When we bought our first home, the builder neglected to mention that it was built upon a river. Of course a river at the bottom of a garden is a charming sight. Something that seeps up through the cellar is less attractive, and so, in due course, the builder was called back to install a sump pump. Our young sons were fascinated by the hole in the basement floor and the coppery water that flowed at the bottom and wondered whether, with the help of makeshift fishing poles, it could yield some fish.
However, with the passage of time, we gradually ignored the sump pump gurgling away beneath our feet. That is, until something shut the power off to the pump and the water slowly but inexorably rose and spread out across the basement floor.
As in our basement, there is a sogginess in the data today that is spreading out across the economy. It is a quiet dampness – and it is apparently imperceptible to equity investors who have resumed their partying upstairs. However, it bears watching. Even as the economy avoids recession for now, investors would be well advised to be cautious in case the dampness eventually turns into something more serious.
The Sogginess in Jobs Data
On Friday, the S&P500 rose by 1% and 10-year Treasury yields climbed from 4.40% to 4.51% in reaction to what was deemed a solid jobs report. Payroll employment grew by 139,000, slightly above the consensus forecast of 125,000, while the unemployment rate stayed at 4.2%, in line with market expectations.
However, a deeper look at the numbers reveals areas of softness:
- First, job growth for the prior two months was revised down by a combined 95,000 so that average monthly job growth in the first five months of 2025 is now just 124,000 compared to 168,000 for all of last year.
- Second, while the unemployment rate, rounded to a tenth, was unchanged at 4.2%, taken out to three decimals, it rose from 4.187% to 4.244%, with the number of unemployed people rising by 71,000 to 7.237 million, the highest number since October 2021.
- Third, the admittedly very volatile household survey showed a decline of 625,000 in the civilian labor force and a fall of 696,000 in the number of people employed.
Nor was Friday’s report the only signal of labor market weakness in last week’s data:
- Initial unemployment claims ticked up to 247,000 with continuing claims remaining above 1.9 million for a second consecutive week.
- The monthly jobs survey from the National Federation of Independent Businesses showed a net 12% of small businesses planning to hire in the next three months – one of the lowest readings seen in the past decade.
- The Conference Board’s consumer confidence survey for May showed the smallest positive gap between “jobs plentiful” and “jobs hard to get” seen since last September.
- Layoff announcements remained elevated for a fourth consecutive month with Challenger tabulating 93,816 planned job cuts in May, up 47% from a year earlier, and
- The Quarterly Census of Employment and Wages showed just a 0.8% increase in jobs in the year ended in December 2024, compared to a 1.3% gain reported in the payroll survey. This suggests that, as was the case last year, payroll job numbers will see a significant downward adjustment when benchmark revisions are announced next September.
There are some more positive data points including a rise in reported job openings in the JOLTs survey and gains in the employment components of the ISM manufacturing and service surveys for May. Moreover, because of falling net immigration, even slower payroll growth should not translate into a fast-rising unemployment rate. However, putting it all together, the jobs market mosaic reveals a weakening trend in the spring of 2025.
The Hidden Sogginess in GDP
This is in line with a slowing trend in economic activity overall – although you have to cut through a lot of noise to discern the true picture.
Real GDP fell 0.2% in the first quarter but we expect it to rise 3.5% in the second. The dramatic swing is almost entirely due to imports, which are a subtraction from GDP. In the first quarter, real imports surged by 43% at an annual rate and we now expect them to fall by 32% in the second quarter. This reflects the actions of businesses to try to stock up ahead of the tariffs, amplified by particularly dramatic swings in gold and pharmaceuticals. Inventory data have also seen a similar but smaller swing.
However, to get a sense of the actual momentum in the economy, it is probably better to look at real final sales to domestic purchasers, which excludes both international trade and inventories. This measure rose at a respectable 2.0% pace in the first quarter. However, we estimate that it may grow by just 0.2% in the second quarter and fall in the third as economic weakness spreads.
The weakness so far is broad but not dramatic:
In travel, TSA data show fewer people going through checkpoints in 28 of the last 38 days while non-immigrant visas fell by 2% year-over-year in March and April combined. Hotel industry data show a year-over-year decline in occupancy rates in eight of the last nine weeks.
In construction, the National Association of Homebuilders’ Market Index fell to its lowest level in 18 months in May while single-family building permits fell to a two-year low in April. High mortgage rates, high prices and weakening demographics are all impeding homebuilding.
In autos, pre-tariff buying vaulted light vehicle sales to an annual rate of 17.8 million units in March. However, this fell to 17.3 million units in April and 15.6 million units in May and should fall more in the months ahead with buyers discouraged by higher prices and lower inventories.
In energy, crude oil prices at $65 a barrel have led to relatively low gasoline prices, with AAA reporting a national average price of $3.13 down from $3.46 a year ago. However, these prices are also discouraging drilling activity, with the Baker Hughes U.S. rig count falling to its lowest level since 2022.
These are, of course, the most visible areas of slowdown. We may, in time, see a slowdown in capital spending due to tariff and economic uncertainty. Exports will presumably be hit by retaliatory tariffs once trading partners feel that they have reached the limit in trying to negotiate lower U.S. tariffs. In addition, although federal government employment has now fallen by 59,000 since January, most of the federal job losses are ahead of us. We also expect to see less hiring by state and local governments, universities and health-care facilities as decision makers brace for declines in federal spending.
All of this may be countered, to an extent, by steady spending in other areas of services, still healthy corporate and consumer balance sheets, enthusiasm about AI and, eventually, stimulus for the big tax bill currently heading through Congress. However, the broad picture is one of a slowing economy.
Four Reasons Why the Fed Won’t Cut Now
In this environment, the President has urged the Federal Reserve to cut interest rates sharply now. There are four reasons we don’t think this is likely to happen.
First, while this week’s CPI and PPI readings should still look relatively benign, they should include increases in year-over-year inflation as the first of the tariff impacts take hold. We expect this to become more obvious in the months ahead, with consumption deflator headline inflation rising to 3.5% year-over-year by the fourth quarter – well above the Fed’s 2% target.
Second, the Fed will not want to make a move on monetary policy until it has a clearer idea on fiscal policy. Moreover, if the bill eventually passed includes major fiscal stimulus for 2025 and 2026, it could boost inflation into 2026, undermining the argument for monetary ease.
Third, even as the administration has succeeded in stopping illegal immigration across the southern border and is intensifying its deportation efforts, traditional immigration is falling. In March and April combined, immigrant visas issued by U.S. embassies abroad fell by 10% year-over-year. This could intensify a squeeze on labor supply thereby boosting wage growth and inflation pressures even as it restrains any rise in the unemployment rate.
Finally, as of this morning, the S&P500 is back over 6,000 and up 2% year-to-date. With valuations already at high levels, the Fed won’t want to further boost asset prices.
In the opening statement of his last press conference, Jay Powell made the Fed’s position clear:
“We may find ourselves”, he said, “in the challenging scenario in which our dual-mandate goals are in tension. If that were to occur, we would consider how far the economy is from each goal, and the potentially different time horizons over which those respective gaps would be anticipated to close. For the time being, we’re well positioned to wait for greater clarity before considering any adjustments to our policy stance.”
In this context, it is important to note that the Fed’s inflation goal is a 2.0% year-over-year increase in the consumption deflator and that they are currently targeting a 4.2% long-run unemployment rate in their summary of economic projections. In April, they were very close to these targets with 2.1% year-over-year inflation and 4.2% unemployment. However, by the end of the year, they (and we) expect to see both rise, with inflation climbing further above its target than the unemployment rate. In this environment, we expect them to be very reluctant to ease, delivering just one 25-basis point rate cut, at most, at the end of this year and something similar in 2026.
Investment Implications
For investors, the outlook for the economy has not really changed that much over the past two months. However, stock prices have, with the S&P500 rallying by over 20% from its lows. Consequently, caution is in order. Investors would do well to monitor the spreading sogginess in the U.S. economy and, if the recent rally has increased the concentration and riskiness in their portfolios, this is still a time to diversify, in a tax-efficient manner, away from the most expensive sectors in markets and towards, value stocks, international stocks, core fixed income and well-managed alternatives.