Both Directions at Once
Updated: Aug 4, 2022
The God of Change, Janus, to Whom We All Now Kneel
The deity of doorways, edges, and verges, Janus is at once both where we are and where we're going
We don't know much about Janus, a god wholly unique to the Romans* and who does not have an analog in Greek mythology. His name gave us our word for the first month of the year, as well as our word 'janitor'. He is depicted in his statuary as a man with two faces, one on each side of his head, with which he can see before and behind him at once; perhaps he has only one face, but this was the only way the Romans could portray him as simultaneously looking both directions at once. While he had no dedicated priest, he was recognized at every religious festival and juncture in one's life. His compass includes both the past and future, which is why we see him preside over so many thresholds in ancient architecture.
Periods of transition are marked by the characteristics of their preceding and proceeding phases. So it is that we find ourselves surrounded by seemingly incongruent economic data: at once, it seems that the economy is sound and continues to expand; at the same time, we feel the economy tremble, and see semaphores of contraction on the horizon. How can both be true?
The US Economy Remains Quite Strong
Unemployment in the United States has stayed very low and is probably below the natural rate of unemployment, which is estimated to be somewhere in the neighborhood of 5%. Unemployment at 3.6% is historically low, in fact--yet it continues the trend rate the US economy achieved on the eve of the global pandemic. As a clear sign of strength, everyone who wants a job has one.
While the Unemployment Rate measures how many people in the labor force have a job, the Labor Force Participation Rate measures how many people who can work are either employed or actively looking for employment. This measure hasn't recovered from the declines it saw in the wake of the Global Financial Crisis, although it has for the most part recovered from the lows it plumbed during the depths of the pandemic-induced recession. At the moment, it seems to have stabilized at its new lower level, meaning workers are not leaving the workforce faster than new workers are entering it, or that new workers are entering the workforce faster than older workers are leaving it.
Furthermore, wage growth has continued to trend higher, though higher inflation erodes higher wages' purchasing power. Below we show Personal Income growth since 2008. As you can see, wage growth declined, then stabilized from 2010 until the pandemic. Since then, it has been extraordinarily volatile, peaking at 29.5% in March of 2021 and bottoming out at -11.4% in March of 2022. Growth appears to have coalesced about its average rate of around 5% over the past ten years.
Employment data are therefore rather robust--and it's generally the condition of the labor economy that we consider when we talk about recessions since it is the lives of the working class that are most impacted by contractions in the broader economy. One last measure that is concomitant with retractions in economic conditions is the Sahm Rule Recession Indicator, which we reproduce below. At least as far as the labor market is concerned, the likelihood that we are in a recession is 0.00.
Expanding economies also place upward prices on goods and services, resulting in higher inflation. As goodstead's readers are no doubt aware, inflation has persisted at multi-decadal highs, as a result of both elevated consumer demand and constrained productive capacity. Were the economy not so strong, inflation wouldn't register at such high levels. Recent inflation reads have seen the change in the inflation rate decelerate--a potential signal of weakness to come--but as of this writing, remains elevated and indicative of too much, rather than too little, economic activity.
Core inflation is an important measure for economists since it is an indication of how broad price increases in the economy are. The supply and demand for specific goods are always changing, and prices are constantly updating to reflect the market clearing price that matches quantity supplied with quantity demanded. Core inflation tells us whether overall inflation is due to changes in the supply and demand of a specific good or service, or to all goods and services considered together. Of course, core inflation doesn't really matter that much to households with a high propensity to consume, or without a lot of income to spare. What matters to them are the prices of the goods and services that consume the largest share of their pocketbook: things like shelter, gasoline, heating oil, food and electricity. More on this later, but for now, inflation remains elevated, which is what you would expect to see in an economic expansion. But a large contributor to the so-called "Misery Index" is the price of gasoline, which has fallen off its recent highs by almost 20%.
In addition to the favorable decrease in the price of gasoline, US Durable Goods Orders increased in June, mostly on strength for transportation equipment. Defense spending was on an absolute tear, increasing 81%. The non-transportation increase came primarily from non-defense capital goods such as electrical equipment, components, and computers--all key components for dealing with labor shortages. The economy might be finding another way to continue growing.
Corporate profits have fallen from the heights that they climbed during the extraordinary economic boom of the past year. They now register at a more normal level, but critically have not yet turned negative. As of this writing, about 1.5 times as many companies beat their quarterly earnings estimates as missed them. Earnings are in many ways the capitalist economy's means of distributing productivity growth to providers of capital, and so are a pretty good indicator of economic strength. As inflation bites and higher interest rates dampen demand, projected earnings slow and profits go down.
S&P 500 performance, the equity index that represents the largest American (global) corporations, has been down as much as 23% this year-to-date, but has recently clawed back 10% of its loss to -13%. While this may or may not be reflective of new assumptions about profitability growth for the next year, it is certainly an arrow in the quiver of those who argue that what we're seeing is a moderate slowdown in the economy, if there's a slowdown underway at all.
The Federal Reserve Bank of Atlanta's GDPNow forecast shows that, given the economic indicators we have in, the economy is currently growing, albeit very slowly, at a rate of 1.26%. In a strange convergence, the Federal Reserve Bank of New York's Weekly Economic Index similarly shows slow, but positive, growth of 1.62%.
Taken together, it is difficult to justify worries about economic contraction.
Other Indicators Signal Impending Economic Weakness
All that said, there are plenty of reasons why looking ahead we don't see smooth sailing. First, economies are just all the aggregated buying and selling decisions of consumers, businesses, governments and other entities--which is to say, they're the sum total of the actions of human beings. Human beings, for all of our natural endowments of reason and dispassionate judgment, are nonetheless affected by emotions--but most of all by Fear and Greed. If everyone in an economy feels just a little more fearful of what the future holds, the economy will grow less. How do we determine how concerned everyone is about the future? One (unscientific)** method of measuring people's concerns about recession is just to look at how many people are searching for information on internet search engines. As you can see below, searches for 'recession' are higher than they've been since the Global Financial Crisis.
When people are concerned about the future, they buy less. That means that businesses can't move inventory, resulting in a higher ratio of inventories to sales. The chart below shows how we've gone from having very, very little inventory during the pandemic (a result of supply chain disruption) to having far too much. The amount of unsold inventories has improved, but retailers are still oversupplied. That means that they will have to hold onto inventory longer, or discount inventory--both of which impact corporate earnings negatively.
When retailers sit on inventories they can't sell, they order less new inventory from manufacturers. The effect of this contraction in demand is evident up the supply chain in manufacturers' surveys. The Institute of Supply Management's (ISM) Manufacturing Purchasing Managers' Index (PMI) (a lot of acronyms, sorry) reflects an accelerating contraction in new orders for the month of July, down 1.2%. The overall index shows a deterioration in the manufacturing sector--both new orders and employment--to the point where it is barely growing overall. The United States doesn't derive a lot of its domestic growth from manufacturing--the US is primarily a service economy--but the PMI is nonetheless a pretty good leading indicator of overall economic activity.
If retailers are having trouble selling, and manufacturers are having trouble selling, then we should see the impacts of the slowdown in US Real Gross Domestic Product (GDP). GDP is like the net income, but for countries, and measures how much in goods and services was produced by the economy within the observation period. For the first and second quarters of the year, the US has slightly negative GDP growth, which means that the economy actually shrunk over the first half of 2022. (In the first quarter, it would have been positive except that the US imported more than it exported.)
As we mentioned earlier, corporate profits are like Capital's draw on the profits of the economy. Earnings growth for the second quarter has been pretty good; however, Captains of Industry are forecasting lower earnings growth in the future. Partly this is due to higher input costs like raw materials, labor and transportation--but partly due to their registering of a contraction in demand on the behalf of consumers, whose activity drives approximately 2/3 of the economic activity of the United States.
One way the Federal Reserve slows down the economy is through interest rate policy, whereby its higher rates make financing purchases more expensive and saving more attractive. Nowhere is this deceleration more evident than in the housing market, where we see a decline both in New Mortgage Applications as well as in Existing Home Sales.
As the bite of higher interest rates takes hold, the number of mortgages issued drops and housing transactions fall through or are put off. The evaporation of demand hits the economy in two ways: first, home prices fall--and they have a long way to fall after their run-up in the wake of the Global Pandemic--
and a reduction in the building of new homes. As we've written before, the United States is woefully under-housed, meaning that the demand for houses far outstrips the supply of houses, leading to higher home prices and economic loss. We'll write more on this topic at a later date, but suffice it to say that new home construction used to be, and still should be, a huge source of productivity growth for the United States with extraordinary value to its citizens. Unfortunately, yet again, home construction is faltering because of the instability of demand due to buyers' inability to finance their purchase.
One of the more classic indicators of coming economic weakness is the inversion of the yield curve. Briefly, long-term debt is supposed to pay more than short-term debt. This reflects the premium that you should get for locking up your money for longer. When this relationship reverses--inverts--then short-term debt pays more than long-term debt, which is typically taken as a signal that the market consensus is that recession or a cessation of economic activity is imminent. While the yield curve has inverted a couple of times in the recent past, it is now more inverted and has stayed inverted.
Lastly, we end where we began: with employment. When economists worry about inflation, it is primarily because of something called the wage-price spiral. It's a positive feedback loop whereby higher prices beget demands for higher wages, which in turn beget higher prices, and so on and so forth until either the central bank gets inflation under control through the imposition of repressive interest rates, or the economy implodes, and the angry citizenry bust out the pitchforks and torches. If interest rate policy works the way it's supposed to, then higher interest rates depress economic activity, demand is curtailed, corporate earnings contract, and companies shed workers. The tightening cycle really reached another, higher gear when 372,000 new jobs were gained in June and the Federal Reserve realized that it would have to tighten rapidly to cool the economy. (200,000 new jobs per month is typical of an economy that is expanding at a normal rate.)
Fast forward to today, and we see that higher interest rates are beginning to have an impact on the demand for labor in America. In June of 2022, the number of job openings contracted by 5.4%, meaning that the labor market is beginning to cool--albeit ever so slightly. Higher demand for labor translates directly into higher wages for workers, which seems like a good thing--unless those price increases are so large that wage increases can't keep pace.
No one can tell the future. We don't pretend to have any better ability to predict what's going to happen than anyone else. The world economy continues to reel from the shock of Putin's invasion of Ukraine, Xi Jinping's shuttering of the Chinese economy, and the supply chain disruptions engendered by the Global Pandemic. It's anyone's guess when these factors will dissipate in importance, if at all. Until then, the Federal Reserve will continue to watch the tape as it comes in, and has vowed to pursue a flexible monetary policy to deal with whatever may come. While we believe it is likely that higher prices and higher interest rates are here to stay, and that a prolonged period of lower growth is likely to plague investment portfolios for the foreseeable future, these are by no means predestined. As such, we maintain a portfolio that is positioned to perform better given higher inflation and lower growth rates. We continue to believe that the run up in asset prices during the aftermath of the Global Pandemic was unjustified, and that these valuations will have to be unwound over the coming year, spelling a doom of decline for equity prices. Whatever the case, we do believe that volatility will remain elevated as the market--and the Fed--determine whether the future will look like the recent past, or if we face a far more uncertain future.
*At least according to the Romans and Greeks.
** There's been a lot of interest recently about whether the United States is in a technical recession, so some of this search interest may be to settle definitional arguments rather than to express concern about being in a recession.