August 16, 2019
Both the markets and Fed officials continue to expect significant economic weakness or even a recession. The stock market has fallen 5.0% from its record level set less than a month ago. The yield curve has inverted slightly. A Wall Street Journal poll of leading economics in July had the greatest probability of recession since 2011. But expectations may or may not happen. Reality can be quite different. While we are in a minority, we believe that the economy is doing just fine, that inflation will soon begin to climb, that the Fed did not need the first rate cut and certainly does not need any additional ones.
The S&P 500 stock index is now 5.0% below the record high level it set in mid-July. But the stock market is always volatile. We had a notable swoon in the fourth quarter of last year as GDP temporarily slowed and the government shut down operations for a protracted period. But the market quickly recovered and set a new record high level before its latest slide. While currently just 5.0% off that record high level, it feels like a 20.0% drop because of heightened volatility.
Sizable declines in the market one day followed by a spark of optimism the next are clearly disquieting. But we had even more pronounced volatility in February of last year and again in October. Because the business upswing has lasted more than ten years and is now the longest on record, stock investors believe that a recession cannot be far off. They are hyper sensitive to any hint of emerging weakness and react accordingly..
One thing that has bothered the market is the Wall Street Journal’s quarterly survey of leading economists which in July showed the highest probability of recession since 2011. That sounds ominous, but we are still waiting for the economist’s 2011 fear of recession to turn into an actual one. Don’t be too alarmed by fears of impending doom. The reality may be quite different.
Also bothering both the markets and the Fed is the recent inversion of the yield curve. An inverted curve has occurred prior to every recession in recent history so it is important. But we believe there is a fundamental difference between the current yield curve inversion and prior inversions.
We view an inverted yield curve as a sign that Fed policy has become “too tight”. Typically, the economy is expanding rapidly, inflation is on the rise, the Fed tries to slow things down by sharply raising short-term interest rates, the yield curve inverts and, eventually, the economy goes over the edge into recession because Fed policy has become “too tight”. But with the funds rate today at 2.1% it is slightly below the Fed’s estimate of a neutral rate which is 2.5%. Furthermore, in “real” or inflation-adjusted terms it is far below the 3.0% level that has typically been the catalyst for previous recessions. With the funds rate today at 2.1% and the CPI at 2.0%, the real rate is 0.1% which is not even remotely close to the 3.0% danger level. Fed policy simply is not “too tight” which means no recession for the foreseeable future.
Two other things are worth noting. This past week retail sales for July jumped 0.7%. And while it has risen a solid 3.4% in the past year, it has climbed at an impressive 6.2% rate in the last three months. Certainly the consumer is showing no sign of slowing down. And why not? Jobs are climbing by 170 thousand per month. Real disposable income is growing at an impressive 3.3% pace. The unemployment rate is at a 50-year low. Mortgage rates have fallen to a near record low of 3.6%. This is important because consumer spending accounts for about two-thirds of GDP.
The other item of importance this past week was the release of the second quarter productivity data. Productivity rose 2.3% in the second quarter after having climbed 3.5% in the first quarter. Productivity is growing rapidly. It has risen 1.6% in the past three years, 1.8% in the past year, and 2.9% in the past two quarters. It seems to be accelerating. We suggest that the tight labor market is causing business leaders to spend money on technology. By doing so they can increase output without increasing headcount, which results in a significant increase in productivity.
The most important part of the productivity release is that compensation growth was revised upwards sharply. For example, nonfarm business hourly compensation rose 3.1% in 2018 which is 0.5% faster than thought previously. Even more significant is the fact that compensation jumped 9.2% in the first quarter. Originally the first quarter estimate was 1.8%. An upward revision from 1.8% to 9.2% is a serious upward revision! Compensation climbed an additional 4.7% in the second quarter. As a result, in the past year hourly compensation has risen 4.3%.
With much more rapid growth in compensation only partially offset by increases in productivity, unit labor costs (labor costs adjusted for the increase in productivity) rose 5.4% in the first quarter, 2.3% in the second quarter, and have risen 2.5% in the past year. This is the best indicator of upward pressure on inflation stemming from a tight labor market. With the acceleration in unit labor costs to 2.5% and the Fed’s inflation target of 2.0%, it appears that the labor market is likely to put upward pressure on the inflation rate in the months and quarters ahead. The markets seem to think inflation is headed lower. We disagree.
The bottom line is that the economy is doing just fine and likely to increase 2.5% in the third quarter after rising 3.1% in the first quarter and 2.1% in the second. Interest rates are very low. The funds rate is roughly in line with its neutral rate and far below a level that would typically be associated with a recession. The yield on the 10-year note and the 30-year mortgage rate are both at record low levels. And with upward pressure on unit labor costs the inflation rate seems likely to head higher.
We understand the market’s fear but we think that fear is misplaced.