On Tuesday, we learned that employers in the United States had a record 11.5 million vacancies as of March. This is perhaps the clearest sign that the economy is booming, as hiring workers is not cheap and most employers would only do so if they no longer have demand-side staff.
There are currently only 5.9 million people unemployed. In other words, there are nearly two jobs per unemployed person. Non-compliance means that workers have many opportunities, which means that they have many levers to demand more pay. Indeed, employers are paying at a historic rate.
But the boom in demand, record jobs and higher wages … are bad?
The Federal Reserve and many in the economic profession are not so outspoken. But that is actually their message.
Situation: Demand for goods and services is well ahead of supply1, which sends inflation to high decades. This is partly due to the fact that higher wages mean higher business costs, many of which raise prices to maintain profitability. Ironically, these higher wages have helped strengthen the already strong finances of consumers who are willing to pay, and thus essentially allow businesses to continue to raise prices.
It is important to add that this growing demand is supported by job creation (ie a phenomenon in which one goes from earning nothing to earning something). In fact, the United States has created a whopping 2.1 million jobs in 2022 so far.
The Bureau of Labor Statistics has an indicator called the Aggregate Weekly Wages Index, which is a product of jobs, wages and hours worked. This is a rough proxy for the total nominal cost of labor. This figure increased by 10% on an annual basis in April and was over 9.5% since April 2021. Before the pandemic was a trend of about 5%.
This combination of job growth and wage growth only exacerbates the problem of inflation.
The story continues
So, the best solution at this point seems to be to tighten monetary policy so that financial conditions become a little more challenging, which should lead to a cooling of demand, which in turn should ease some of these constant inflationary pressures.
In other words, the Fed is working to get some of the good news out of the economy, because that good news is actually bad.2
The Fed is trying to reduce “excess demand”
In a long-awaited move, the Fed raised short-term interest rates on Wednesday by 50 basis points to a range of 0.75% to 1.00%. This was the largest increase the central bank had made in a single statement since May 2000.
In addition, Fed Chairman Jerome Powell signaled the intention of the Federal Open Market Committee (ie the Fed’s monetary policy committee) to keep interest rates rising at an aggressive pace.
“Assuming that economic and financial conditions develop as expected, there is a broad sense in committee that further increases of 50 basis points should be discussed at the next few meetings,” Powell said. “Our overarching focus is to use our instruments to bring inflation back to our 2% target.”
To be clear, the Fed is not trying to force the economy into recession. Rather, it seeks to bring excess demand – as reflected in the fact that there are more jobs than unemployed – more in line with supply.
“There’s a lot of demand,” Powell said.
Fed Chairman Jerome Powell (Getty Images)
There are currently huge economic winds, including excessive consumer savings and thriving capital spending orders that need to boost economic growth for months, if not years. And so there is room for the economy to release some of the pressure from demand without falling into recession.
Here is more from Powell’s press conference on Wednesday (with added links):
It would be a much riskier situation if consumer and business finances were stretched in addition to the lack of unnecessary demand. But this is not the case at the moment.
So while some economists say the risk of a recession is rising, most do not have this as a baseline scenario for the near future.
Is it bad news for stocks? Not necessarily.
When the Fed decides it’s time to cool the economy, it does so by trying to tighten financial conditions, which means the cost of financing things is rising. Generally speaking, this means a combination of higher interest rates, lower stock market valuations, a stronger dollar and stricter lending standards.
Does this mean that stocks are doomed to fall?
Well, the Fed’s hawk is certainly a stock risk. But nothing is certain when it comes to forecasting stock prices.
First of all, history says that stocks usually rise when the Fed tightens monetary policy. It makes sense when you remember the Fed tightening monetary policy when it believes the economy has some impetus.
However, the prospect of higher interest rates is certainly a cause for concern. Most stock market experts, such as billionaire Warren Buffett, generally agree that higher interest rates are bearish for valuations, such as the P / E ratio for the next 12 months (NTM).
But the key word is “valuations,” not stocks. Stock prices should not fall to lower valuations while earnings expectations rise. And expectations for profits are rising. Indeed, ratings have been falling for months.
The chart below by Credit Suisse’s Jonathan Golub captures this dynamic. As you can see, the NTM P / E is moving lower than the end of 2020. However, stock prices are rising mostly during this period. Even with the recent market correction, the S&P 500 is higher today than it was when ratings began to fall. Why? Because the profits for the next 12 months are essentially only increasing.
To be clear, there is no guarantee that stocks will not continue to fall from their January highs. And it is certainly possible that future profit growth will become negative if the business environment deteriorates.
But for now, the outlook for profits remains remarkably stable, and this may provide some support for stock prices, which are currently experiencing a fairly typical sell-off.3
More from TKer:
Rear view 🪞
📉📈📉📈 Shares go wrong: the S&P 500 fell just 0.20% to end an incredibly volatile week. On Wednesday, S&P rose 2.99% in what was the biggest one-day rise in the index since May 18, 2020. The next day it fell 3.56% on the second worst day of the index for the year.
S&P is currently down 14.4% from its January 4 high of 4,818. For more information on market volatility, read this, this and that.
💼 Job creation: US employers added 428,000 healthy jobs in April, according to BLS data released on Friday. That was significantly higher than the 380,000 jobs economists expected. The unemployment rate is 3.6%. For more information on the state of the labor market, read this.
📊 Growth in services activity is cooling: According to a survey collected by the Supply Management Institute, activity in the services sector slowed in April. From Anthony Neeves, Chair of the ISM Services Business Research Committee: “Growth continues for the services sector, which is growing for all but two of the last 147 months. There was a withdrawal in the composite index, mainly due to the limited labor pool and the slowdown in the growth of new orders. Business activity remains strong; however, high inflation, capacity constraints and logistical challenges are obstacles, and the war between Russia and Ukraine continues to affect material costs, especially fuel and chemicals.
Up the road 🛣
There is no greater history in the economy at the moment than the direction of inflation. So all eyes will be on the April Consumer Price Index (CPI) report, which will be released on Wednesday morning. Economists estimate that the CPI increased by 8.1% on an annual basis during the month, which would be a slowdown compared to the March 8.5%. Excluding food and energy prices, the main CPI is estimated at 6.1%, down 6.5% in March.
Check out the calendar below from The Transcript with some of the big names announcing their quarterly financial results this week.
1. We will not go into all the nuances of supply chain problems here (eg how labor shortages in the US, the blocking of COVID in China and the war in Ukraine disrupt production and trade). However, we know that supply chain problems persist, which is reflected in the ever-slow delivery times of suppliers.
2. For those of you who are new to TKer, I wrote a little about how good economic news was “bad” news. You can read more about it here, here, here and here.
3. Investing in stocks is not easy. This means that you have to deal with very short-term volatility while waiting for these long-term gains. Everyone is welcome to try to determine market time and sell and buy in an attempt to minimize these short-term losses. But, of course, the risk is to miss those big rises that occur during unstable periods that can cause irreversible damage to long-term returns. (Read more here, here and here.) Remember that there is a whole industry of professionals aiming to beat the market. Few are able to perform better in a given year, and of these better results, few are able to continue this performance from year to year.
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