Defend Truth


Ominous bear in slumber sees US labour market resilience obscure nation’s weak growth outlook


Natale Labia writes on the economy and finance. Partner and chief economist of a global investment firm, he writes in his personal capacity. MBA from Università Bocconi. Supports Juventus.

Economic history has shown that you cannot have a recession without higher unemployment, and in the US that has simply not materialised. Forecasts underestimated the ability of the US economy to create jobs. 

They say that a recession is when your neighbour gets laid off, and a depression is when you get laid off. But what if the US economy is so strong and the labour market so tight that no one will get laid off at all? After the last 12 to 18 months of seemingly everyone — this columnist included — saying that recession is three months away, what if it is not?

The argument for why a recession should have happened is more or less as follows. To quash the post-Covid surge in US inflation (caused by both short-term supply chain blockages and more structural demand side factors resulting from overly generous fiscal and monetary stimulus in 2020 and 2021) the Fed began the most rapid monetary tightening in four decades. 

While the Fed hoped for a “soft landing” — aggregate demand moderating enough to bring prices down alongside a robust labour market preventing a recession — many economists thought this was fanciful. Such scepticism looked warranted when the Fed’s response swiftly led to serious ruptures in the financial sector (a mini financial crisis with three bank failures in the US and the collapse of Credit Suisse in Switzerland), soaring corporate bond yields and tanking commercial real estate valuations. Surely the Fed had overtightened the screw?

Furthermore, this recession was meant to be an inventory-based one. Goods consumption rocketed during the pandemic as Americans splurged on PlayStations and Pelotons. Post 2022, this demand recalibrated towards services, as consumers were finally able to eat out and book long-awaited Caribbean cruises. This created a supply glut of excess inventories for both retailers and manufacturers, which, usually, should be accompanied by companies laying off workers, further compounding a slowing economy. Economic slowdown, recession and higher unemployment were seemingly imminent.

This all sounds compelling except for one thing; it was wrong. Economic history has shown that you cannot have a recession without higher unemployment, and in the US that has simply not materialised. Forecasts underestimated the ability of the US economy to create jobs. Moreover, credit creation continued to be robust and even the housing market is showing nascent signs of turning the corner. What is going on here?

The reality is that what happens, as we have said before, will simply come down to inflation. And inflation, despite having moderated, remains too high. This saga is not over yet.

US CPI data last week showed that core inflation — the critical indicator for the Fed which strips out volatile fuel and food prices — actually increased 0.4% month on month, and shows very little downward momentum. This data suggests the Fed has made little progress in getting underlying inflation down.

The arguments used late last year and early this year therefore still apply. It is not that inflation is about to soar again, it just seems there is a limit to how far it will fall on its own, without growth having to materially slow first. If CPI stabilises at around 3-4%, it will still be higher than the historical average and above the Fed’s target of 2%. The Fed then would either have to continue hiking interest rates, or keep rates higher for longer, precluding any chance of the cut which markets are expecting before the end of this year.

Equity markets have baked the assumption of monetary easing into the cake. The S&P500 is back into bull market territory from its lows late last year, with the tech-heavy Nasdaq up an astonishing 30% year to date.

With so many investors having believed in a looming recession and slowdown in earnings, few have participated in this recovery.  It must be one of the most reviled stock market booms in memory. However, such investors, smarting at having missed out on the opportunity, may do well to remain patiently cautious. This market is looking peaky, and all bear markets have rallies. Volumes are thin, and astonishingly the S&P500’s gains this year have come from only seven over-hyped tech mega-caps, benefiting from a questionable AI theme trade. 

Clearly, inflation has fallen and can continue to fall, on its own. However, there is no chance it will fall back to the Fed target of 2% without high interest rates, weaker growth and higher unemployment. If this is correct, and one believes that the Fed is not about to jettison its 2% target, the question is just when, not if, the recession finally arrives. As to when the equity market turns over, that is simply down to when the market drags the last bear, kicking and screaming, into becoming a bull. DM


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