While market concerns remain focused on inflation and recession fears, the incoming data remains consistent with above-trend economic growth, with few odds of a near-term recession.
The data also suggest supply-chain issues are slowly being worked out; wage inflation is down from its recent peak and the participation rate continues to grind higher as the pandemic fades. Importantly, longer-term inflation expectations seem to remain contained, unlike the 1970s inflation period. All of this implies a path exists for a soft landing, which could support further profitability and stock prices.
Economic Readings Remain Healthy
Last week brought us important monthly updates from business surveys and the labor market. These readings are consistent with strong economic growth and support the Federal Reserve’s planned 0.5% interest rate hikes in June and July.
The ISM Manufacturing PMI (a timely survey of business sentiment) increased in May, reflecting an improvement in factory activity during the month, while the level of the PMI remains historically consistent with robust growth in manufacturing output. Growth remained widespread, with 15 of the 18 ISM industries reporting expansion, and only one (furniture & related products) contracting. The breadth of industry expansion also implies continued manufacturing output growth. The ISM Price Index fell 2 points to 82, nearly 10 points below its cycle high in mid-2021, but still consistent with elevated price pressures.
While the ISM Services PMI suggests that services activity has moderated from peak levels earlier in this cycle, it is nonetheless consistent with robust growth. The supplier delivery index fell to its lowest reading since March 2021, indicating less supply-chain stress. The Prices Index also ticked down, as cost pressures eased slightly from a record high in the previous month.
The combined latest readings of the ISM Services and Manufacturing PMIs correspond to about 3% annualized economic growth. For perspective, the economy averaged about 2% growth during last decade’s expansion.
The labor markets remained tight in May. Nonfarm payrolls expanded by 390,000—above the consensus of 328,000. They were up 4.5% y/y, the fastest pace since 1984 (outside of the pandemic), and much faster than what has been seen at the start of all post-WWII recessions except 1953. Such strong payroll growth suggests low odds of recession in the near term. The unemployment rate remained at 3.6% for the third consecutive month, above the consensus of 3.5%, which was the prior cycle trough. The y/y change of average hourly earnings eased to 5.2% from 5.4%, in line with expectations.
Private nonfarm payrolls increased 333,000, the smallest gain in over a year, but still solid from a historical perspective. In comparison, private payrolls had increased an average of 169,000 per month in the year prior to the last recession and had gained an average of 161,000 per month during the previous expansion. The May increase brings private payrolls to just 207,000 below their level in February 2020, as a full jobs recovery is likely only a month away.
Aggregate payrolls—which combine payrolls, hours worked, and earnings—rose 9.6% y/y for all workers. This is more than double the pre-recession pace, which bodes well for personal income and spending growth, and suggests no recession in the near term.
The Market Has Priced in a Significant Economic Slowdown
The stock market performance suggests equity investors have already braced for a slowdown in activity, but not a deep contraction. The nearly 20% drop in the S&P 500 from its peak in January was more modest than the typical recession peak-to-trough decline. The median decline around 12 recessions since WWII equals 24% (implying an S&P 500 level of 3,650) while the average decline equals 30% (S&P 500 level of 3,350). From a valuation perspective, the P/E multiple during a recession typically contracts by 21%. The P/E also contracted 20% in 2022. This suggests investors appear to have priced a meaningful amount of recession risk into U.S. equities.
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