Essential Economics

 — Mark Frears

Different or the same?

It is amazing how two kids can grow up in the same family and be totally different. My brother was the outgoing athlete, and I was the introverted bookworm. My oldest son takes after me and my youngest is more like my brother. Same house, same parents, same schools, two very different people. The markets are trying to figure out if the current economic picture is different or retelling the same story. 

Recession

If you follow the pure definition, we have had, or are in, a recession. Two consecutive quarters of negative economic growth (Gross Domestic Product (GDP)) are on the books. First and second quarters of this year did not make it above zero. What do you think? Has your behavior changed? Your spending habits? Has the behavior of people in your city/region changed? As we are in Texas, a business-friendly environment, we are not seeing a lot of change. So, instead of listening to the media talking heads, let’s look at recent economic releases.

Manufacturing

Last week we saw the S&P Global Manufacturing releases for July. The overall number at 52.2 is still above 50, showing an expanding sector, but just barely. The Services component is showing contraction at 47.3. So, we are right on the cusp here. The Institute of Supply Management (ISM) Manufacturing numbers also came out this week. It was also above 50 for July, at 52.8, while the Services component was stronger at 56.7.

The Global Purchasing Managers Index (PMI) slipped to 51.1 in July, the lowest level since July 2020. New orders and export orders also slowed. The only pickup was for inventories, and that is not a positive as it indicates slowing demand. While price pressures are easing due to fewer supply chain issues, they remain at elevated levels.

Heigh-ho, heigh-ho

The headline item for the week was the Nonfarm Payroll release on Friday. Before we get to that, weekly Jobless Claims continue to rise, indicating more people are out of work.

Source: Bloomberg

This is a common feature of late cycle economic slowdown. Continuing Claims are on the rise also.

So, you would think we would see fewer jobs added in the monthly Nonfarm Payroll release for July. Not so fast, my friend. Expectations were for 250,000 jobs to be added and the actual number was 528,000! Well above estimates and hardly consistent with a slowing economy. The other headline was that this addition to the workforce brought the number of jobs back up to pre-pandemic levels. While this is true from an actual number of people, the participation rate has not caught up. As a percentage of the working age population, we are only at 62.1%, falling recently and not close to pre-pandemic 63.4%. Where are all the people? The Job Openings and Labor Turnover Survey (JOLTS) shows 10.7 million job openings! 

What do you make of this job market? Even though prices have increased, wages are still rising. These increases are not enough to keep up with 8 or 9% inflation. There is a disparity of news from companies. While Walmart is laying off people, Uber is seeing an increase. You cannot have an economic slowdown when jobs are still plentiful, and wages are strong. The FOMC can only work on slowing demand and they will have to keep raising rates if the labor market continues this performance.

To add a counterpoint, we are seeing the unemployment rate stay at a very low 3.5%, which comes from the Household survey. There is not a small inconsistency in these two measures of employment. The Household survey shows a net add of 273,000 jobs over the last six months, while the nonfarm survey shows a gain of over 2,000,000 jobs. Which number do you believe?

Bond, UST Bond

Fixed Income markets reflect expectations of upcoming economic activity in the rates along the yield curve. The short end, out to two years, is showing expectations of FOMC activity and the longer end reflects inflation expectations.

Source: Bloomberg

The chart above shows current rate in green and rates from June 30 in yellow. First thing you notice is the one-month rate is significantly higher now. This is primarily due to the larger than expected nonfarm payroll release. Leading up to this number, the markets were starting to buy into a scenario where the economy was slowing and the FOMC would not have to raise short-term rates as aggressively. Now the concern is that the rate hikes are not having an impact yet, so more are coming! The longer end of the curve, 10- to 30-year, has not moved as much with the view that inflation, while still high, has peaked.

Much has been made of the inversion of the curve from two to 10 years, as an indicator of coming recession. As you can see above, the 10-year has not moved materially, and the two-year is higher because of more FOMC short-term rate hikes.  Does that mean a recession is coming?  Maybe some time in the future.

Credit spreads are the rate differential between a risk-free rate and the rate where corporations can issue bonds. As you would imagine, riskier companies must pay a higher spread above UST to attract buyers. This spread is watched closely for indications of stress in company’s health. So far, these spreads are not widening; another sign in the “not in recession yet” camp.
 

Decision time

Turning to equities, we are in a bear market. That much is obvious. The question is, when will we come out of it? We have never seen a bear market end before the recession began. Period. 

So, we have several possible scenarios. One, the recession has already begun, and stocks bottomed in June. Two, the recession has not started yet and a new low in stocks is still to come. Three, the Fed will engineer a soft landing and the bear market ended in June. Four, it's different this time, and the bear market is over before the recession begins.