And Yet

And Yet Labor Economy Government Bonds

Last week was pretty important in confirming the trend change in interest rates and solidifying a slowdown in economic activity. Evidence of the economy slowing is reflected in more U.S. firms cutting their earnings guidance versus raising them.

Number of US firms with corporate guidance announcements in 2022

As the above chart shows, healthcare has been a sector that has seen a large number of companies lowering their guidance, although there is still a cohort of firms raising theirs. Commensurate with the sector’s lower guidance is the prospect for greater loan defaults in the future, as this chart shows.

Market Signal probability of default median scores in select sectors in the US at quarter-end

One of the economy’s pockets of strength has been capital spending in the technology sector. If the decision of firms like Google, Microsoft, Meta, and Salesforce is any indication, then the trend for this continuing is not favorable. These companies, along with many others, have laid off thousands of employees. Cost control, disciplined capital spending, and cash flow preservation and growth are now the primary focus of these management teams. 

Tech Capex Growth Has Yet To Soften US Technology Investment YoY 1985 - 2020 January 19, 2023

One can see that tech layoffs have really picked up and now have exceeded what took place during the height of Covid.

55,000 global tech-sector employees have lost jobs in 2023_ layoff-data tracker January 20, 2023

Tech layoffs since COVID-19 Q1 2020 - Q1 - 2023

And here is the latest announcement from Google.

Google to Cut 12,000 Jobs in 6% Reduction of Global Workforce January 20, 2023

The momentum in global credit creation is extremely weak, as this chart shows, which represents a headwind for economic growth.

Exhibit 3_ The global credit impulse is negative January 19, 2023

Retail sales appear to be softening quite materially as this chart shows how sales have contracted over the last two months.

US Retail & Food Services Sales MoM -

And while retail sales have remained quite elevated on a nominal basis, the picture changes quite significantly when factoring in inflation.

US Retail Sales ($ bn) US Retail Sales ($ bn, Deflated by Goods, CPI, 2016 Dollars) Jun 2016 - Dec 2022

Although consumers still spend more on services than goods, since Covid, however, the market share of goods has grown quite significantly at the expense of services. Later I will discuss some of the challenges of the labor market in terms of large numbers of people having dropped out of the labor force. This has disproportionately hit the services sector, especially for those businesses that help support the office economy, which has been hit incredibly hard by the massive move of workers doing their jobs remotely.

U.S. Real personal consumption with linear trend 2012 - 2022 January 20, 2023

This slowdown in spending is coming at a time when retail sales represent a large percentage of consumer spending, although still less than its historical highs.

Retail sales spending as a proportion of total consumer spending

Retail sales is not the only area of the economy experiencing weakness. Industrial production is softening as well.

US Industrial Production MoM US Manufacturing Production MoM 2021 - 2023

This chart shows how manufacturing output has peaked and is now rolling over.

US Manufacturing Production 2017 =100 US Manufacturing Capacity Utilization 2016 - 2022

This chart shows how the pace of deceleration has picked up for manufacturing, excluding autos.

Manufacturing output ex autos, m_m% (Left) January 19, 2023

Now that we have some clear evidence of slowing economic output, the next question from a Federal Reserve perspective is what is happening on the inflation-fighting front? From a Producer Price Index (PPI) standpoint, the news is improving here as well.

US PPI MoM SA UW Core PPI MoM US Core PPI Less Trade Services MoM

The much improved CPI trends, along with PPI, have dramatically changed Inflation expectations as compared to six months ago, particularly in the shorter term.

 USD Inflation Swap Curve 2Y - 30Y

The combination of weaker economic data and substantial progress on the inflation front has led to a material drop in 10-year and 2-year Treasury yields. It does seem like the highs for this cycle have been reached, so the trend should be for yields to continue to drop as the economy weakens and the Fed has to reverse course.

 US 10yr Government Bond Yield US 2yr Government Bond Yield 2022 - 2023 January 18, 2023

The yield curve has not experienced this level of inversion (3-month yields higher than 10-year yields) in the last 30 years. This suggests that the Fed will have no choice but to start cutting rates.

 US 10yr - 3mo Government Bond Spread (bps)

Historically, recessions start about 17 months after the 2s/10s Treasury curve has inverted for three months. This would put us approximately nine months away from that point.

Figure 1_ Months between first 2s 10s yield curve inversion and US recession. The 3 month rule only triggers when the inversion lasts for 3 months

And yet, despite all of the data showing an economic slowdown (contraction?), the labor market, as measured by unemployment claims, shows great resilience. We could be seeing a bifurcated labor market with strength for lower-wage jobs and weakness at the higher end (tech, finance, real estate, etc.).

US Initial Jobless Claims (NSA, '000) 2014 - 2021

According to this researcher, much of the labor force reduction is in the service sector, which may be contributing to more demand versus supply for lower-wage workers.

Job Market's 2.6 Million Missing People Unnerves Star Harvard Economist

The labor supply issue may be exacerbated by parents not having as many daycare options as they did prior to Covid, which may have led more people to remain out of the labor force to care for their kids.

Job Losses since COVID January 2020 - Jan 2023

And if Goldman Sachs’ forecast has validity, then labor shortages exist not only in the services sector but in the manufacturing sector as well. This looks to become even more challenging given the aging labor force and more companies seeking to diversify their supply chains away from China, which should increase the demand for manufacturing workers as onshoring grows in the years ahead.

US manufacturing labor surplus_shorortage 2002 - 2030

I have called this post “And Yet” because in spite of economic data, positive trends on the inflation front, and a bond market screaming that the Fed is going to overtighten, the labor market is showing some powerful resilience that may be with us for a while and may require the Fed to keep rates higher to ensure that it pushes the unemployment rate higher to better align labor supply and demand by curtailing demand. I have written about the challenges of following this policy and some of the unintended consequences, but once again, the Fed has now seen inflation come down and the economy softens, and yet, it has still not cracked the labor market. Only time will tell, but the bond market believes the Fed will do just this.

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