Economic And Financial Markets Review, July 2023

By David W. Berson, Ph.D.

Summary

The US economy continued to move forward in July, although some portions (especially manufacturing) are stumbling. Moreover, inflation has retreated further and is closer to the Fed’s goal than it is to the peak levels of a year ago. Still, the Fed tightened policy again at the July FOMC meeting and suggested that further tightening would occur if inflation remained a concern. Financial markets were heartened by this combination of an expanding economy with slower inflation, hoping that an elusive soft landing would occur rather than a recession. We have projected a downturn in the economy for some time, given the magnitude of Fed tightening, although the timing was always uncertain given the long and variable lags for the impact of Fed moves. Our best guess was always for a downturn later this year, and that is still the most likely course. Certainly, growth is better than the alternative - as long as inflation moves back within bounds - but until the business cycle is repealed, the next downturn will always be looming. If trend inflation moves lower sooner, then perhaps the next downturn will come later than we currently expect. At least we can hope so.

Economic Activity

While job growth remained solid in June, nonfarm payrolls (NFP) rose by 209,000 for June, the smallest increase since the end of the Covid recession (other than an anomalous drop in December 2020). The U-3 unemployment rate slipped to 5.6 percent and has ranged between 3.4-3.7 percent for more than a year. This is a range similar to what was seen in the year leading up to the Covid downturn, and other than those months, unemployment hasn’t been below 4.0 percent since the start of 1970. Other figures also show continued labor market strength. The Job Openings and Labor Turnover Survey (JOLTS) showed modestly fewer job openings again for June, but the level is still historically high. The quit rate gave up its May increase but appears to be mostly trendless this year at a relatively high level, something usually not seen when workers are increasingly concerned about finding another job. And in a reversal from the February-June period, weekly unemployment claims moved lower over July. A sign of firms holding tight to employees in an environment of worker shortages? Or a sign of renewed job strength?

Consumer spending is the largest part of the economy, and it would be difficult for a recession to occur with spending moving higher - and, with a tight labor market with lots of job openings pushing compensation upward, there is scope for consumers to spend. The broadest measure of consumer spending, personal consumption expenditures (PCE), increased by nearly 0.6 percent for June and by 0.4 percent when adjusted for inflation - the fastest pace since January. The key to ongoing strength in this key sector is the job market along with less rapid inflation. Moreover, consumer confidence and sentiment have both moved sharply higher over the past couple of months - both are now at the highest levels since mid-2021. But financing rates on big-ticket items remain high, with 48-month new-car loan rates at the highest levels since 2009 and 30-year fixed-rate mortgage yields around the highest since 2001. Moreover, surveys from the Fed show that banks have further tightened lending standards. Jobs and confidence have so far offset tighter policy, but can that continue?

Housing demand is still good despite higher mortgage rates and house prices. According to the National Association of Realtors, affordability has not been materially lower since 1985. But positive demographics and the solid job market are holding housing demand up. Supply constraints on the existing home side of the market continue to hold down sales. On a seasonally adjusted basis, the number of existing homes for sale is near an all-time low. With the bulk of mortgages outstanding having interest rates below current levels (well below in most cases), current homeowners are reluctant to sell their homes and buy new ones carrying (potentially) significantly higher mortgage rates. That sentiment will change over time as job relocations and changing household characteristics encourage current homeowners to move, but that shift is a long-term event. In the near term, unless mortgage rates drop, the only relief for the lack of supply is increased construction of new homes. Single-family starts are clearly off their bottom and are trending higher, despite a small decline in June. From their post-Covid bottom in November, single-family starts were up by 16.3 percent. Still, they remain significantly below the levels of 2021-22. But while starts may be down, single-family completions are only slightly below their longer-term trend, so the actual number of new homes reaching the market is rising. New home sales dipped modestly in June, but the trend in sales has been higher over the past year. Even pending home sales (existing sales counted at contract signing, as are new sales) may finally have stopped declining (at least they did for June), although it is unlikely that they will move noticeably higher in the near term. The ongoing lack of housing supply has kept house prices rising in most parts of the country, but the gains have slowed substantially, especially compared with the double-digit increases of the past two years.

Measures of business activity continue to be mixed. The Institute for Supply Management (ISM) manufacturing survey index for June dropped to its lowest level since the Covid recession and has been below 50, indicating contraction, for eight consecutive months. (New data released as this report was being finished showed another month under 50 for July). The Small Business Optimism Index from the National Federation of Independent Business (NFIB) climbed again in June to the highest level of the year, but it remains at historically low levels. Fortunately, the services side of the economy continues to expand, with the ISM services index moving further above the breakeven level of 50 for June. (The July figure was not yet available).

Leading indicators of recession continue to point strongly toward a future downturn. June saw the fifteenth consecutive monthly decline in the Conference Board’s Index of Leading Economic Indicators, and June’s 12-month change of -7.8 percent is at a level that has always preceded recessions. Additionally, the yield curve continues to be significantly inverted, with short-term rates above long-term rates. Moreover, the inversion is greater, by a significant margin, than it was at any time before the past four recessions. As many have noted, 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. On average, economic downturns have occurred between 12-18 months after Fed tightening begins. With the Fed tightening more significantly starting last May (after a small move in March), a downturn (if one is coming) could reasonably be expected later this year. But Fed tightening started from a base of extreme ease. One measure of the tightness of monetary policy is whether, and by how much, the inflation-adjusted fed funds rate is positive. Measured this way, monetary policy didn’t become contractionary until March, and the real fed funds rate is still below the levels seen before the recessions that began in 1990, 2001, and 2007. So perhaps the next downturn is still a bit farther away.

Inflation and the Federal Reserve

Inflation has slowed substantially this year by virtually all measures. Using the Fed’s preferred measure, the Personal Consumption Expenditure (PCE) Price Index (a much broader measure of inflation than the more commonly viewed Consumer Price Index, CPI), the 12-month trend rate fell to just under 3.0 percent – the slowest since March 2021. This is still above the Fed’s long-term goal of 2.0 percent, but it is certainly closer. The trend core rate (removing the volatile food and energy components) also fell sharply, but at 4.1 percent it was well above the Fed’s goal. Additionally, the “super core” inflation rate (PCE services less energy and housing), also dropped to around 4.1 percent. The Zillow Observed Rent Index continued to show slower 12-month increases, down to under 4.2 percent in June, and this trend will eventually put additional downward pressure on the broad inflation measures.

The declines in overall inflation are certainly good news and, if continued, should reduce the need for the Fed to tighten significantly further. But with most inflation measures remaining above the Fed’s goal (and some well above), the Fed may not be quite finished with tightening yet. The year-ago inflation comparisons will become a bit more difficult in the next several months, making further declines in trend inflation harder to achieve in the near term. The Fed presumably wants to bring inflation back down close to its goal sooner rather than later, in order to restrain inflation expectations and keep them from affecting wage- and price-setting behavior. Recent salary agreements with large unions suggest that some incipient wage-price inflation may be taking hold.

Financial Markets

There was another bank failure at the end of July, Kansas Heartland Tri-State Bank, but that was a very small institution, and there appears to have been no impact from it on financial markets or the economy. The Fed tightened monetary policy again at the July FOMC meeting, raising the target federal funds rate by 25 basis points to a range of 5.25-5.50 percent. At the press conference following the meeting, Fed Chair Powell noted that policy going forward would be determined by the data leading up to future FOMC meetings. But he again emphasized that regardless of whether the Fed tightens further, the FOMC members did not expect to cut rates soon.

Short-term interest rates moved higher with the Fed’s action. The yield on the 1-month Treasury note also rose by about 25 basis points over the month. Long-term interest rates climbed by a bit less than short-term rates did, with the yield on the 10-year Treasury note ending the month slightly under 4.00 percent (3.97 percent). Note that the yield climbed a bit above 4.00 percent a few times during the month, but there was little change from the yield on July 5 (after markets reopened following the Independence Day holiday) and at month-end. While the Fed can closely control short-term rates, it can influence long-term rates to a lesser degree. Changes in inflation expectations, however, can have a meaningful impact on movements in long-term rates, and it appears that some of the increase in longer-term rates in July stemmed from modestly higher inflation expectations, with the implied 5- and 10-year inflation rates rising again. Credit spreads on investment-grade corporate bonds were little changed in July, but spreads on non-investment-grade (junk) bonds dropped again over the month to the lowest levels since last February. Perhaps this is a sign that financial markets have more confidence in a soft-landing scenario.

Equity markets certainly appear to be pricing in a soft landing, with broad equity market averages moving upward again over the month. From the end of June to the end of July, the S&P 500 Index climbed by 3.1 percent. It is now up by 19.5 percent thus far in 2023 (and by 11.4 percent from a year ago). The Dow Jones Industrial Average rose by 3.3 percent last month (and by 7.3 percent this year), while the NASDAQ Composite climbed by 4.0 percent in July (and has surged by 37.1 percent so far this year). Mid- and small-cap averages also moved upwards, with gains of 4.0 and 5.4 percent, respectively, for July (and by 12.3 and 10.8 percent for the year).

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.