Not long after Friday’s Employment Report multiple analysts and commentators were calling it a “goldilocks” report, by which they meant it showed that the economy was neither “too hot” nor “too cold,” but instead, “just right.”
In turn, the theory goes, the Federal Reserve could stop raising short-term rates earlier and at a lower peak than previously expected, inflation would continue to cool, and the economy could pull-off an elusive “soft landing.”
The biggest headlines from the Employment Report were definitely good news. Nonfarm payrolls rose 223,000 in December, beating the consensus expected 203,000. Meanwhile, civilian employment, an alternative (although volatile) measure of jobs that includes small-business start-ups, surged 717,000. Rapid job creation helped push the unemployment rate down to 3.5%, tying the lowest level since Joe Namath was a reigning Super Bowl champion. (If you’re a Millennial or Gen Z, yes, that’s the same guy in the Medicare commercials.)
But, behind the headlines, the data were not as good. Temporary help service jobs (temps) fell 35,000 in December, the fifth straight monthly decline, to a level of temp jobs below a year ago. Why are these jobs important to watch? Because, when businesses face increased demand, the quickest way to respond is hiring temporary help. And the same thing happens in the opposite direction.
Meanwhile, the total number of hours worked in the private-sector ticked down 0.1% in December, the second consecutive monthly decline. Even though payrolls were up, total hours worked data show less work was done. Putting it all together, this is the equivalent of losing 125,000 jobs in December, not gaining jobs. Fewer temporary workers and fewer hours worked suggest some weakness in the job market. What this means is that businesses are still hiring, but their workers have less to do.
Why would businesses do that? Because finding qualified workers has been unusually difficult during the re-opening from the COVID shutdowns. In turn, many firms might be willing to keep hiring workers until it’s clear the economy is in a recession. But this also means that if a recession happens – and we continue to think it will – more workers have to be let go.
The figure that the optimists focused on the most was the wage report, which showed a relatively moderate gain of 0.3% in average hourly earnings in December and a gain of 4.6% versus a year ago. Moderate wage growth, the conventional thinking goes, diffuses the potential for a “wage-price spiral” that keeps inflation high or even pushes it higher. But this is a basic misunderstanding of inflation dynamics. As Milton Friedman taught us, it’s loose money that causes inflation to go up. The fact that wages sometimes go up faster at the same time is also a sign of loose money, but it’s not a sign that wage growth causes inflation.
What analysts, commentators, and the markets should have spent more time chewing over was the ISM Services report, which screamed stagflation. The overall index came in at 49.6, well below consensus expectations and the first reading in contraction territory since the onset of COVID. In fact, excluding very early COVID, it was the first sub-50 reading since 2009. Meanwhile, although the prices paid index declined to 67.6 (versus 70.0 in November), that’s still higher than it ever was between mid-2011 and early-2021.
This week’s CPI report should show tame overall inflation for December itself, but that’ll largely be due to falling energy prices. The ISM report suggests inflation isn’t going back to the Fed’s 2.0% target anytime soon.
Put it all together and it looks like both the surge in M2 growth in 2020-21 (which created the inflation) and the abrupt slowdown in 2022 (which would cause slower growth) are still wending their way through the economy. If so, we should see weak economic data, soon. Further forward, if the Federal Reserve maintains slow M2 growth – an open question given the Fed’s reluctance to focus publicly on the monetary aggregates when setting policy – we could see a major slowdown in inflation in 2024. Time, and the direction of monetary policy, will tell.
Right now, it looks like Real GDP expanded at a 2.5 – 3.0% rate in the last quarter of 2022. But how fast it’s growing in the first quarter of 2023 – if at all – is anyone’s guess.
The Housing Outlook for 2023
The housing sector was a huge and early beneficiary of the super-loose monetary policy of 2020-21. But, once the Fed started tightening, housing took the lead downward, as well. This isn’t a repeat of the 2006-11 housing bust, but it will drag on. Don’t expect any real recovery in housing until at least late 2023 or early 2024. Home sales and prices will continue to drag in 2023, particularly in the existing home market.
From May 2020 until June 2022, both the national Case-Shiller price index and the FHFA price index rose more than 40%. But, since June 2022, Case-Shiller is down 2.4% and the FHFA is down 1.1%. The biggest declines so far have been out West, in San Francisco, Seattle, Phoenix, San Diego, and Las Vegas. But every major metropolitan area is down in the past three months, no exceptions.
The drop in home prices should continue. Prices got too high relative to rents and need to fall more to better reflect rental values. We expect a total decline, peak-to-bottom in the 5-10% range, nothing like the 25% drop in 2006-11. Why a smaller drop this time around? First, compared to the average of the past forty years, home prices are already close to fair value when measured against construction costs. Second, there is no massive excess inventory of homes, unlike during the prior housing bust. And, unlike during the subprime-era, the vast majority of homeowners with mortgages are locked-in at extremely low fixed rates, which means they will be very reluctant to sell.
The real effect of the change in interest rates is evident in the existing home market. Sales hit a 6.65 million annual rate in January 2021, the fastest pace since 2006. But, by November 2022, sales were down to a 4.09 million annual rate, a drop of 38.5% so far. Meanwhile a decline in pending home sales in November (contracts on existing homes) signals another drop in existing home sales in December.
Existing home buyers have two major problems: first, much higher mortgage rates, which means substantially higher monthly payments. Assuming a 20% down payment, the rise in mortgage rates and home prices since December 2021 amounts to a 52% increase in monthly payments on a new 30-year mortgage for the median existing home.
Meanwhile, it’s hard to convince a current homeowner with a low fixed-rate mortgage to sell. If anything, it makes sense for them to ask for even more money if they’d have to take out a new mortgage elsewhere at a much higher rate. In other words, sellers should now want more for their homes, while buyers want to pay significantly less. This won’t change soon and so expect existing sales to be even weaker in 2023 than last year.
New home sales are also down substantially since the COVID peak, but should find a bottom sooner. The key is that with a new home, the seller is a contractor. Also, housing has been underbuilt in the previous decade. The average price of a new home will likely fall, but we need more of them. And more houses will be likely be put in rental pools.
What’s important to remember is that this business cycle isn’t normal. COVID led to a massive surge in government stimulus, both monetary and fiscal, to fight widespread and overly draconian shutdowns. Housing is rarely a bright spot in recession years and this year should be no different. But don’t expect a catastrophe like the prior bust and, once a recession is over, housing will rebound much more swiftly than after the Great Recession in 2008-09.
The Federal Reserve raised short-term interest rates by three-quarters of a percentage point (75 basis points) on Wednesday. The day before, the Fed had released M2 money supply data for June and it fell slightly, the second decline in three months. At his press conference after the rate hike, Fed Chairman Jerome Powell was vague about the Fed’s future intentions on rates, but was not asked one single question about the money supply.
For now, with the federal funds rate at 2.375%, the futures market is leaning toward a rate hike of 50 bps in September. The Fed has apparently abandoned “forward guidance” partly because it has already pushed rates close to what many Fed members said is “neutral.”
Meanwhile, the 10-year Treasury yield has fallen from north of 3.4% to under 2.7% suggesting the market thinks the Fed will either slow down rate hikes, or maybe even cut them next year. Unless, inflation falls precipitously, this makes no sense. “Core” PCE inflation is closing in on 5% and a “neutral” interest rate should be at least that high, or higher. The Fed has never managed policy under its new abundant reserve system with inflation rising this fast. No one, even the Fed, knows exactly how rate hikes will affect the economy under this new system. (See MMO)
Many think the economy is in recession already, because of two consecutive quarters of declining real GDP. But this is a simplified definition. Go to NBER.Org to see the actual definition of recession. A broad array of spending, income, production and jobs data rose in the first six months of 2022. GDP is not a great real-time measure of overall economic activity for many reasons. Jerome Powell does not think the US is in recession, and neither do we. What we do know is that inflation is still extremely high and the only way to get it down and keep it down is by slowing money growth.
And that does look like it’s happening. So far this year, M2 is up at only a 1.7% annual rate, after climbing at an 18.4% annual rate in 2020-21. By contrast, M2 grew at a 6.2% annual rate in the ten years leading up to COVID.
Slow growth (or even slight declines) in M2 is good news. The problem is that the Fed never talks about M2 and the press never seems to ask. Moreover, slower growth in M2 may be tied to a surge in tax payments – when a taxpayer writes a check to the government, the bank deposits in M2 fall. Data on deposits at banks back this up. However, banks have trillions in excess reserves and total loans and leases are growing at double digit rates. At this point, it is not clear that the new policy regime can persistently slow M2. Will higher rates stop the growth of loans? This looks to be happening in mortgages, but it appears to be demand-driven, not supply-driven.
The bottom line is that the Fed seems determined to bring inflation down but thinks raising short-term interest rates, all by itself, can do the job effectively, even at the same time that it is willing to hike more gradually when inflation is well above the level of rates. This is not a recipe for confidence in the Fed. Expect rates to peak higher than the market now expects and keep watching M2.
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Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
While the outcomes of the elections are uncertain, one thing we can count on is that plenty of opinions and prognostications will be floated in the days to come. In financial circles, this will almost assuredly include any potential for perceived impact on markets. But should long-term investors focus on midterm elections?...
NAFTA is Dead As USMCA is Born
Understanding the United States-Mexico-Canada Agreement
While on the campaign trail, Trump repeatedly singled out NAFTA – the North American Free Trade Agreement – as being one of the worst deals for Americans that he’s ever seen.
Blasting former President Bill Clinton, Trump said, “[Clinton] approved NAFTA, which is the single worst trade deal ever approved in this country," adding "NAFTA was one of the worst things that ever happened to the manufacturing industry and the worst trade deal maybe ever signed anywhere, but certainly ever signed in this country."
Was Trump right? Or was it just bombastic campaign rhetoric? The answer, like most things, is complicated and depends on who you ask.
Nevertheless, the reality is that Trump fulfilled his campaign promise and NAFTA will be replaced by the United States-Mexico-Canada Agreement or USMCA.
Background of NAFTA
NAFTA – in theory – was designed to set the rules of trade and investment between the US, Canada, and Mexico. It was envisioned by President Ronald Regan and the concept was simple: reduce trading costs, increase business investment, and help North America be more competitive in the global marketplace.
NAFTA was signed by President George H.W. Bush, Mexican President Salinas, and Canadian Prime Minister Brian Mulroney in 1992. It was ratified by the legislatures of the three countries in 1993, including the US House of Representatives on November 17, 1993, the US Senate on November 20, 1993 and finally signed into law by President Bill Clinton on December 8, 1993. It went into effect on January 1, 1994.
NAFTA 2.0 – USMCA
The USMCA has a total of 34 chapters, 12 more than the original NAFTA, which only had 22 chapters. In addition, the USMCA has a staggering 1,809 pages – 1,572 pages for the treaty, 214 pages for annexes, and 23 pages for side letters.
In reading the new text of the USMCA, many would conclude that the original foundational pieces of NAFTA will remain largely in place. But according to proponents of the new USMCA, it was designed to increase labor protections, improve access to certain markets, remove barriers to certain trade and bolster reciprocity. Let’s explore a few of the key provisions:
The USMCA will be revised every six years, allowing the countries to consistently renegotiate the trade deal and avoid another NAFTA-like scenario wherein a country could threaten to withdraw.
Implications for Stock Markets
As your financial advisor, I don’t know the answer to that question. I do note, however, that the day after the USMCA was announced, global markets advanced as did the Canadian dollar. The DJIA rose almost 200 points for a gain of 0.7%, the S&P 500 rained 0.4% and NASDAQ lost 0.1%. But one day does not make a trend by any stretch.
That being said, while the new USMCA will preserve a $1.2 trillion trade zone between the three countries, investors should keep an eye on how negotiations with China proceed. Because China is after all America’s largest trading partner.
In fact, according to the Office of the United States Trade Representative (where you can read all 1,809 pages of the USMCA): “U.S. goods and services trade with China totaled an estimated $710.4 billion in 2017. Exports were $187.5 billion; imports were $522.9 billion. The U.S. goods and services trade deficit with China was $335.4 billion in 2017.”
That’s why I preach diversification
Equity Opportunity in Emerging Markets
Stocks in the U.S. have rocketed to big double digit gains for 2013, leaving investors wondering, "when is it time to sell high?" Consider the options. For example, despite the recent emerging market stock rebound, EM equities were still trading at a 36% discount to U.S. stocks [link]
Big Importer to Bigger Exporter?
Transformative changes are taking place in the U.S. energy sector. The United States is fast becoming a major oil producer, with some estimates indicating it could surpass production levels of Saudi Arabia and Russia within the current decade. One potential implication: The U.S., once a major energy importer, could possibly emerge as an energy exporter. [link]
An Impending Energy Revolution
The United States is likely on the verge of an energy revolution. In fact, both companies and consumers are already feeling some benefits, as natural gas prices have dropped and the price of oil has stabilized. What does this mean for your investments? [link]
Consumption is Key to US GDP
The rise in home values has had a positive influence on consumers in the US, through a so-called “wealth effect.” And consumption is critical in the US economy. The dependency of consumption on consumer confidence and the subsequent reliance of the economy on consumption leaves the economy too vulnerable to financial market conditions. [link]