Commentary on Political Economy

Sunday 10 December 2023



The Nuanced Economy of 2023

The US economy is slowing down, ever so gradually. Unemployment is rising, but not very fast, and far more slowly than virtually everyone had anticipated. What’s happened to date is fully consistent with an eventual recession, but would also be in line with a milder outcome (which we're obliged these days to call a “soft landing”). 

That’s what you might call the TL;DR (Too Long; Didn’t Read) summary of what you need to take away from Friday’s big download of employment and payroll figures from the Bureau of Labor Statistics. It’s possible that inflation data on Tuesday, followed by the year’s last meeting of the Federal Open Market Committee on Wednesday, will point more clearly in one direction or another; but that’s unlikely.

Instead, the November jobs report just continued a story that has been running all year. People are miserable, but there isn’t a recession. If this sounds rather too wishy-washy to have sparked what’s been a banner year in securities markets, that’s only because you need to take expectations into account. The following beautiful chart from Bankim Chadha of Deutsche Bank AG shows what growth expectations for US gross domestic product have been since the final quarter of 2022, as compiled from the Bloomberg economist surveys, and the actual outcome in each quarter:

Throughout the year, economists have braced for an imminent mild recession. Quarter after quarter, they’ve been surprised by strength. And now, consensus expectation has shifted upward slightly. GDP growth is forecast to bottom out still just in positive territory — and even that prediction requires a very sharp slowdown from where we currently are. In such circumstances, of course risk assets have performed well, and of course bonds (which benefit from a slow economy) haven’t. And it even makes sense to hope for more of the same. To quote from Deutsche: 

Markets react differently to anticipated events than to surprises. Just like stock prices hardly react if a company reports a loss that has been widely anticipated, markets could react less negatively once a long anticipated recession materializes. Also, a recession would most likely lead to even more cuts from central banks than markets are currently pricing in, which could limit the downside further.

Going into more detail, the non-farm payroll report — compiled by surveying employers — came in ahead of expectations with a net gain of 199,000 jobs. Meanwhile, the unemployment rate — compiled by surveying families — fell to 3.7% from 3.9%.

There’s great interest in recession indicators at present. Steadily falling Leading Economic Indicators and a yield curve that has been inverted for more than a year both predict a recession. But those based on the employment market have not yet predicted such a thing, and they still don’t after Friday. 

The following is the so-called “Sahm Rule,” named after Bloomberg Opinion colleague and former Federal Reserve economist Claudia Sahm. It gains its strength from the standard pattern in employment. When a recession is coming, employment peaks, begins to decline slowly, and then reaches a tipping point and falls much faster. Sahm’s rule suggests that that tipping point is reached when the three-month rolling average of the unemployment rate exceeds the minimum three-month average over the preceding 12 months by 0.5 percentage points. This measure had been rising in a sinister fashion, while remaining below the threshold. The November data take it a little further away from the tipping point:

Diving further into the thickets, Dhaval Joshi of BCA Research posited an improvement, named the Joshi Rule. As some elements of unemployment are more cyclical than others, he suggested using Sahm’s rule, but substituting the unemployment rate of those who have lost a job and are not temporarily laid off. That avoids being confused by events such as the pandemic or, more recently, the strike by the United Auto Workers union, and concentrates on the jobs most likely to be driven by the economic cycle. Joshi’s rule made a recession look closer than Sahm’s, but neither has yet been triggered. The numbers of these core job-losers barely changed last month from the month before. 

So a soft landing remains possible. So does a much bumpier one; the numbers on wages would make the central bank reluctant to cut rates. Average hourly earnings are still rising at an annualized clip of 4%, too high when the Fed wants inflation firmly below its 3% upper range target. On a year-on-year basis, wage rises have been falling, but remained unchanged last month. The month-on-month rise registered a rebound. It’s hard to see the Fed cutting rates until these numbers are clearly lower:

A surprise like this could have had a big impact on stock markets, particularly after so many had rushed to put their chips on early rate cuts and rising unemployment. Bond yields rose and expectations for cuts by the Fed came back a little, but the reaction could have been much greater.

That’s clearest from the behavior of the yield on Treasury Inflation-Protected Securities, which directly tighten economic conditions. The 10-year TIPS yield didn’t move Friday. After a massive adjustment in early 2022 as it dawned on traders that inflation was real and that a -1% real rate was no longer sustainable, the 10-year yield has been oscillating close to 2% for more than a year. Until recession predictions actually begin to come true, real yields are probably at about the right level:

Throughout its time wavering around near 2%, the 10-year yield has been driven by undulating opinions on prospects for a recession, illustrated above. Until such predictions actually begin to come true, real yields are probably at about the right level.

Differences of Opinion

People continue to tell pollsters that they’re very unhappy with the economy. They also say they don’t intend to vote for another presidential term for Joe Biden. The latest Wall Street Journal poll, showing Donald Trump clearly in the lead, came out the day after the jobs data. And yet, as we’ve seen, the economy doesn’t seem so bad. Consumers’ behavior, indeed, suggests that they must think things are pretty good. So what’s going on?

The University of Michigan’s monthly consumer sentiment survey came out at the same time as the payrolls, and showed an improvement, both in assessment of current conditions and in expectations. They remain uncomfortably low.

The detail of the report continues to show a steep divide between self-identified Republicans and Democrats. That’s clearest in inflation expectations. Immediately in the wake of the last presidential election, expectations for the next year’s inflation were almost identical between partisans. Since then, Republicans have continued to perceive a far worse inflation picture than Democrats. The gap isn’t as wide as it was at the beginning of 2022, but it’s actually widening. So the failure of the administration to convince a chunk of the population that it can be trusted is a contributory factor both to ongoing inflation problems, and pervasive sense that things are worse than the official numbers say:

Other explanations canvassed include the impact of echo chambers in social media (definitely an amplifier, but it’s hard to believe social media can persuade millions of people that their position is worse than it is); the effect on a generation new to a world of higher prices, which they expect now to fall back down to pre-pandemic levels (which history tells us very clearly won’t happen); a pervasive and reasonable perception of injustice; and the effect of generational divisions that makes it clear that younger people are going to have a tougher time than their parents, thanks to their inability to afford a house, the burden of student debt, and so on. None of these explanations is mutually exclusive, and all have elements of truth. But the fact that the consumer entered the year with expectations just as low as those of economists, but have since perceived something quite different, remains to be explained. An explanation might help Biden’s political fortunes — but whoever is running the US economy in 2025 is going to need an answer. 

How Are We De-Globalizing? Let Me Count the Ways…

There is far more to the steady fraying of globalization than the traditional preoccupation with tariffs policy, free trade and protectionism. What really matters is the movement of capital. And it’s here that the changes are most dramatic.

The retreat from China has many good reasons. Xi Jinping’s government is not friendly to business and does not at present offer the kind of stability and predictability that investors need; the pandemic demonstrated to everyone that there was something to be said for keeping supply chains short; Chinese labor is no longer as stunningly cheap as it used to be; the deterioration of relations with the US deters many investments for security reasons. The question is the impact that it will have.

Last week brought the amazing news that for the first time since China’s accession to the World Trade Organization in 2001, foreign direct investment during the third quarter was outright negative:

This is significant. It would be crazy to suggest otherwise. There are some ways in which it could be overstated. Bank of America points out that firms placing money overseas to gain higher interest rates would make FDI numbers look weaker on the balance of payments accounts. Also, the phenomenon is not just about the global attitude to Xi, because it is affecting the rest of Asia:

There’s a huge internal market of consumers, of course, which will continue to encourage investment by foreigners, even if they no longer wish to use the country as a base for exports. But it’s hard to view this as a positive for China. 

Implications for everyone else are that “near-shoring” or “friend-shoring” looks to be real. That should be good news most obviously for Mexico, and also for the eastern European countries that have become manufacturing centers for the EU. The prospects for manufacturing employment in the US and western Europe themselves look that much better.

The fall in FDI also suggests that the long-running Chinese anchor on global inflation is over. Whatever happens to prices in the next few months as the bizarre economic cycle started by the pandemic shock plays itself out, the reasons to expect inflation to be higher on a secular basis for the next generation look strong.

And in the longer run, a bipolar or multipolar world is likely to be less dynamic. There was plenty of growth and development during the 45 years of stark division into capitalist and communist camps, so this isn’t the end of the world. But the fall in investment into China is yet another reason to expect less dynamism in future.

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