What Can Go Wrong When Everything Is Right

The major market averages rallied for a second week in a row, making it look more like the pullback that ensued in early April from fears over higher-for-longer interest rates has concluded. Corporate profits for the first quarter limited the drawdown, as earnings are now exceeding estimates, and the contribution to earnings growth for the S&P 500 is broadening well beyond the technology sector. There was also an abrupt pivot in the outlook for monetary policy last week. After shrinking to as few as one 25-basis point rate cut by the end of this year, the consensus now sees two starting as early as September. The pivot was instigated by Friday’s jobs report, which showed an economy that is rapidly cooling down from its break-neck pace during the third and fourth quarters of last year.

We learned that the economy created a mere 175,000 jobs in April, which fell well short of estimates, while wage growth and the length of the workweek also fell short of expectations. This dampened concerns about elevated employment costs earlier in the week from the Employment Cost Index (ECI) for the first quarter. A softening labor market, especially one with slowing wage growth, is what leads to a lessening of price increases for goods and services. This is what the Fed wants to see to begin easing monetary policy from its currently restrictive stance, which bodes well for risk asset prices. That was the impetus for the rally in stocks last week, but as we pivot back to easing earlier and more often, the naysayers will renew warnings about recession.

A deceleration in the rate of economic growth that is accompanied by disinflation is the recipe for a soft landing, At the same time, that deceleration does not occur in lock step each month with a declining rate of inflation. This opens the door for concerns about a recession, and if inflation remains elevated as growth slows, we will hear warnings about stagflation. I think both are unlikely this year.

I was encouraged to see the OECD raise its global growth forecast last week from 2.9% to 3.1%. It also indicated that inflation was cooling faster than expected in several countries. The US has been the primary engine of economic growth over the past several years, and if the rest of the world starts to pick up speed as foreign central banks begin to ease monetary policy it will help counter any domestic deceleration in growth and should improve our trade deficit, which would contribute to our GDP.

When everything is going right, it is time to start looking for things that could go wrong. Today, my greatest concern is that the economy cools too rapidly before the Fed begins to ease monetary policy, which works with a lag, and we come dangerously close to a quarter of contraction in economic activity. This is why I am extremely focused on the real (inflation adjusted) rate of consumer spending growth, which is the primary driver of economic growth. Consumer spending is what creates jobs, so waiting for the labor market to tell us when the economy is in trouble is like reading yesterday’s newspaper.

Typically, I would be myopically focused on the rate of change in real retail sales on a year-over-year basis. Historically, when we see a negative number, we are on the cusp of a downturn in the economy, led by the stock market, as we last saw in March 2020. Additionally, the stock market typically bottoms out at the deepest level of contraction in real retail sales. The pandemic skewed this indicator, as consumers shifted their spending focus to services, while retail sales are predominantly goods. This is why I ignored the year-over-year declines in this number during the past two years as a recession warning, the latest of which was a 2.76% drop in January 2024.

Instead, I am focusing on real personal spending, which includes both goods and services. Note in the chart below that this rate of change has held positive on a consistent basis since the last recession. In fact, when real retail sales declined in January of this year, real personal spending still grew 1.88%.

The service sector is clearly starting to show signs of slowing, so I will be watching to see that we keep our head above water on a real annualized basis moving forward, as we wait for the Fed to start becoming less restrictive with monetary policy.

To be clear, this is not a concern today, but it is something on which I am keeping a watchful eye. I think this bull market has plenty of gas left in the tank, and the soft landing I am still anticipating will be the mid-cycle slowdown phase of the ongoing expansion.