By Chief Investment Officer & Co-Founder, Dr. Charles Lieberman
Prospects for a soft landing for the economy are discussed everywhere now, but it is presumptuous to think such an outcome is assured. Growth and inflation are moderating, but remain too high. Both need to moderate further. Additional moderation in the pace of economic growth is extremely likely, but the likelihood of inflation hitting the Fed’s 2% target without additional policy action is much lower. It remains our judgment that interest rates may need to increase further.
We have been anticipating a slowdown in economic growth for some time, but for a different reason than most investors. Market participants have presumed a slowdown, or even a recession, due to the rapid pace of Fed hikes. That view is embedded in the inverted yield curve, which has anticipated policy rate reductions for nearly a year. That view was premature and wrong, yet it is still the market view, only pushed out further into the future. The yield curve now anticipates rate declines in 2024. In contrast, we have been anticipating slower growth due to labor scarcity, which constrains hiring by companies supplying goods or services. We thought this would show up in the data this past Spring, but a surge in labor force participation enabled hiring to remain somewhat more robust than we expected. Recent data revisions suggest we were closer to the mark than we realized just a few months ago.
The difference in causes of the slower pace of growth is very important for assessing whether the Fed has more work to do. If growth is slowing due to higher interest rates constraining demand, wage inflation should moderate further, enhancing prospects for getting back to 2% inflation. That’s the soft landing scenario the Fed is seeking. But if labor scarcity is the key factor constraining growth, it will become manifest in wage inflation remaining stubbornly high. Rising labor costs will limit the moderation in inflation. There is simply no path to 2% inflation with labor costs running around 4%. If productivity runs about 1%, (and it can deviate meaningfully from 1% in either direction, especially over short-term periods), inflation would settle around 3%. And if labor scarcity is the key driver of slower economic growth, efforts by firms to hire workers could push wage inflation above 4%. That’s why the higher-than-expected average hourly wage increase of 0.4% in Friday’s jobs report was so significant. (A few days earlier, the Q2 employment cost index came in at only 1.0%, about 4% at an annual rate, ever so slightly better news.)
Labor availability could easily have a large impact on any projections. As noted above, we expected slower growth because of labor scarcity and were surprised by the surge in labor force participation, as originally reported. Much of the rise in participation has now seemingly ceased. Participation was 62.1% a year ago, but has been stuck at 62.6% for 5 consecutive months. Our population has grown by about 250,000 monthly over the past year, while participation grew slightly faster! That’s why the unemployment is unchanged. But it is doubtful participation can remain so robust and even more doubtful it will increase further. If it slows more than hiring, the unemployment rate will resume its decline, adding to wage pressures. Such an outcome isn’t guaranteed. Hiring could slow more than participation. That’s essentially what investors and the Fed are counting on, but that scenario isn’t particularly likely.
In the meantime, signs of the tight labor market are showing up in wage agreements, as unions take the opportunity to demand larger compensation packages. Strike activity and the threat of strikes are leading to better deals for workers. Airline workers have recently obtained quite generous wage agreements, as have UPS and dockworkers. Auto workers are up next. A meaningful moderation in wage increases doesn’t appear to be in the cards without far more of a slowdown in economic growth.
Markets seem to presume a soft landing as the most likely outcome. That expectation is built into the yield curve, which remains quite inverted and still implies reductions in Fed policy rates by early next year. This expectation conflicts with public comments from Fed officials suggesting that some still think another hike is coming later this year and most suggest that rates are likely to remain higher for longer. Indeed, the bond market surged on Friday after the jobs report, so the market inferred an increased likelihood of the soft landing.
There is no doubt that banks have tightened lending terms. It shows up in the Fed’s quarterly survey of banks and slower growth in commercial loans. Mostly, it is smaller firms that are adversely affected by the change in market conditions. Larger firms can borrow in the bond market and the lower yields available there make issuing bonds with longer maturities far more attractive than paying more to borrow short-term from banks. (This surely curtails corporate demand for bank loans.) And business development companies, which lend to small and medium sized companies, are jumping at the opportunity to lend under more favorable terms while banks retreat from this market. Surveys suggest that the scarcity of labor remains a far greater problem for small firms than obtaining finance.
In the meantime, growth is holding up very well. The Atlanta Fed Now forecast anticipates growth of 3.9% in Q3 and J.P. Morgan and Bank of America economists have followed the Fed’s own economists in taking a recession out of their 2023 projections. Even so, few economists have tempered their projections of further moderation of inflation. They still expect further progress towards 2%, which in our judgment, seems optimistic. Many agree that the “easy” part of reducing inflation from 9% has already been accomplished, but making further progress to 2% will be more difficult. So, it seems a bit presumptuous to assume we will get there without additional restraint from the Fed. Indeed, the market isn’t oblivious, so the inverted yield curve has become less inverted. This implies that some investors worry that long-term yields are too low, which is part of our view, and explains why we continue to keep our bond market duration short of our benchmarks. That’s an easy position to take, since we earn a higher yield on those shorter maturities and take less risk.
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