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A Full-Employment Recession: Post-WWII Growth Model Flawed

There were three big interrelated economic events at the end of October. We had the first pass at Q3 GDP, followed by the Fed meeting (another reduction in the Fed Funds Rate), and the week ended with a much stronger than anticipated jobs report. The data continue to imply that the traditionally accepted post-WWII growth model (emphasis on positive aggregate GDP growth) is no longer applicable, and policies based on it are flawed.

GDP

GDP came in at +1.9%, better than expected (+1.6%), albeit, first passes by BLS include a lot of guesstimates. It is likely that, in a slowing economy, the revisions will be to the downside. Everything in the GDP report was weak except the consumer, but even that growth rate, +2.9%, was considerably slower than Q2’s 5.0%. With consumer confidence now falling, consumption will further deteriorate in Q4 and Q1.

  • The Conference Board’s Consumer Confidence Index fell to 125.9 (Oct.) vs. 126.3. But, it is expectations that drive spending, and these have fallen off a cliff: Oct.: 94.9; Sept.: 96.8;  Aug:. 106.4; July: 112.4. In addition, auto buying plans, always a good indicator of the consumer’s disposition, fell to 9.9% (Oct.) from 12.1% (Sept.) and 13.0% (Aug.), the lowest since October 2015.
  • Of the 1.9 percentage point growth, 0.8 percentage points, or 42%, came from auto factory output. This occurred at a time when consumer spending on autos was stagnant. (The Conference Board’s auto-buying plans index is at the lowest level since 2015.) Perhaps it was GM’s response to the impending strike. In any case, without that, real GDP growth would have barely been more than 1%.

The Fed

The second big event was the Fed meeting. As expected, the Fed Funds Rate was cut by 25 bps (to 1.50% – 1.75%). Also, as expected, the Fed said they would now “pause.” This tells markets not to price in a guaranteed rate cut for the Fed’s December meeting set. “The Committee will continue to monitor the implications of incoming information,” the statement said. (Isn’t this what they’re supposed to do?) This clearly means that if the weakness we currently see progresses, they will have to act (i.e., more rate cuts? Or more QE? (They are already injecting $60 billion/month)).

Employment

The third event was the employment report, which surprised to the upside. October jobs (Establishment Survey) rose 128k (consensus was 85k) and was much stronger than markets had anticipated. Add to that the upward revisions to August and September (a total of 95k), and the fact that the GM strike and some backtracking in census hiring reduced the count by about 60k, and you have a seemingly very robust labor market.

(As always, I am a bit cautious about drawing conclusions based on BLS’s labor report. This month, on a seasonally adjusted basis, the birth/death model of small businesses was responsible for nearly 40k of the 128k-job growth. These are jobs that were not counted in the survey because BLS does not survey small businesses. Instead, it plugs in a number based on a mathematical algorithm having nothing to do with current business conditions.)

The Post-WWII Growth Model Error

While the report looks quite robust, its strength is really less than meets the eye because it is viewed in the context of the post-WWII economic growth model. There is a seeming contradiction between slowing growth and contracting business, and a low level of unemployment. The answer lies in the demographics.

A key to understanding this apparent contradiction is the realization that the unemployment rate is simply a ratio, a percentage. It says nothing about the volume of labor that is required to support the current or desired level of GDP. So, if there aren’t enough workers, it is quite possible to have slower aggregate GDP growth, no aggregate GDP growth, or even recession at the same time there is a low unemployment rate.

Today, the pool of available labor is 10.6 million. It is less than the number of job posts, and is the lowest level the pool has been since the turn of the century. The bulk of those remaining unemployed are there because they either don’t have the skills, or they don’t live where the jobs are (and maybe can’t afford to live where they are!).

The Phillips Curve Failure

In that post-WWII model, when unemployment was low, wage inflation was supposed to be high (this is known in economic parlance as the “Phillips Curve”). We haven’t seen this relationship this cycle. Wages simply are not rising rapidly despite a 3.5% unemployment rate. Yet the Fed, especially in 2018, acted as if the Phillips Curve was alive and well and raised rates in anticipation of such. They clearly overtightened and have walked back those rate increases this year.

A Full-Employment Recession?

This is where we are today. Clearly there is a business recession, either on its way or, most likely, in its early stages in the U.S. (much more mature in the rest of the world). It is also true that jobs are available. We even see low unemployment rates in those economies already in recession (Japan, China, the U.K., and Europe). Perhaps this will be the first full-employment recession. It certainly won’t be the last as the demographics continue to be such that the working aged population as a percentage of the total continues to fall.

As long as the business/political/academic communities cling to the post-WWII growth model where aggregate GDP growth is the primary measure of success, there will be confusion/uncertainty over the paths of fiscal and monetary policies.

Of late, fiscal policies sporting historic deficits while the labor market is at/near full employment, make little sense. Meanwhile, the Fed’s approach has been slower and more measured. Still, there is a high probability that they, too, will react to extremes if aggregate GDP growth turns negative, even while the labor market is at/near full employment.

A Different Model

We need to address the following: If there is full employment, are stimulative and sometimes extreme policies, like negative interest rates, QE, and gigantic budget deficits, necessary? Should we have an alternative measure of economic well being, like per-capita GDP growth or per-capital GDP growth of the working aged population? That could lead to less panic on the part of policy-makers when aggregate GDP slows or turns negative, and more rational monetary and fiscal policies.

In this recession, however, business will feel the punch. We are already seeing this in lower aggregate profits (Q3 was the third quarter in a row of lower Y/Y aggregate profits), lower revenues, exports, and in manufacturing overcapacity and downward pressure on prices (especially at the business level).

U.S. Current Data

  • NY Fed Nowcast for Q4 GDP growth: +0.9%.
  • Dallas Fed Manufacturing Index (Oct.): -6.6 points to -5.1 (Orders, Production, Employment all fell hard).
  • Pending Home Sales (Oct.): +1.5% M/M. This is clearly a reaction to lower interest rates. But, the first-time homebuyer is still absent, and, without that group, the impact on GDP is marginal (this is existing homeowners trading with each other – impact is on realtor commissions and on home improvement). Mortgage apps, on net, continue to be in a negative trend despite falling mortgage rates. There simply isn’t enough affordable housing.
  • Chicago PMI: 43.2 vs 47.1 (consensus 48.3). This is the weakest this index has been since December 2015. The previous eight times this index was below 44, the economy was in recession. Similarly, the Milwaukee PMI slipped to 42.5 from 45.4 (remember, <50 means contraction).
  • The ISM Manufacturing PMI (Oct.): 48.3 vs. 47.8 (consensus: 48.9). Only five of the 18 industries reported positive growth. The good news is that the data didn’t contract further. The bad news is that this is the third month in a row of contraction, and it looks pretty much like 2009.

Current Data- Rest of the World

  • PMIs in So. Korea, Japan, Malaysia, Indonesia, and Taiwan are all <50 with Thailand and Vietnam very close to the 50 level as well.
  • Bloomberg Article: “China’s Slowdown Rolls On Into October…”
  • Germany: Unemployment up, inflation down; GfK measure of consumer confidence (Oct.): -14 vs.-12
  • Japan: Industrial Production, housing starts, exports and construction are all in negative trends.
  • So. Korea: Industrial Production  (Sept.) -2.9% Y/Y, and trade with China -21.8% Y/Y.
  • Most of Latin America is in shambles (Venezuela, Chile, Argentina are in various states of collapse, and Brazil still looks to be in or near recession).
  • China: NBS Manufacturing PMI (Oct.): 49.3 vs. 49.8 with new orders, and exports falling; Non-Manufacturing PMI fell to 52.8 from 53.7.
  • Hong-Kong: GDP -3.2% Q3. Q2 was -0.4% (technical recession).

As demographics slow the world’s potential economic growth and the trade wars reduce the actual growth rates, will policy makers, worldwide, recognize that unnecessary and extreme policies will only distort the outcomes? Current indications are that they are still stuck in the post-WWII growth model.

Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU).

 

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