The employment report for the month of December showed that the American economy added 223 thousand new jobs in the last month of the year. Thus, the year 2022 became the second best year in the history of the American labor market, with an addition of 4.5 million jobs, right after the year 2021 in which 6.74 million were created New jobs. It is enough to read the last sentence to understand the unusual strength of the economic cycle of the last two years. Not only did the addition of jobs in December remain high, but also that the unemployment rate fell slightly to 3.5% and the unemployment rate in its broader definition (which also includes those who have given up looking for work or who work part-time for financial reasons) dropped to its lowest level since it began to be measured (1994) and stands at 6.5%.
Such data paint a very clear picture of the labor market in the US, which appears to be tighter and stronger than ever. However, to the delight of investors, the wage pressures that contribute to the increase in inflation and constitute the greatest threat from the Fed’s point of view are actually eroding as the annual change in hourly wages continued its downward trend and stands at 4.6%, compared to 5.6% in March. Not only that, but also the average number of hours per employee decreased in December to 34.3, which actually means that the rate of wage slowdown is faster than can be learned from the hourly wage alone.
Despite the good signs in the labor market, it is time to pour some cold water on the enthusiasm in the markets. First, as we have already mentioned several times in the last few months, the employment data in the US probably suffer from statistical biases that may be corrected next month when the BLS makes its annual update. By the way, if you look at the household report then it is possible that since March the American economy in general has shed 288 thousand full-time jobs and added 886 thousand part-time jobs and 684 thousand second jobs (ie people who work more than one job). This is not how a labor market that can support the private consumer over time looks like. More importantly, the labor market always lags behind the economic activity so that the employment situation in the US (as well as in Israel, Europe or anywhere else) shows more about the position in the economic cycle we were in and not about the one we will be in soon.
On the other hand, sentiment indices such as the purchasing managers’ indices precede the economic activity and paint for us a picture of the part of the economic cycle that is expected to arrive and how to put it mildly? The picture doesn’t look anything at all. Both the industry purchasing managers index and the services purchasing managers index are below the 50 point level and indicate a contraction in activity.
Moreover, when you go into the details of the report, you find that all the components of demand, especially the components looking to the future, have dropped sharply.
So, for example, the component of new orders in services collapsed from 56 points, a level indicating the expectation of a solid increase in orders, to a sharp contraction at the level of 45.2 points. To understand the orders of magnitude, this level is correlated with a contraction of about 2% in private consumption in the US with a view to the coming months. When we take together the decline in the Purchasing Managers’ Index in industry and services, we get that the combined index dropped to a level of 49.5 points, a level that corresponds historically with a contraction of about half a percent in GDP. In other words, it is difficult to see how the American economy avoids a recession in the first half of the year. Yes, inflation will decrease and we will probably return to a disinflationary world already this year, but this will happen because interest rate increases all over the world will do their job and cool the economy Significantly.
The next economic cycles depend mainly on the decision makers
If you take into account the combination of the strength of the economic cycle created by the corona virus – both in the recession of 2020 and in the growth of 2022-2021 with the massive inflows of money from governments around the world, it is easy to understand how we reached a situation where inflation is so high, even after putting aside the effects of the supply side. If at the beginning we still had questions about structural changes in the labor market or the “natural” inflation environment, today we can say with high certainty that in total what we saw in the last year was a normal economic cycle. Unusual in its intensity, but normal. Accordingly, we also estimate that the interest rate increases will do their job and will manage to moderate inflation back to the long-term trend. The important question for the medium term then is what is the level of the long-term inflation trend? Until the beginning of 2020, there was a clear answer to this question that is accepted by almost everyone, and that is that we live in a disinflationary world, that is, in a world where inflation will remain low in the long term and allow interest rates to be low as well. Is this answer different today? Not really.
The three main factors that made it difficult for inflation to raise its head in the years before the corona were demography, technology and globalization. Of these three, the only factor that has changed is globalization and this for two reasons: First, the energy market is expected to undergo upheavals in the coming years as a result of Europe’s desire to break away from dependence on Russia. Secondly, following the Corona, many countries realized that supply chains cannot be concentrated in just one country. On the other hand, the demographic effects of the world’s aging population are only getting stronger and technology is not really slowing down, ask GPT. Therefore, after the recession passes and with it the inflationary pressures from the labor market, it is likely that we will return to a world where basic inflation and the equilibrium interest rate are relatively low compared to the second half of the 20th century.
As far as the financial markets are concerned, this is a relatively comfortable world situation where growth comes mainly from improved productivity and technological developments and the risk-free alternatives seem less attractive. At the same time, it is impossible not to consider the risks to this forecast from the point of view of economic decision makers. On the one hand, the central banks today sound very hawkish and are determined to return inflation to its natural place, but of course it is easy to sound hawkish when the unemployment rate is so low. Even during the recession and the social and political pressures it will bring, will the central banks around the world maintain their determination? Let’s hope so, but it’s hard to say for sure.
On the other hand, the corona crisis and the governments’ treatment of the economic side of it has returned to the political discourse the ability to support the economy, after years of focusing on fiscal responsibility and trying to address the deficits and duplicate debts of the countries in the West. It is not impossible that even during the coming year the governments, which usually look mainly to the short term for political considerations, will want to use similar tools in order to support their voters. Excessive use of such tools will actually offset the effects of the interest rate and thus will not allow inflation to return to its place and/or will force the central banks to continue raising the interest rate more than necessary. By the way, in Israel, for example, this is a risk that definitely needs to be taken into account against the background of wage agreements, coalition commitments and the effect of government policy on the dollar exchange rate. Bottom line, traditional problems are solved with traditional tools and that is exactly what is happening now in the economic cycle. The interest rate hikes will cool the global economy and bring inflation back to its place, this is of course assuming that the decision makers will do what they have to do, even when the situation will be more difficult than the current one.
S&P Refers to the effects of the political environment on the rating
As we were informed this morning, the rating company S&P referred specifically to the political risks in Israel and their impact on the rating. According to S&P, the independence of the Bank of Israel and the judiciary is essential to maintaining Israel’s current high rating. This is not an immediate risk of a downgrade, but as you can see in the last month, there is no doubt that since the announcement by the Norwegian Wealth Fund, and more specifically since the inauguration of the government, the financial entities abroad have raised the level of awareness of the political risk in Israel. You can see in the last month that the shekel is one of the weaker currencies In the world against the dollar, and in our estimation this is actually an outcome of this. As long as the foreign bodies are convinced that the political environment in Israel may produce economic instability, and/or a jump in the deficit and debt, so will the trend in the foreign exchange market continue. In terms of the bond market, it is worth remembering that in recent years the holdings of foreigners in the government bond market in Israel have increased significantly, if they decide to reduce their holdings, this may lead to an increase in yields.
The writer is the chief strategist of Psagot Investment House