More Evidence Of A Slowing Economy – When Will The Fed React?

Despite equity market gains in May, driven largely by tariff news, underlying economic data suggests a significant slowdown, with soft data like consumer surveys and hard data like housing starts and Q1 GDP growth indicating potential recessionary conditions. The Federal Reserve, according to the article, is lagging in its response by focusing on backward-looking indicators like year-over-year CPI, while forward-looking data suggests inflation is withering and aggressive rate cuts are warranted, a move markets are not currently pricing in until September.

Analysis

Equity markets, particularly the Nasdaq with a 9.6% advance in May, demonstrated notable strength, seemingly driven by tariff policy fluctuations rather than underlying economic conditions; the Magnificent 7, for instance, gained 2-3% in the last week of May, though Apple (AAPL) underperformed for the month and the group remains down 4.2% year-to-date on average. This market buoyancy contrasts sharply with a growing body of evidence pointing to a significant economic cooling. Soft data, including a New York Federal Reserve survey indicating one in eight respondents may miss a debt payment and Walmart (WMT) announcing 1,500 job cuts, signals weakening consumer health and corporate caution. Hard data corroborates this, with Q1 GDP contracting by -0.2%, and troubling declines in the housing sector: single-family starts fell -14.0% in March and -2.1% in April, pending home sales dropped -6.3% in April to an index level (71.3) below the Great Recession's nadir, and the Case-Shiller Home Price Index recorded a -0.3% decline in March. Furthermore, auto and credit card delinquencies have risen to 2008 levels, April's durable goods orders fell -6.3%, retail sales have been stagnant, and manufacturing output has been flat to negative for 18 months. The labor market is also softening, with the JOLTS survey showing a falling rate of new hires and the U3 unemployment rate at 4.2%, projected by the article to reach 5% by year-end, surpassing the FOMC's 4.5% estimate. The Federal Reserve appears to be misjudging the situation by focusing on lagging indicators like the year-over-year CPI (+2.3%), while more current metrics such as the three-month annualized CPI (1.6%, or 0.7% if adjusted for current rents) suggest inflation is rapidly abating, warranting immediate monetary easing which markets only price with high probability by September.

Key Decisions for Investors

• Investors should exercise caution regarding the current equity market rally, as it appears disconnected from deteriorating economic fundamentals such as negative Q1 GDP (-0.2%) and a sharply declining housing market.
• Closely monitor upcoming Q2 GDP, JOLTS reports, and unemployment figures (currently 4.2% but projected to rise) as these will be critical in confirming the deepening economic slowdown and potential recession.
• Consider the risk that the Federal Reserve's focus on lagging inflation indicators (year/year CPI at +2.3%) over more current signals (3-month annualized CPI at 1.6%) may result in monetary policy remaining inappropriately tight, potentially exacerbating a downturn.
• Re-evaluate exposure to cyclical sectors sensitive to economic contraction and scrutinize individual company performance, noting that even strong recent performers like the Magnificent 7 (excluding Apple for the month) are down 4.2% YTD on average amid rising economic uncertainty.