and falling industrial production signals a slowing in the manufacturing economy. Germany has already slipped into a technical recession, and he continues to forecast a “stall speed” economy across Europe.

At the same time, some of the inflation data point to improvement, with headline and core consumer price indexes on the continent declining at a better-than-expected rate. That’s still a long way from the ECB’s 2% target, but progress has been made, and the significant undershoot in the producer price index may portend more improvement on the consumer side. These data suggest that a pause in the hiking cycle may be appropriate after a 25-basis point hike in June. We hope that dovish, 25-point hike will be delivered, with indications of a “wait and see” approach to follow in July. With central bankers continuing to fight for credibility, the risk is that the ECB continues on the tightening path, goes too far, and ultimately throws Europe into a recession.