Economic Update

The U.S. economy does not appear to be in a recession right now. But risks continue to skew to the downside, in our opinion. We believe there’s a 75% chance of a U.S. recession in the next 2 years.

The employment situation continues to show a tight U.S. labor market. Despite some notable tech layoff announcements, U.S. nonfarm payrolls in November rose +263,000 m/m, with only small revisions to prior months. Workers who are fired seem able to get new jobs quickly (consistent with still-elevated job openings data). The labor force participation rate declined to 62.1%, which is disappointing (labor supply is still not showing up). The unemployment rate remained low at 3.7%. Wage gains popped: average hourly earnings rose +0.6% m/m (!) and 5.1% y/y in Nov.

The overheating domestic labor market is egging the Fed on. In an era of weaker productivity as we have seen, 5% wage gains are too hot for a 2% inflation target. We look for a +50 bp Fed hike on Dec 14th, with a terminal funds rate of 5-5.25% in early 2023.

So, this is where the risk comes from. The goal of economic policy is to help balance supply and demand (imbalances create inflation). Unfortunately, it has been very difficult to achieve this balance, not just domestically but in many economies over the past 3 years. There have been very large global shocks, due to health concerns as well as geopolitical events. Demand exceeding supply has generated the largest inflation concern in the past 40 years in the U.S.

The Federal Reserve is an institution that, by mandate, is tasked with fighting inflation. But the Fed does not control the supply side of the economy, only demand. If supply will not come up to meet demand, then demand must fall to meet supply. Bringing demand down, when extreme, is another way of saying the economy will be in recession.

A minimum condition for a restrictive monetary policy is a positive real (inflation-adjusted) interest rate. Policy rates started out near zero this cycle, that is, basically as low as they can be. With inflation now running hot (even excluding some volatile components it is close to 5%), interest rate hikes have been aggressive in the past year. These moves make sense, but they are jarring.

But that’s not all. Monetary policy generally acts with a lag, so today’s actions will continue to impact the economy in the coming years. Even if we pass the bulk of the rate hikes, we are not past the effect of these policies. While some sectors of the U.S. economy (eg, housing) are already feeling the effects of higher interest rates, the labor market has been slow to respond. A change in the labor market data is likely to be significant as we enter 2023, specifically job loss and rising unemployment.

The bottom line: risks to economic growth skew to the downside currently and are likely to continue to do so for some time. Price stability must be preserved by decree. With restrictive monetary policy, inflation should come down. But the cost is likely to be a recession and declines in U.S. job counts, given what the Fed must do to create economic slack.

There are several cushions that could help limit the damage in 2023. There remains some excess cash savings left over from the fiscal stimulus which came about in response to the recent pandemic. Additionally, the U.S. labor market is so tight that there are nearly 2 job openings for every unemployed person currently. The Fed’s hope is that they can destroy job openings before destroying too many jobs.

History teaches us that there should be a symmetry to the inflation process, ie, the steeper the increase in price pressures, the steeper the decline. While, as always, there are idiosyncratic events that could matter in the short run (eg, oil price volatility), this trend should be the underlying pattern in 2023. Eventually, the Fed should feel less urgency. That’s key for getting past the downside risk to economic growth and corporate earnings – but we’re still waiting.

Source: Strategas

Market Index
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv


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