My colleague Sam Millette, manager, fixed income on Commonwealth’s Investment Management and Research team, has helped me put together this month’s Economic Risk Factor Update. Thanks for the assist, Sam!
The economic reports released in June largely showed continued economic growth during the month. The June employment report indicated that the pace of hiring remained strong, which was an encouraging sign that the labor market remains healthy despite the headwinds created by high levels of inflation throughout the economy. That said, both service sector and consumer confidence continued to decline, which could be a headwind for future spending growth.
Despite the continued economic growth, high levels of inflation, the Fed’s plans for tighter monetary policy, and the uncertainty caused by geopolitical and health risks remain. We have left the overall risk level at a yellow light for now.
The Service Sector
Signal: Yellow light
Service sector confidence declined by less than expected in June, as the ISM Services index fell from 55.9 in May to 55.3 in June against calls for a larger decline to 54. The larger-than-expected drop in service sector confidence during the month was primarily due to supply constraints and struggles with finding labor.
This is a diffusion index where values above 50 indicate growth, so this result signals continued expansion despite the decline in the index. As you can see in the chart above, service sector confidence remains well above the lows from initial lockdowns and near pre-pandemic levels despite the larger-than-expected drop during the month.
While confidence remains in expansionary territory, the recent relative weakness of the index is a potential cause for concern and highlights the challenges businesses are facing due to rising prices and labor shortages. Given that the index continued to decline in June, we have left this indicator at a yellow light for now with an eye for future downgrades if we see further declines.
Private Employment: Annual Change
Signal: Green light
June’s employment report showed that 372,000 jobs were added during the month, which was better than the 265,000 jobs that were projected and only slightly below the downwardly revised 384,000 jobs that were added in May. The better-than-expected June result marks 18 consecutive months with strong job growth and indicates that the labor market recovery continued at a healthy pace despite headwinds created by higher employment costs and labor shortages.
The underlying data was also encouraging. The unemployment rate remained at 3.6 percent in June for the fourth month in a row, which ties to the lowest level since the start of the pandemic and is largely in line with pre-pandemic levels.
Given the better-than-expected job growth in June and the solid underlying data, we have left this indicator at a green light for now.
Yield Curve (10-Year Minus 3-Month Treasury Rates)
Signal: Green light
The yield curve flattened notably in June. This result was caused by short-term interest rates rising faster than long-term rates during the month. The 3-month Treasury yield increased from 1.16 percent at the end of May to 1.72 percent at the end of June. The 10-year Treasury yield, on the other hand, rose from 2.85 percent at the end of May to 2.98 percent at the end of June.
The rise in short-term yields was primarily due to tighter monetary policy from the Fed due to high levels of consumer and producer inflation. The Fed has hiked the federal funds rate by 150 bps so far this year, and economists expect to see the Fed focused on combating inflation in 2022. This could lead to larger and more frequent rate hikes as the central bank tries to normalize monetary policy to combat rising prices.
Given that the spread between the 3-month and 10-year Treasury rates remains well outside of the historical inversion danger zone, we have left this signal at a green light for now.
Consumer Confidence: Annual Change
Signal: Red light
Consumer confidence dropped from a downwardly revised 103.2 in May to 98.7 in June against calls for a more modest decline to 100. On a year-over-year basis, confidence declined by 23.4 percent in June, marking four consecutive months with year-over-year declines in confidence.
Historically, declines in confidence of 20 percent or more during the past year are a signal of a potential recession, and the June result is a concerning development. That said, this is the first month we’ve seen confidence decline by more than 20 percent since February 2021. So, it’s too early to say if the drop in year-over-year confidence will remain in this historical danger zone for a sustained amount of time.
Given the fact that confidence continued to decline on a year-over-year basis in June and now sits at historically concerning levels, we have downgraded this indicator to a red light for now.
Conclusion: Growth Continues Despite Current Risks
The data releases in June continued to show signs of economic growth despite inflation concerns. Looking forward, further economic growth remains the most likely path forward; however, as we’ve seen throughout the pandemic and the first half of the year, there are real risks that remain in this outlook.
The continued strong hiring growth during the month was an encouraging development, but even with the better-than-expected job growth in June, we’ve seen the pace of hiring slow over the past few months. The declines in service sector and consumer confidence were potentially concerning, and both should be monitored in the months ahead. Ultimately, the pace and path of the expected recovery in the short term remain uncertain, and caution is still warranted.
We have left the overall economic risk indicator at a yellow light to reflect continued uncertainty and the potential for new setbacks in the months ahead.