The Recession Story Takes a Hit

1. Tight Labor Market Supports Aggressive Fed Action Continuing. Last week, we received an abundance of economic data showcasing the state of the U.S. economy. While JOLTS job openings decreased 5% m/m to 10.7 million, the number remains near all-time highs. The Challenger, Gray & Christmas survey reported a 21% m/m dip in July U.S. job cuts, following a 57% m/m surge in job cuts in June, and simultaneously the lowest hiring announcements since November 2021. Additionally, in July the economy added 528,000 new nonfarm jobs (against expectations for 258,000) with 5.2% annualized wage growth acceleration. A persistently low participation rate of 62.1% and total unemployment at 3.5% show that the labor market is still extremely tight. The U.S. economy has created 926,000 jobs in just the past two months and more than three million year-to-date. 

Chart 1: Elevated Job Openings and Nonfarm Hiring, Low Participation Rate¹ 

Moving on to the economic activity that, among other factors, is helping to generate such a tight labor market, ISM Services PMI and new orders flashed 56.7% and 59.9% respectively – faster growth than the previous month and both leading economic indicators (>50% indicates expansion). The prices paid index, within ISM surveys, came down dramatically for both manufacturing – lowest since August 2020 – and services – lowest since February 2021. The economy is slowing, but this data does not support the narrative that we are currently in a recession and suggests the Fed’s tightening has not been felt extensively. 

Chart 2: Year-to-Date Activity Still Expanding, Prices Falling as Supply Chains Ease² 

After the July FOMC meeting, some interpreted Fed Chair Powell’s remarks to be relatively dovish, with the idea of a Fed pivot in 2023 surfacing. However, last week’s strong economic data has reversed this sentiment – inflation remains too high, and the tight labor market is adding fuel to the fire. James Bullard, President and CEO of the St. Louis Fed, indicated last week that a Federal Funds Rate of 3.75%-4.00% by the end of the year is likely (note he is just one Fed governor and is not a voting member). Prior to the nonfarm payroll and unemployment reports, the futures market priced in a 70% chance of a 75 bps move in September, up from 60% prior to the data release. For now, the Fed remains data dependent – all eyes will remain on inflation data in the coming two months. 

2. The Fed has Hiked 225 bps since March; Why Isn’t Inflation Retreating? It takes time for higher interest rates to impact economic activity, and the more persistent inflation coupled with aggressive Fed tightening raises the economic risks. Most prices remain elevated, and the sticky components to inflation, like rents and wages, continue to accelerate. Consider too the lagged impacts of Fed bond purchasing (quantitative easing) that continued until March. 

Chart 3: Pace of Rents, Wage Gains Well-Above Trend³ 

In addition to the Fed’s poor record at executing a soft landing (just four of 12 post-WWII rate hike cycles have resulted in soft landings), many headwinds still remain, with the Fed indicating a year-end target rate in the range of 3.0-4.0% (the current fed funds rate is 2.00-2.25%). This leaves at least another 100 bps of tightening across the final three meetings of 2022. Coupled with historically high debt-to-GDP, spiking inventories and only pockets of softening demand, the Fed’s impact is far from complete. 

3. Strong Earnings, But Don’t Fight the Fed. Despite all the recession headlines, strong earnings have painted a different picture. Real Estate Investment Trusts (REITs), which have been average performers this year, reported strong Q2 earnings.  

Energy companies are staying disciplined with their capex spending while using their strong cash flows to accelerate their return-to-shareholder programs. Even as inflation costs creep into operating margins, companies are optimizing their assets, lowering their breakeven and paying-off debt ahead of a seasonally strong second-half. Industrials are noting tailwinds from the supply chain challenges – supporting customer demand for onshoring, capacity and efficiency solutions. 

While strong earnings are coming from the value names (+17.7% y/y vs. growth -1.2% y/y), the market has pivoted to favor growth – believing what we believe to be an inaccurate assessment of a looser Fed. While it is unlikely the economy is currently in recession, a tightening Fed is troubling for long-duration assets like growth stocks and non-earners. This is being displayed front-and-center in fixed income markets. 

4. Tighter Spreads, Flatter and Inverted Yield Curve. Looking at movements in yields, the 2s/10s spread continued its inversion, reaching -40 bps for the first time since the year 2000. The municipal yield curve flattened rapidly last week. The three- and six-month yields rocketed 72 bps and 63 bps respectively, while the long end moved a meager 3-5 bps. Corporate spreads show no signs of slowing their tightening. High Yield spreads finished the week at +468 bps, well off the peak of +609 bps seen in early July. 

With more than seven weeks remaining until the next FOMC meeting, there is plenty of data to alter voting members decisions. One voting member, Governor Michelle Bowman, remarked last week that she has “seen few, if any, concrete indications that support” peak inflation has passed, mentioning she will “need to see unambiguous evidence of this decline before [she] incorporates an easing of inflation pressures into [her] outlook.” 

5. The Week Ahead. 

Earnings – Monday: D, BNTX, TSN, TTWO. Tuesday: EMR, SYY, RBLX, COIN, WMG, H, WYNN. Wednesday: DIS, NIO, FOX, BMBL, WEN. Thursday: BAM, ILMN, RIVN. Friday: SPB. 

Economics –Tuesday: NFIB Small Business Index (July), Preliminary Unit Labor Costs and Productivity(Q2). Wednesday: CPI (July), CPI (July), Hourly Earnings (July). Thursday: PPI (July), OPEC Monthly Report, Initial Jobless Claims. Friday: Michigan Consumer Sentiment Surveys (August). 

Stephanie Link: CNBC TV Schedule 

Return for Selected Indices⁴ 

Sources

1. FactSet (chart)
2. FactSet (chart)
3. FactSet (chart)
4. Bloomberg

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