The Longest Journey Begins with a First Step

By Chuck Lieberman, CIO & Co-founder

For the second month in a row, job growth reported in the household survey vastly outstripped the job gains reported by the establishment survey. Even so, all the job market data indicate that the labor market remains very strong. While the Fed opened the door to interest rate hikes as early as March, as indicated by the minutes of the latest FOMC meeting, markets promptly repriced for an increased likelihood that the first rate hike will come in March, immediately after the Fed completes its bond buying program. We agree. Inflation pressures are clearly still rising, the Fed has fallen behind the curve in addressing the problem and it must now play catchup. Concurrently, interest rates are rising, as they must to both reflect the expected higher rate of inflation and the tighter monetary policy that looms down the road.

The plunge in the unemployment rate to 3.9% is the clearest indication yet, among a slew of other measures, that the labor market is very tight and the overall economy is overheating. The chart shows that job openings are at an all-time high compared to the unemployed, which accounts for the rise in wage inflation to 4.7% year over year and around 6% over the latest 6 months. At 3.9%, the unemployment rate is below the Fed’s full employment estimate and close to the 3.5% low prior to the pandemic. Other such low levels of unemployment occurred only during wars, such as Vietnam and the Korean War. Unambiguously, labor is now scarce and firms are experiencing considerable difficulty finding workers. Even the Fed now describes the labor market as “very tight”. Incomprehensively, the Fed’s own forecasts suggest above trend growth for the next two years with unemployment falling to 2.5%, yet inflation moderating to 2.1%.

This is all great news for workers and the economy, but it is troublesome for policymakers who must contain inflation. The inflation genie appears to be escaping the bottle and the Fed is slow to contain it, even if they are finally slowly stepping up their pace of response. It was hoped that labor force participation might surge once the extra unemployment benefits expired and people could no longer support themselves on government payments. Instead, many baby boomers retired and others chose to become self-employed. So, the Fed is now warning that it may have to move faster than previously suggested. We have been anticipating this and fully agree.

The Omicron variant may introduce a speed bump for economic growth, but likely only a small and brief one. The data show that Omicron is extremely contagious, but causes fewer hospitalizations, is less fatal than the flu and far less fatal than Delta. Hospitalizations are also much shorter. Yet, more people are getting vaccinated, but also increasingly participating in normal activity. Former FDA Commissioner Scott Gottlieb just predicted that Omicron cases will likely peak and start to recede this week. Such a decline is already evident in data for South Africa, Germany, and the Czech Republic, and also in major cities that were hit earlier, including New York and London.

The net result is markets are responding first and foremost to the economic data, notably the tight labor market and inflation pressures, and largely ignoring the inflow of new information on Omicron, which is coming in largely as expected. It is striking how much interest rates have surged within the past week. Nonetheless, they have considerably further to go. 10-year Treasury yields of around 1.75% are still dramatically below prevailing inflation or even the Fed’s optimistic inflation expectations. At the same time, the outlook for economic growth and corporate profits remains very positive. So, we continue to favor stocks, especially of those companies that benefit from the reopening of the economy, own real assets, or benefit from higher inflation or higher interest rates. High growth rate companies are at a distinct disadvantage, because their growth goes out into the future and that future will be discounted at higher interest rates. On the fixed income side, we remain highly defensive, holding shorter maturities and floating rate securities that will protect capital in a rising rate environment.

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