Supply-Side Recession?

Most Wall Street strategists have been saying that a recession is 3–6 months away — but they’ve been saying this for the last two years and so far, no recession has materialized. With US equity markets up over 10% and GDP growth last quarter of 2.1% (annualized), now many Wall Street firms such as JPMorgan and Bank of America are completely reversing their calls and saying that no recession is in sight. Even the Federal Reserve shifted its position and said that their economists are no longer forecasting a recession in the near term. However, when the financial world begins to agree on a common forecast, the markets and economy usually do the exact opposite. So, what is the state of the economy currently and what is likely for the economy and the financial markets over the next 12 months?

Currently, most economic metrics indicate that the US economy is doing very well. As of the end of August, equity markets (as proxied by the S&P 500) were up 17.4% for the year, erasing about two-thirds of its losses from 2022. GDP growth accelerated in the 2nd quarter of 2023, growing by 2.1% (annualized) from the 1st quarter; while GDP for the 1st quarter had grown 2.0% from the 4th quarter of 2022. There were 8.83 million job openings as of the end of July, as compared to 5.84 million unemployed. The ratio of jobs available per unemployed person remains at record levels compared to pre-pandemic values — jobs are plentiful. The 3-month moving average of wages grew 5.7% (annualized) as of July 2023. With CPI growing at just 3.1%¹ (3-month rolling, annualized), that meant workers’ wages grew 2.6% in real terms over the last year. So with not enough workers to fill jobs, companies are bidding up wages to attract and retain workers — workers are doing extremely well. The inflation rate over the last 12 months has been 3.2%, high by historical standards, but it is also an indication that consumers seem to have spending power for goods and services (hence bidding up prices).

While these metrics provide a fairly robust picture of the US economy, the time-series trends on these and other economic metrics provide a different picture. Corporate earnings for the second quarter (Q2) decreased 3.8% from Q2, 2022. It is the third straight quarter in which earnings are down from the previous year’s quarter. With inflation running at 3.2% for the last year, on a real basis the earnings decreases look substantially worse. Corporate capital expenditures grew annually at 7.7% from 2010 to the start of 2022. However, over the last 4 quarters, capital expenditures have decreased by 10.4%. The Manufacturing PMI² in August, 2023 measured 47.6, implying that manufacturing in the US was contracting. That was the 10th consecutive month of contraction for manufacturing. The Manufacturing PMI has been progressively getting worse since early 2021, but in the last ten months it has been indicating actual contraction of the manufacturing sector rather than merely a slowdown of its expansion. The economy overall, however, has been expanding, and that is because of the other major part of the private economy: the services sector. The Services PMI³ for July, 2023 came in at 52.7, indicating a slow expansion. Because services are a larger fraction of the US economy than manufacturing, services expansion has been more than offsetting the manufacturing contraction to generate overall economic expansion for the US, though a slow one. However, the trend on the Services PMI is not a good one either. The July, 2023 reading was down from June’s reading of 53.9 and down more from a reading of 56.1 a year ago. Similar to the Manufacturing PMI, the Services PMI has been on a downward trend since late 2021 when it peaked above 60. If this trend continues, services soon will not be able to offset manufacturing contraction, and indeed, services may start contracting as well.

The impact of the above trends can be seen on the major input into both services and manufacturing: labor. As noted above, while the current ratio of job openings per unemployed person is at 1.5, one quarter ago that ratio was at 1.8, and at the end of last year, it was at 2.0 — job availability is quickly decreasing. And workers are responding by sticking with their jobs longer — the quits rate (job resignations divided by total employment) is down to 2.3%, compared with 2.4% the prior month and 3.0% in mid-2022. Companies have also been been cutting their use of temporary and contract workers — temporary help services have steadily decreased 6.5% since March, 2022, the longest stretch of declines since the 2008 Financial Crisis. Finally, important metrics of consumer financial health such as consumer default rates on credit cards as well as auto loans that are overdue by 60+ days have both risen and are now substantially above pre-pandemic levels. Similarly, corporate defaults on below investment grade bonds are above pre-pandemic levels and continuing to accelerate.

While most economic trend indicators seem to be indicating a recession on the horizon, one major one is not: unemployment. Despite all the negative trends over the last year and a half, unemployment has barely moved. Since hitting a high of 14.7% in April, 2020, the unemployment rate came down quickly to 3.9% in December, 2021 and has stayed relatively flat since then. In August, 2023 the unemployment rate stood at 3.8%. Adding to the mystery on unemployment is the fact that inflation has come down dramatically from 9.1% in mid-2022 to the current 3.2%. The Philips Curve in economics would dictate that unemployment should have gone up substantially.

The mystery behind the split in the relationship between inflation, unemployment, and the weakening economy can be explained by an economic shock that we have not seen in some time: a supply shock. The US economy (as well as the global economy) has experienced a negative supply shock — a shock that reduced the availability of goods and services in the global economy. The supply shock emanated primarily from the Covid pandemic and was then amplified by geopolitical issues and subsequent economic fragmentation. The shock resulted in volatility of the availability (and, at times, the absolute lack of availability) of inputs that firms use to create goods and services. This volatility occurred even as the global economy was recovering from the highly restrictive shutdowns due to Covid. The inputs included things like raw materials, intermediate components, and, most importantly, labor. For most firms, non-labor inputs are sourced from long supply chains spanning multiple countries all running in sync. The uneven spread of Covid (as well as the uneven response to Covid by countries) resulted in the disruption of the timing of these supply chains.⁴ The disruptions were amplified as manufacturers started hoarding inputs whenever they had an opportunity to receive any.

The labor component of inputs was equally disrupted as people either could not or would not get back into the labor force. The employment ratio (the ratio of the workforce to total population) hit a post World War 2 low of 51.3% during the pandemic and has not recovered back to the 61.1% level it was at prior to the pandemic. It rose to 60.1% in March, 2022 and has stayed fairly flat since then — it stands at 60.4% in August, 2023. The 0.7% difference between August, 2023 and the pre-pandemic value represents about 2.4 million US workers. So, 2.4 million workers essentially left the workforce and have yet to return. This loss of labor explains why the ratio of job openings per unemployed person rose dramatically to 2.0 by the end of 2022 — firms were desperate for workers.

Where did these workers go? After the Covid pandemic, many workers left the workforce as they either retired, became full-time caregivers to their family, or became sole proprietors. The number of new businesses created increased dramatically during the pandemic as many people, working remotely and/or stuck at home, decided to become consultants, contract workers, etc. New business creation in the 15 years prior to the start of the pandemic averaged about 220,000 per month. Immediately after the pandemic lockdowns started, new business creation rose to 550,000 per month and has been averaging about 450,000 ever since.

As the economy has weakened, many of these new businesses have been shutting down (bankruptcies and shutdowns are at the highest levels since 2010), and workers have been slowly re-entering the corporate workforce. This has caused the slow rise in the employment ratio over the last year. This is also why the unemployment rate has not increased (yet) as the economy has weakened. Firms who have been desperately short of workers are absorbing these workforce re-entrants, even if those firms don’t currently need them.⁵ However, the hiring has been slowing down as evidenced by the drop in job openings mentioned above. And the unemployment rate is finally beginning to edge up⁶ with the economy’s 2-year slowdown persisting.

So, what will happen going forward? While the economy has been slowing down for the last 2 years, it is not yet contracting, or in a recession. The question now is whether the recent trend of economic weakening continues, and the economy enters a recession, or whether the economy takes a u-turn and growth starts picking up.

Historically, when the economy is at a tipping point like this, the Federal Reserve steps in to ease monetary conditions and get the economy going again. However, with current inflation substantially higher than the Fed’s target rate of 2%, the Fed is effectively out of the picture. Furthermore, the weakness we have been seeing is the result of a supply shock, while monetary policy acts mostly on the demand side of the economy, so the Fed would have little effect on easing the supply-side issues.

What might be able to turn the economy around is fiscal stimulus, and that is precisely what has started hitting the economy. The Infrastructure Investment and Jobs Act of 2021, the Chips and Science Act of 2022, and the Inflation Reduction Act of 2022 are all about to result in hundreds of billions of dollars per year of new federal spending boosting the economy for several years. This spending is in addition to the substantial increase in defense spending that has occurred due to current geopolitical tensions⁷ as well as the emergency spending to support Ukraine and Israel. As these tensions showing no signs of easing, both US and foreign defense spending will likely continue to increase over the next decade. In addition to speeding up the transition and healing of global supply chains, all of this federal spending has a high likelihood of re-accelerating growth in the US economy.

The danger from this huge fiscal stimulus however is the possibility of reigniting high inflation. Inflation in the US was running in the 9–10% range and is now down to 3–4%. With all of the coming additional federal spending it seems unlikely that inflation will make it back to the Fed’s target of 2% anytime soon. Producer prices, where we would expect prices to rise first due to all the federal spending, have already begun re-accelerating. Prices in July rose 0.4%, while prices in August prices rose 0.7% — the highest in over a year. Consumer prices are likely to follow soon. Indeed, inflation seems more likely to remain at an elevated level (3%-4%) for several years. After the bout of elevated inflation in the ’80s for example, it took 8 years to get headline inflation back to 2%, while core inflation took 14 years to get back to 2%.

The natural next question is how the Federal Reserve will react to the re-acceleration of inflation. It could for example speed up its Quantitative Tightening (QT) policy that it began last year, thus causing a substantial rise in the yield curve. Many bond market strategists have been saying that the increase in interest rates that we have seen over the last year is due to the bond markets anticipating such a reaction from the Fed. How this might play out against the fiscal stimulus remains uncertain. We may have the monetary and fiscal policies stalemating each other for the next several years, resulting in slow economic growth. Or we may see the Fed allow fiscal stimulus to drive the economy forward while it patiently applies QT and other tools over a span of a decade or longer in order to get inflation to its target. We saw precisely this ideal outcome in the late ’80s when after two bouts of inflation (due to another supply shock — in oil) and monetary tightening, major fiscal stimulus (especially on the supply side) was unleashed on the US economy, which eventually powered the US economy and drove the equity and bond markets higher for decades (and the Fed allowed inflation over a decade to get back to target).

Footnotes

[1] This value is not seasonally adjusted in order to make it comparable to the 3-month moving average of wages, which is also not seasonally adjusted.

[2] The Manufacturers Purchasing Managers Index (PMI) measures the economic activity in the manufacturing sector. A reading above 50.0 indicates expansion in the sector, while a reading below indicates contraction in the sector.

[3] The Services PMI number is interpreted the same way as the Manufacturing PMI — a reading above 50.0 indicates expansion and below 50.0 indicates contraction.

[4] Each company in the supply chain also took labor and physical capital as inputs, and each was disrupted just as much as the companies above and below them on the chain.

[5] These firms are hoarding workers to ensure they are not caught with too few workers if the economy picks up again.

[6] The unemployment rate went up from 3.5% in July to 3.8% in August, though most of this bump upwards was the result of increased workforce participation, i.e., people who had left the workforce and now returning.

[7] This increased spending has occurred globally, so US companies that export just parts and services into the defense sectors of these countries are seeing an increase in demand and thereby contributing to US economic growth.