The enigmatic American economy

Good morning. We spent the weekend wondering how the Chinese spy balloon saga could be turned into an extended metaphor for what’s happening in the stock market. No chance; sometimes a balloon is just a balloon. So we wrote about the jobs report instead. Email us: [email protected] and [email protected]

The report on booming jobs and the disoriented economy

Unhedged feels confused about the economy. Is it firing on all cylinders? Towards a mid-cycle slowdown? Rushing into a Fed-induced recession? Friday’s jobs report didn’t help. It showed that the US economy added half a million jobs in January, beating expectations and making any recent labor market cooling truly marginal.

It’s not just job data. As Jay Powell said last week, “It’s not like other business cycles in a lot of ways.” We’ve summarized several data points that we examine below. If there is an obvious primordial story, it eludes us:

However, the labor market is an important part of it. The Fed worries about a price category called basic non-housing services, which it sees as the beating heart of persistent inflation. And historically, this category has seemed terribly sensitive to wage growth. This chart from Deutsche Bank shows the close correlation (ECI is the Employment Cost Index, a measure of wages):

With that in mind, Friday’s huge jobs count presents a question. Does a strong labor market data surprise make a soft landing more likely, or less? The question is a bit pat; a month of data can always be a blip. But the rock-solid job market has been surprising everyone for months now. Is this good or bad news for investors?

The range of opinions is wide. Some in the “most likely soft landing” camp, like BlackRock’s Rick Rieder, see strong employment as a sign that the economy can withstand higher interest rates without a recession. He wrote on Friday:

Central banks are accepting the slowdown in excessive levels of inflation seen over the past year, while perhaps not having to sacrifice as many jobs as previously thought. We believe the Fed would be well served to consider this a success and believe that slowing the pace of the increases (and potentially ending them over the next few months) would allow the labor market to ease, but perhaps not break. Today presents good evidence of a labor market that is not crashing and evidence of how the economy can adapt and adjust to remain buoyant in the face of major headwinds (such as rising rates). higher interest).

Others point to the decoupling of wage growth (slowly decelerating) and employment (still growing). The hope is that we can get the best of all worlds – strong employment disinflation – as long as the Fed’s anti-inflationary zeal doesn’t get in the way. Preston Mui of Employment America writes:

For months, the Fed has been saying that “pain” in the labor market will be needed to bring inflation down…

The Fed should revise its views based on the data of the last few months. The unemployment rate is at a historic low. The prime-age employment rate, while not at an all-time high, is at its highest level since the onset of COVID.

Meanwhile, nominal wage growth is slowing…

Along with recent CPI disinflationary data, we are seeing what many said was impossible: slowing price and wage inflation even as levels of labor market strength remain high across the board.

On the “less likely” side, Don Rissmiller of Strategas argues that the Fed is focused on its price stability mandate to the exclusion of everything else. Inflation is high, so rates should remain restrictive until this is no longer the case. Labor market resilience only prolongs the process:

The default position remains that the US labor market is overheating, with the unemployment rate cycle low again. Underlying inflationary pressure remains, so central banks are mandated to steer policy towards a tight stance and stay there.

The FOMC still looks poised to lift fed funds above 5% in early 2023. The US labor market will likely need to show more slack to create an endgame for the tightening – we’re not. still there with the surprising momentum we see at 1Q.

Jefferies’ Aneta Markowska points out that a structurally tight labor market combined with lower price inflation is a recipe for squeezed margins and, ultimately, layoffs. Yes, wage growth is slowing, which in theory eases pressure on margins, but can it last? Markowska calculates that in December there were 5.3 million more vacancies than unemployed, but only 1 million potential workers likely to join the labor pool:

In this environment, labor should still enjoy significant pricing power . ..

Price growth is expected to slow much more sharply. In other words, firms lose their pricing power faster than labor. This indicates a marked slowdown in revenue growth, while costs remain rigid. The result: margin compression.

So, despite weaker wage growth than we had expected in January, the data remains broadly in line with our scenario. The base case continues to be a 1H margin squeeze, triggering more mid-year layoffs and a 2H recession. In the meantime, it is possible that Goldilocks’ account [ie, slowing wage growth and low unemployment] stays alive and kicking around for several months. But we doubt he will survive this summer.

Markowska’s skepticism about the decoupling of wages and employment for a long time seems right to us. Both are a function of workers’ bargaining power, which is high. Wage growth is still strong by any measure, and a small deceleration seems weak evidence that strong employment disinflation is ahead.

But a good dose of modesty is needed. The likelihood of a soft landing depends on how easily inflation falls. Nobody really has a clue what’s going to happen, largely because of the massive shift from spending on goods to spending on services in the wake of Covid: we’ve never seen an economic event like this -this. A comparison with history illustrates the enormity of the change. As far back as the data goes, there is no real precedent, including World War II:

Remember that the reports of cooling inflation that the markets have been cheering for lately are all due to commodity disinflation. How long will this inflation last? Is the current services inflation, like that of goods two years ago, just a temporary Covid distortion spreading through the economy? Or is it a more entrenched expression of labor shortage? We just don’t know. (Ethan Wu)

A good read

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