Universal Value Advisors

As the Fed Confronts the Inflation/Recession Dilemma, Markets Display Signs of Indigestion


Employment numbers for December were much weaker than expected with net new job creation at +199K, significantly below the +422K consensus view.  In addition, the workweek contracted as did factory overtime.  But, markets didn’t react much to this.  Instead, because the Labor Force Participation Rate (LFPR) continued well below its pre-pandemic level and didn’t budge in December (as expected), the labor market remained tight with wage growth, which had been confined to lower skilled sectors, breaking to the upside in several of them.  This raised already sky-high inflation concerns and sent yields higher and the higher-flying equities lower.  The real concern here is how the Fed maneuvers policy around growing inflation considerations (normally met by tighter monetary policy) while the economy’s growth falters (normally met by policy easing).

Ugly Employment Details

Let’s start with ADP’s 807K number from Wednesday.  That gave markets expectations for a blockbuster December report.  But, as we suggested in earlier blogs, a lot of holiday shopping occurred earlier than normal due to the “shortage” narrative.  The Johnson Redbook chain store sales data has been consistently showing up with negative comps to the same 2020 weeks (latest data now greater than -4%).  On a Seasonally Adjusted  (SA) basis, the Retail sector showed up with no net new jobs (-2.1K).

As indicated, the Establishment (Payroll) Survey was a disappointing +199K (SA).  As we have preached, the SA data may be misleading since, as discussed below, the pandemic is still having a big economic influence, and the pandemic is not seasonal.  Not Seasonally Adjusted (NSA), the Establishment data was an even weaker +72K.  Of course, when market bulls don’t get what they want, they find the data that fits their mantra.  In this case, the much more volatile Household Survey showed a SA +651K increase.  (That’s potentially a lot of Uber Eats, Grub Hub, and Door Dash drivers!)  The NSA data, however, at -65K, leaves one with a not so exuberant feeling.   

The real key here is the stagnation in the Labor Force Participation Rate (LFPR), the percentage of the working aged population either having a job or looking for one.  It remained at 61.9% in December, still significantly below its 63.4% pre-pandemic level.  And this caused two significant developments:

  1. The U3 unemployment rate fell from 4.2% to 3.9%, not because employment was strong, but because the LFPR was weak.  There appears to have been a significant change in attitude toward work in low skilled jobs in America vs. pre-pandemic times.  Had the LFPR returned to its pre-pandemic level, like it has in Canada, the U3 unemployment rate would be north of 6%! (And it is near that number north of the border.) 
  • Outsized wage growth has now become widespread.  Previously, it had been confined to lower skilled jobs (leisure/hospitality, retail), but now has broken out – this due to the LFPR issue.  The M/M change in wages was, as expected, +0.8% in the leisure/hospitality sector.  But, look at what happened to wages in the following sectors:
    • Utilities: +1.8%
    • Wholesale Trade: +1.0%
    • Education/Health Care: +0.8%
    • Financial: +0.7%
    • Construction: +0.4%

Couple these trends with continuous media coverage of inflation (much of which has been caused by supply issues), a public up in arms, and a political class now running for cover, this translates into pressure on the Fed to do something.  Thus far, they have embarked on a campaign of “less ease,” i.e., the “taper” of asset purchases.  But, of late, the Fed, through various Fed Governor speeches/interviews, spokespeople, and releases of minutes has convinced the markets that interest rates will be rising, and much sooner than markets had previously expected.  Thus, the rapid rise in Treasury yields.  (Of course, equities abhor Fed tightening.)

The Fed’s Dilemma – Inflation vs. Weakening Economy

The problem for the Fed is that we simultaneously have inflation AND a weakening economy:

  • The employment survey was taken the week of December 12-18 when concerns over the omicron variant were low/just starting to emerge, and no one was paying any attention to those saying that the upcoming holiday festivities would cause a spike in infections.  But, for sure, the January survey week (January 9-15) will contain such concerns, and weakening job growth, together with a continued upsurge in wages will keep pressure on the Fed. 
  • Markets react to the Fed’s “announcement,” of its action, not to the action itself.  The 10-year Treasury yield is the benchmark for mortgage rates.  It has risen 40 basis points (.4 percentage points) since the middle of December (from its 1.37% low on December 16 to a 1.77% high on January 7) due to various “hints” coming from inside the Fed.  Pending home sales were already toppy in November (-2.2% M/M and down in four of the last five months).  The rise in the 10-year benchmark yield is sure to have a negative impact on mortgage rates and future housing data.
  • We closely watch the weekly jobs data, Continuing Claims (CCs) (those receiving benefits for more than one week), and Initial Claims (ICs).  The December CC data are especially concerning, up nearly one million since Thanksgiving.  Similar for ICs where the NSA number went from 258K to 315K in the latest weekly data release, still significantly above its pre-pandemic 200K level (see chart). 
  • The high and rising levels of omicron infections can’t help but weigh on employment and economic activity as the quarter progresses.  It  is already apparent in Open Table’s measure of restaurant activity, and we’ve seen it in the “call-in sick” issue that caused a plethora of airline cancellations over the year end holidays.
  • Auto sales, at 12.4 million units (annualized) in December, are down nearly 24% Y/Y and have fallen in seven of the last eight months.  A “normal” month is 16 million. 
  • The latest data show that U.S.consumers went on a borrowing binge of $40 billion in November (consensus was $20 billion), this after drawing down the savings rate to 6.9%, a four year low, from 10.5% earlier in the fall.  With weak employment growth, savings nearly exhausted, and not much hope of additional “helicopter money” from the federal government, debt repayment will be a negative for growth in 2022.
  • Both the ISM Manufacturing and Services Indexes plunged in December.  The Manufacturing Index fell to an 11 month low to 58.7 from 61.1 (once again, the consensus (60.3) missed on the high side).  Services got whacked, sliding to 62.0 from 69.1 (consensus – yes, missed on the high side at 67.0).  Last week, the Chicago Fed’s National Activity Index (NAI) for November was at half of its October level.

Conclusions

We can’t escape the fact that the markets are and have been overly optimistic about economic growth.  This is obvious from the consistent misses on the high side of the Bloomberg consensus data.  In most of the misses, the consensus had penned in slightly less optimistic numbers for the current month than that which existed in the prior, but in almost every case, the actual data proved to be much weaker. 

Thus, the Fed has a real dilemma.  Politically, they must “fight” the inflation that is no longer considered “transitory” (even if it really is).  That means tightening policy, not just reducing the level of monetary ease.  As discussed above, the economy is slowing at a much faster rate than is commonly viewed.  Under such a scenario, actual monetary tightening almost always results in recession.  Econmist David Rosenberg recently pointed out that when the yield curve has the flatish shape that currently exists, 100% of the time, (repeat, 100% of the time) real GDP has slowed in the ensuing year, and by a average of two percentage points.

The chart at the top of this blog points out how equity valuations are out of touch with their historic levels.  Thus, it’s no wonder that equities are having a bout of indigestion.  Our view is that, if the labor markets don’t soon ease (a rise in the LFPR) and show some moderation in wage growth, the Fed will have little choice but to validate the bond market’s rising rate view, and this will ultimately be a policy mistake in a decelerating economic growth scenario.

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog.)