We live in unprecedented times. Since the COVID pandemic, the economy has been deeply influenced by a massive increase in government spending, COVID-related shutdowns, and a huge increase in the money supply.  In all our years of economic forecasting, the task of identifying where we are and where we are heading has never been so difficult.  Now more than ever, it is important to follow real-time data on the economy. The charts in the High Frequency Data Tracker follow data that are published either weekly or daily, providing a check on the health of the US economy. 

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Implications:   If you have followed our recent reports on the US labor market the main theme has been ambiguity, and the data in May was no different.  Once again, we have a report on the labor market with solid headlines but worrisome details.  First, the good news. Nonfarm payrolls increased 339,000 in May, easily beating the consensus expected 195,000.  On top of this, job gains from prior months were revised up by 93,000 as well, bringing the net gain to 432,000. However, if you stopped reading today’s report after these admittedly strong numbers, you wouldn’t be getting a full picture of the labor market. First, civilian employment, an alternative measure of job growth that includes small business start-ups, declined 310,000 in May.  That means the gap between what was reported by the establishment (nonfarm payrolls) and household survey (civilian employment) that make up the overall labor market report was 649,000 in May. Notably, this is one of the largest divergences between the two measures since the early days of the Pandemic. Talk about ambiguous!  The big decline in civilian employment, paired with a 130,000 person increase in the labor force, resulted in the unemployment rate rising to 3.7% in May. While it’s too early to tell, one explanation for the dichotomy between the institutional and household surveys in today’s report could be that smaller businesses are beginning to pare back their workforces while larger employers who can afford it continue to hoard labor. For example, despite the big headline gain for nonfarm payrolls, the total number of hours worked (which also comes from the institutional survey) slipped 0.1% in May.  In other words, these businesses were hiring but there was less for their workers to do.  In turn, this is consistent with our view that the labor market will be a lagging indicator as we enter the next recession.  If larger employers hoard workers to fulfill future increases in business activity, but those increases don’t come, that just means more workers will get laid off later on.  Finally, average hourly earnings increased 0.3% in May and are up 4.3% in the past year.  However, wage growth should be taken in the context of the high inflation environment we are currently in, and with consumer prices up 4.9% as of May workers are at best treading water.  Overall, today’s labor market report echoes a lot of the concerns we raised in this week’s Monday Morning Outlook. It’s easy to find surface level good news on the US economy, but the data behind the scenes leaves us feeling cautious.  In other recent news, automakers sold cars and light trucks at a 15.0 million annual rate in May, down 6.5% from April but still up 19.6% from a year ago.  In addition, sales of medium and heavy trucks hit a 558,000 annual rate in May, the fastest pace since 2019.    

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Implications:  Today’s report on the US factory sector showed that activity continued to slow in May, with the overall index remaining in contraction territory for the seventh month in a row.  Looking at the details, only four of eighteen industries reported growth in May. We continue to believe a recession is on the way and today’s report continues to show that the goods sector of the economy is likely to lead the way.  Survey respondents in May noted worries about slowing demand from customers on the horizon. With this in mind, it wasn’t surprising to see the new orders index fall near a new post-pandemic low in May. In fact, the customer inventories index rose to 51.4 in May, the second reading in a row in expansion territory which hasn’t happened since 2016! Consumers have been shifting their preferences away from goods and back toward services.  A combination of less demand from consumers and built-up inventories at retailers means factory output is likely to remain sluggish.  One piece of good news is that fewer new orders and improvements in supply chains has allowed factories to catch up on order backlogs, with that index falling to 37.5 in May.  This is the lowest reading for this index since the 2008 Financial Crisis. Another positive this morning was the increase in the employment index, which rose to 51.4 in May, the second month in a row in expansion.  That said, the hiring to reduction ratio among panelists’ comments was 1-to-1 in May and only five of eighteen industries reported employment growth.  Finally, on the inflation front, the prices index dropped to 44.2 in May, disrupting the recent upward trend. In employment news this morning, ADP’s measure of private payrolls increased 278,000 in May versus a consensus expected 170,000. meanwhile, initial claims for jobless benefits rose 2,000 last week to 232,000.  Continuing claims rose 6,000 to 1.795 million. We also got data on construction spending this morning which increased 1.2% in April.  This larger than expected gain was driven by an increase in manufacturing projects and home building which more than offset declines in power and sewage projects.  Finally, the national Case-Shiller index rose 0.4% in March while the FHFA index increased 0.6%.  Notably, while the Case-Shiller index is still down from its peak in June by 2.3%, the FHFA index is now at a new high and up 0.7% from the previous high.    

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The stock market finished Friday on a high note, with the S&P 500 index just north of 4,200 for the first time since August 2022 and up 17.6% versus the market bottom in October.

Part of recent gains are related to optimism about the effect of Artificial Intelligence on some high-tech stocks.  Another part might be due to signs that Congress and the White House are closing in on a budget agreement that might limit spending growth for the next couple of years while averting a debt default.

But the recent rally also seems related to a general sense of increasing optimism about the broader economy, with investors getting more confident the economy will avoid a recession this year and next.

For the long-term, we remain optimistic about the US economy and the stock market.  But we don’t share the stock market’s optimism about the next year or so and think recent data support the case that the US is still headed for a recession. 

Economy-wide corporate profits declined 5.1% in the first quarter of 2023, the fastest drop for any quarter since 2020 during the early days of COVID.  As some analysts have pointed out, the drop appears to be driven by large and unprecedented losses at the Federal Reserve, a result of the Fed paying banks higher interest rates for them to hold reserves, combined with the Fed’s massive balance sheet.

But appearances can be deceiving.  Yes, the Fed is losing more money than ever before, but those losses are due to payments to banks that should lift those banks’ profits.  And despite that boost to banks’ profits, economy-wide profits excluding the Fed’s losses were still down 2.7% in Q1.

These profits are important because that’s what we use in our Capitalized Profits Model to assess the stock market.  That model takes these profits and discounts them by the 10-year US Treasury yield.  These data go back seventy years to the early 1950s.  Using a 10-year Treasury yield of 3.8% (the Friday close) to discount profits suggests the S&P 500 index is fairly valued at about 3,500, well below the Friday close of 4,205.

Meanwhile, there was trouble lurking beneath the surface of Thursday’s GDP report, which included our initial look at first quarter Gross Domestic Income, an alternative way to count economy-wide production (as opposed to GDP) that is just as accurate.  Real GDI declined at a 2.3% annual rate in first quarter, not the 1.3% annualized gain counted for Real GDP.  In addition, Real GDI is now down 0.9% versus a year ago, compared to a 1.6% gain for Real GDP during the same timeframe.

One last problem: The Fed delivered its monthly report on the money supply last Tuesday and it showed that M2 declined another 0.8% in April, the ninth consecutive monthly drop.  We have gone from the Mount Everest of M2 increases in 2020-21 to the Death Valley of declines in 2022-23, with the largest drop since the Great Depression.  It’s hard to see the economy not eventually feeling the pain caused by that drop.

We’re not trying to say the economy is already in a recession.  Recent figures show the job market is still holding up and consumer spending is still expanding.  What we are trying to do is show that we are not out of the woods regarding recession risk, not by a long shot.

We are not often pessimistic about equities and think the long-term is still bright.  However, we think there are still problems ahead in the near term and investors need to be prepared.    

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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We live in unprecedented times. Since the COVID pandemic, the economy has been deeply influenced by a massive increase in government spending, COVID-related shutdowns, and a huge increase in the money supply.  In all our years of economic forecasting, the task of identifying where we are and where we are heading has never been so difficult.  Now more than ever, it is important to follow real-time data on the economy. The charts in the High Frequency Data Tracker follow data that are published either weekly or daily, providing a check on the health of the US economy. 

Click here to view the report

Implications:   Income and spending rose in April as consumers continue to navigate elevated inflation and an uncertain path ahead.  The best news in today’s report was that incomes rose 0.4% and are up 5.4% in the last year, led by gains in private-sector wages & salaries (+0.5% for the month and up 5.6% year-to-year).  Those would be great numbers in a normal low-inflation environment, but the fiscal and monetary mistakes made since COVID have led to persistently high inflation that has taken a big bite out of that spending power, with real (inflation-adjusted) incomes up just 1.0% in the last year.  In spite of lackluster real income gains, consumer spending rose a rapid 0.8%, led by spending on services.  Spending on goods also rose in April after monthly declines in the two months prior, but in the last year, spending on services is up 8.4% while goods spending is up 3.6%.  This transition from goods toward services has been an ongoing theme in the past year.  Given the surge in goods activity during COVID as many services were shut down, we expect goods spending will struggle to keep pace as the economy continues to shift back towards a more “normal” mix of activity.  On the inflation front, PCE prices – the Federal Reserve’s preferred measure of prices – rose 0.4% in April, pushing the twelve-month comparison up to 4.4% from 4.2% in March.  PCE inflation has been coming down on a year-to-year basis since it peaked at 7.0% last June, but this shouldn’t make the Fed sanguine on inflation.  “Core” inflation, which excludes food and energy is up 4.7% on a year ago comparison basis and down less than a percentage point from the 5.4% peak in core inflation last February.  In other words, this has been a slow slog lower.  While goods prices have been moderating (up 2.1% from a year ago versus 10.6% back in June of last year), service inflation remains stubbornly high and has shown little sign of easing (up 5.5% from a year ago versus 5.1% back in June).  Note that the Fed is now closely watching a subset of inflation dubbed the “Super Core,” which is services only (no goods), excluding food, energy, and housing.  That measure rose 0.4% in April and is up 4.5% versus a year ago. Inflation continues to take a toll on the economy, which is also feeling more of the effect of the slowdown in the money supply over the past year.  The economy was still growing in April, but we think tougher times are ahead.

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Implications:   New orders for durable goods rose 1.1% in April, easily beating the consensus expectation for a decline.  However, when you look past the headline, there isn’t a whole lot to like in the April report.  The increase in orders was due to the typically volatile defense aircraft category, which jumped 5.5% in April after declines over the prior two months.  Stripping out transportation, orders slipped 0.2% in April with declines across most major categories.  Diving into the details shows that a 1.0% rise in machinery orders was more than offset by declines in computer and electronic products (-1.4%), electrical equipment (-1.0%), and primary metals (-0.5%), while fabricated metal product orders showed no change.  One piece of positive news in today’s report was that core shipments – a key input for business investment in the calculation of GDP – rose 0.5% in April and, if unchanged in May and June, would be up at a 1.2% annualized rate in the second quarter versus the Q1 average.  While still positive in Q2, that would be the fifth consecutive quarterly deceleration in the pace of growth, and would represent the weakest quarter since the shutdown-restricted second quarter of 2020.  In the past year, orders for durable goods are up 4.2%, while orders excluding transportation are down 0.2%.  But when you consider that producer prices for capital equipment are up 5.5% in the past year, it means that while headline orders are still rising in dollar terms, they are declining when adjusted for inflation.   A number of factors are likely to generate turbulent footing as we continue further into 2023: a tighter Federal Reserve, the tightening of lending standards following stress in the banking sector, and withdrawal symptoms following the COVID-era economic morphine that artificially boosted both consumer and business spending.  In addition, the return toward services means a large portion of goods-related activity will soften in the year ahead, even as some durables that facilitate services recover.  While the data to-date suggests the economy is still growing modestly in the second quarter, we believe a recession awaits us later this year or early in 2024.  In recent news on the housing front, pending home sales, which are contracts on existing homes, were unchanged in April after a 5.2% decline in March.  Plugging these figures into our model suggests existing homes will be roughly flat in May.

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Implications:  Real GDP was revised higher for the first quarter to a 1.3% annual rate from a prior estimate of 1.1%.  The upward revision to the overall number was due to the cumulative effect of a series of small upward revisions to inventories, business investment, consumer spending, and government More important, today we also received our first look at economy-wide corporate profits for the first quarter, which declined 5.1% versus Q4, and are down 2.8% from a year ago.  The government includes Federal Reserve profits in this data, and the Fed is making losses.  So, we follow profits excluding those earned (or lost) by the Fed, which are still up 7.0% from a year ago.  However, profits excluding the Fed declined 2.7% in Q1, the largest drop for any quarter since 2020. Excluding the Fed, domestic non-financial companies’ profits fell the most.  Moving forward, we expect further declines in corporate profits as the economy continues to re-normalize after the massive fiscal and monetary stimulus of 2020-21.  In turn, this will be a headwind for equities.  In addition to corporate profits, we also got a Q1 total for Real Gross Domestic Income, an alternative to GDP that is just as accurate.  Real GDI fell at a 2.3% annual rate in Q1 and is down 0.9% versus a year ago, consistent with underlying economic weakness. These are figures that are normally seen in and around recessions. Regarding monetary policy, inflation remains stubbornly high.  GDP inflation was revised higher to a 4.2% annual rate in Q1 versus a prior estimate of 4.0%.  GDP prices are up 5.3% from a year ago, nowhere near the Fed’s 2.0% target.  Meanwhile, nominal GDP (real GDP growth plus inflation) rose at a 5.4% annual rate in Q1 and is up 7.1% from a year ago.  In employment news this morning, initial claims for jobless benefits rose 4,000 last week to 229,000.  Continuing claims declined 5,000 to 1.794 million. As for other economy-wide news, the Fed recently reported that the M2 measure of the money supply dropped 0.8% in April, is down 4.6% from a year ago, and is down at a 6.3% annualized rate from the peak in July.  Not only have we never experienced a Fed trying to fight an inflation problem under an abundant reserve regime, we’ve never seen M2 grow so fast for so long, or decline so rapidly, at least since the Great Depression.  If the recent data are accurate, this is not a good sign for Real GDP growth in the year ahead and consistent with our view that we’re headed for a recession.

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Implications:  New home sales continued to recover in April, signaling that activity may have hit at least a temporary bottom back in mid-2022.  While sales are on an upward trend recently and are now up 25.8% from the low in July of last year, they still remain well below the pandemic highs of 2020. The main issue with the US housing market has been declining affordability.  Assuming a 20% down payment, the change in mortgage rates and home prices in just the past year amounts to a 13% increase in monthly payments on a new 30-year mortgage for the median new home.  With 30-year mortgage rates currently sitting near 7.0%, financing costs remain a headwind.  However, the median sales price of new homes has fallen by 15.3% from the peak late last year, which has helped sales activity begin to recover.  Notably, while a lack of inventory had contributed to price gains in the past couple of years, in general, inventories have made substantial gains recently.  The months’ supply of new homes (how long it would take to sell the current inventory at today’s sales pace) is now 7.6, up significantly from 3.3 early in the pandemic.  Most importantly, the supply of completed single-family homes has more than doubled versus a year ago.  This is in contrast to the market for existing homes which continues to struggle with an inventory problem often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  Though not a recipe for a significant rebound, more inventories should continue to help moderate new home prices and put a floor under sales activity.  One problem with assessing housing activity is that the Federal Reserve held interest rates artificially low for more than a decade.  With rates now in a more normal range, the sticker shock on mortgage rates for potential buyers is very real.  However, we have had strong housing markets with rates at current levels in the past, and homebuyers will eventually adjust, possibly by looking at lower priced homes.  Finally, on the manufacturing front, the Richmond Fed index, a measure of mid-Atlantic factory activity, fell to -15 .0 in May from -10.0 in April, still signaling contraction.

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If you’ve been to a high school or college commencement lately, then you know the drill: at some point at least one speaker will urge the graduates to be “agents of change,” suggesting they’d like to see these students make the world a better place through some sort of social activism.

The problem with goading students to think this way is that it assumes they should be dissatisfied with the status quo.  It asks students to dwell on the negative, to focus on what is wrong, to obsess on injustices, whether perceived or real.  Which makes us imagine an alternative message that we rarely, if ever, hear: for graduates to go forth thinking about what is already good, to dwell on what is worthy of conserving, and why sometimes it can be important to be barriers to change.

In the context of protecting the environment, this message makes sense to pretty much everyone: let’s be careful stewards of nature.  People may disagree with what this means in certain contexts and may disagree about how to weigh trade-offs, but everyone agrees that environmental concerns shouldn’t be casually dismissed.

At the same time; what does changing or reimagining the US mean?  No country close to the population size of the US has wealth or income per person even close.  People from around the world are eager to move here.  Think about our blessings: property rights, freedom of contract and the ability to enforce those contracts, a democratic republic with a Constitution that separates executive and legislative functions, a bicameral legislature that makes it tough for temporary voting majorities to impose their will, and social institutions that foster individual rights.  The list goes on and on.

And yet the academic class would like those graduating its intellectually narrow, and often overly shallow, confines to dwell on how to make our society different from what it is today.

Maybe that’s a natural consequence of living in a high-income and wealthy society.  Academics, who in times past had higher status than those who run businesses, must think to themselves that something must be seriously wrong or rotten with a society in which so many others have more prestige than they have.  If so, what’s being taught in schools and conveyed in commencement speeches simply reflects the status anxiety of the intellectual class and we should accept it as a symptom of long-term economic improvement (higher income and wealth) for people outside academia.

But, even if so, that doesn’t mean we should completely ignore or reject their message to be agents of change.  After all, our country’s Founders were, in a sense, agents of change themselves, while also doing so in a way that conserved and expanded freedoms that had developed in certain parts of Western Civilization.

We can think of two areas in particular that are ripe for change, just in the education system itself.  One would be breaking up government-run primary and secondary school systems by making school vouchers as widespread as possible.  Another would be requiring colleges to have skin in the game when they get student loan money.  If a student can’t repay a student loan, maybe colleges should eat half the cost.  Or, instead of getting all the loan funds up-front, colleges should only get half up front, while also getting a 50% stake in all future loan payments (interest and principal) made by their students.  How about that for change?

In the end, it’s also important to remember that preserving our dynamic free-market economic system is also a way to foster the kind of change that America needs, the kind that leads to less poverty and higher incomes.  More entrepreneurship means more change, not less.  Every single day, the US is built back better by entrepreneurs, while government flounders around making mistakes.

Look, it may be that the US is headed for a recession in the near term.  But we also think that once graduating students embrace real change that also conserves what is best, while addressing the government failures that make things worse, they will help lead to the next bull market, which will be a long and strong one.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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