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Good morning. We spent the weekend wondering how the China spy balloon saga could be turned into an extended metaphor for what is happening in the stock market. No luck; sometimes a balloon is just a balloon. So we wrote about the jobs report instead. Email us: email@example.com and firstname.lastname@example.org.
The blowout jobs report and the disorienting economy
Unhedged is feeling confused about the economy. Is it firing on all cylinders? Cresting into a mid-cycle slowdown? Hurtling towards a Fed-induced recession? Friday’s jobs report didn’t help. It showed the US economy adding half a million jobs in January, blasting through expectations and making any recent labour market cooling look marginal indeed.
It’s not just the jobs data. As Jay Powell put it last week: “This is not like the other business cycles in so many ways.” We’ve summed up several data points we look at below. If there’s an obvious overriding story, it eludes us:
Whatever is going on, the labour market is an important part of it. The Fed is worried about a category of prices called non-housing core services, which it sees as the beating heart of sticky inflation. And historically, that category has looked awfully sensitive to wage growth. This chart from Deutsche Bank shows the close correlation (ECI is the employment cost index, a wages measure):
With that in mind, Friday’s whopper jobs number presents a question. Does a strong data surprise in the labour market make a soft landing more likely, or less? The question is a bit pat; one month of data can always be a blip. But the rock-solid labour market has been surprising everyone for months now. Is it good news for investors or bad news?
The range of opinion runs wide. Some in the “soft landing more likely” camp, like BlackRock’s Rick Rieder, take employment strength as a sign the economy can muscle through higher interest rates without a recession. He wrote on Friday:
Central banks are embracing the slowdown in excessive levels of inflation witnessed over the past year, while maybe not having to sacrifice as many jobs as previously thought. We think the Fed would be well-served to consider this as a success and think that slowing down the pace of hikes (and potentially ending them over the next few months) would allow the job market to bend, but maybe not break. Today presents good evidence of a job market not breaking and evidence of how the economy can adapt and adjust to remain vibrant in the face of major headwinds (such as higher interest rates).
Others emphasise how wage growth (slowly decelerating) and employment (still growing) have decoupled. The hope is that we might get the best of all worlds — a high-employment disinflation — as long as the Fed’s anti-inflation zeal doesn’t get in the way. Preston Mui at Employ America writes:
For months, the Fed has been telling a story that “pain” in the labour market will be necessary to bring down inflation …
The Fed should revise its views based on the last few months of data. The unemployment rate is at a historic low. The prime-age employment rate, while not at a historic high, is at its highest level since COVID began.
Meanwhile, nominal wage growth has been slowing …
Along with recent disinflationary data from the CPI, we are seeing what many said to be impossible: slowing inflation in prices and wages even as levels of labour market strength remain strong 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 all else. Inflation is high, so rates must remain restrictive until that’s no longer true. Labour market resilience just prolongs the process:
The default position remains that the US labour market is overheating, with the unemployment rate making a new cycle low. Underlying inflation pressure remains, so central banks are mandated to move policy to a restrictive stance & hold there.
The FOMC still looks set to take fed funds above 5 per cent in early 2023. The US labour market will likely have to show more slack to create an end game for tightening — we’re not there yet with the surprising momentum we’re seeing in 1Q.
Aneta Markowska at Jefferies points out that a structurally tight labour market combined with falling price inflation is a recipe for pinched margins and, ultimately, lay-offs. Yes, wage growth has been slowing, which in theory eases margin pressure, but can that last? Markowska calculates that in December there were 5.3mn more job vacancies than unemployed people, but only 1mn in potential workers who could join the labour pool:
In this context, labour should still enjoy a great deal of pricing power . ..
Price growth is likely to slow much more sharply. Put differently, firms are losing pricing power faster than labour. This points to a steep slowdown in top line growth, while costs remain sticky. The result: margin compression.
So, despite softer wage growth than we envisioned in January, data are still tracking broadly in line with our scenario. The base case continues to be margin compression in 1H, triggering more lay-offs around mid-year and recession in 2H. In the meantime, it is possible that the Goldilocks narrative [ie, slowing wage growth and low unemployment] remains alive and kicking for several more months. But we doubt it will live past this summer.
Markowska’s scepticism about wages and employment decoupling for long seems right to us. Both are functions of workers’ bargaining power, which is high. Wage growth is still elevated by any measure, and a little deceleration seems weak evidence that a high-employment disinflation is coming.
But a generous helping of modesty is due. The chance of a soft landing comes down to how easily inflation falls. No one really has any idea what will happen, in large part because of the mass transition from goods spending to services spending in the aftermath of Covid: we’ve never seen an economic event like it. A comparison to history illustrates the enormity of the change. As far back as the data go, there is no real precedent, including the second world war:
Remember that the cooling inflation reports that markets have cheered on lately have all come on the back of goods disinflation. How long will that inflation drag last? Is today’s services inflation, like goods two years ago, just a temporary Covid distortion working its way through the economy? Or is it a more entrenched expression of the labour shortage? We simply don’t know. (Ethan Wu)
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