Calm Before the Storm?

By Dr. Alan Greenspan, Senior Economic Advisor

The Bureau of Economic Analysis (BEA) released their first official print of second quarter Gross Domestic Product (GDP) last Thursday, estimating that the economy contracted at a -0.9% annual rate. The second consecutive quarterly decline in GDP, following a -1.6% annual rate contraction in the first quarter, means that the U.S. economy has entered into what was commonly thought as a technical recession (defined as two consecutive quarters of contraction in real GDP). But the White House, backed by Larry Summers and a consensus of economists, points out that the strong jobs market leads to a more complicated consensus. Indeed, the markets were taking this week’s conflicting data in stride, rising over 5% in the last three days of July and finishing the month with a 9% gain. Indeed, following a volatile summer, they have reason to feel a modicum of relief. Though the Fed followed through on raising rates by another 75 basis points, there will not be another meeting (and therefore rate rise) until the second half of September. Additionally, Chairman Powell expressed confidence during his press conference that the economy is not currently in recession (note: his comments were made before the BEA’s estimate of a “technical recession” and whether the economy is officially in recession is ultimately determined by the National Bureau of Economic Research). Strong earnings reports by a slew of Big Tech companies also helped placate investor worries. While whispers of recession are certainly strange in a time of such strength in the labor market, I believe there are enough storm clouds on the horizon to warrant investor caution going forward.

The main source of my concern is productivity growth, or in this case the lack thereof, and the implications that will have for the labor market and corporate profitability. I remarked, around this time a year ago, on the resiliency that labor force productivity had displayed in the aftermath of the pandemic. While it is not surprising for productivity to increase during or in the immediate aftermath of a recessionary event when the least productive workers are laid-off, the fact that productivity remained at an elevated level was, as I wrote, a silver lining that could sustain the nascent recovery. Productivity gains allowed businesses to maintain profit margins as economic conditions normalized following the pandemic. More productive employees meant wages could be increased as the labor market tightened without having to either pass the increased cost onto the final consumer or sacrifice their own bottom line. Unfortunately, the data show that productivity peaked in the fall of last year and has since fallen below its pre-pandemic trend (see chart).

The sharp drop in productivity is consistent with various reports of firms having difficult times finding what they view as qualified applicants to fill open positions. As hiring managers are increasingly forced to sacrifice quality in order to meet hiring demands and these workers are absorbed into the labor force, productivity growth has begun to stall. However, this dynamic of hiring at all costs may have run its course as corporate executives consider the current economic climate amid declining productivity. Indeed, those reports of firms desperately seeking to hire have slowly been replaced with companies declaring they are overstaffed and intentions to freeze hiring or even decrease head counts. This new caution is beginning to bear out in the data – job openings peaked in March of this year and initial unemployment claims hit a low in the same month. It seems that for now, businesses have decided that a halt to new hiring may be the path of least resistance in weathering any possible downturn in the face of inflation and a slowing economy.

As the fortunes of prospective job seekers diminish, the fate of current employees may begin to dim as well. One consequence of the Federal Reserve’s aggressive tightening cycle is that the U.S. dollar has strengthened markedly against its peers in the currency market. This means that multinational corporations, also the largest employers of the domestic labor force, will pull in less profits from their exports overseas. As their streams of U.S. dollar profits shrink, they will have less leeway to give raises to their domestic workforce without taking a hit to their profit margins. Whether they decide to cut back on raises or pass along more of their input costs in the form of inflation, it spells bad news for the consumer. Having already had to dip into their savings in the face of persistent inflation in the first half of the year, the consumer may not be able to keep calm for much longer.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.