Mean Reversion of the US Economy?

Or is this time different?

Supply chain disruptions and Quantitative Easing (QE) by the Federal Reserve (Fed) were the two major disruptions to the US economy since the Covid pandemic began. The result was overly rapid economic growth (particularly in aggregate demand), an extremely tight labor market, and high levels of inflation. As supply chains have gotten back to normal and the Fed has reversed QE, inflation has cooled.¹ As inflation fades away, now the majority of economic statistics are indicating a steadily weakening US economy (which we wrote about here). The question widely asked on Wall Street now is how weak will the economy get: will it slowly revert and pick up growth (a “soft landing”) or will it continue to weaken and end up contracting (a recession, or “hard landing”)? One suggestion under consideration is that the economy will revert to something akin to the historical average of what we experienced pre-Covid. This would imply that the economy still has to weaken substantially more before it gets to the typical economy of the past 20–30 years prior to the Covid pandemic.

For example, the weakening of the labor markets, which has contributed to this disinflationary process, still has a ways to go to reach historical averages. The unemployment rate has risen from 3.4% at the start of 2023 to 4.1% in mid-2024. However the average unemployment rate over the thirty years prior to the Covid pandemic was 5.9%.² Total non-farm job openings (from the Job Openings and Labor Turnover Survey, or JOLTS) has decreased from 12.2M in March 2022 to 8.2M at the end of June 2024. However the average job openings in the five years prior to the pandemic was was 6.3M.³ As jobs have become more difficult to get, the quits rate (the rate at which people are quitting their jobs) has decreased from 3.0% in April 2022 to 2.2% in May 2024. The average in the twenty years before the pandemic was 1.8%. Weekly initial jobless claims have risen from 187K in September 2022 to 243K in mid-July 2024, while continuing jobless claims have risen from 1.4M to 1.9M in the same time period. During the twenty years prior to the pandemic, initial jobless claims averaged 368K (despite a lower average population) and the continuing jobless claims averaged 3.1M (again, despite a lower population). Consequently the number of unemployed people per job opening has increased from 0.5 in mid 2022 to 0.8 in June 2024. However the twenty year historical average prior to the pandemic was 2.6. The pervasive message that we get from job market data is that while the job market has gotten worse recently (thereby contributing to the decrease in inflation) the job market remains much stronger than it has been historically. If the US economy is on a path to reverting to historical metrics, labor market conditions still have a long path of deterioration in front of it.

As another example, the deterioration of labor income has been driving an increase in default rates for all types of consumer loans. Credit card delinquency rates (measured as credit card payments overdue by over 90 days) have risen from 3.1% in March 2022 to 7.2% in March 2024.⁴ Auto loan delinquency rates (balances overdue by over 90 days) have risen from 1.3% at the start of 2022 to 2.6% in March 2024. The troubling thing with these measures is that the 20-year historical averages (prior to the pandemic) for credit card and auto loan delinquencies are 6.4% and 2.2%, respectively. These measures indicate that despite a recently strong labor market, costs for consumers have risen (due to inflation) at a much faster pace than wages, and with labor markets weakening over the last two years, loan delinquencies are now already well above historical averages. And if the labor market continues its correction to historical averages, these measures could get substantially higher than what we’ve seen historically.

On the monetary side, the Federal Reserve aided the disinflationary process by ending QE and slowly shrinking its balance sheet (a back-door form of Quantitative Tightening), which had grown from $4T just prior to the pandemic to $9T in early 2022. It allowed $95B of Treasuries and mortgage securities to mature without replacement on its balance sheet every month.⁵ This caused bond prices to drop and interest rates across the yield curve to increase, most importantly on the long end of the curve. The benchmark 10-year yield increased from 1.52% at the start of 2022 to 4.41% at the start of June 2024. With the recent weakness in the economy, the Fed slowed this rolloff of bonds to $60B a month, but 10-year Treasury rates continued to go up, to 4.48% at the start of July 2024.

Looking back historically at the 10-year Treasury rate, we cannot simply look prior to the pandemic because the Fed has been employing QE for most of the 2010s. So, if we look back prior to when the Fed began QE, November 2008, the historical 10-year rate during the time when inflation was around the Fed’s 2% target was about 4.5%. So, the 10-year rate today is at the historical average. However, inflation is not; it is sitting at above 3%. If inflation continues its drop to the Fed’s 2% target, the 10-year interest rate should continue to stay around 4.5% with some fluctuations up and down. But if inflation gets stuck at around 3%, which some economists have forecasted, then the 10-year would likely go up to about 5.5%. At that level, the higher cost of capital would act as a further dampener on the economy, which would accelerate the labor market decline.

The weakening of the US economy seems to be showing up across a broad set of economic metrics, but one unusual aspect of the prior two years of economic weakening is that the equity markets have seemingly performed extremely well. The S&P 500 has increased 42% over the last 1.5 years (from Jan 2023 thru June 2024) — 26% per annum — while the economy has been weakening. However, one needs to look behind the aggregate numbers to get a more accurate picture. For example, the “Magnificent 7”⁶ is up 149% during the same time period, but the S&P 493 (the remaining companies in the S&P 500) is up only 21%. And if we exclude the tech sector completely, the return of the remainder of the S&P 500 drops to about 13%, or about 8% per annum — not much higher than the 5% per annum one would have earned on 1-month T-bills.⁷ So the financial markets when looking outside of the tech sector seem to reflect the growing underlying weakness in the economy.

One important question is why the economic weakening is occurring so slowly, or rather how has the economy managed to stay so strong despite the headwinds it has faced for two years. The answer is multi-faceted. First, the personal savings rate has fallen over the last three years from 8.7% to its current 3.4%. The 3.4% is well below where it was pre-pandemic at 7.7% as well as the 20 year pre-pandemic historical average of 6.0%. So consumers are spending down their savings (or saving considerably less than before), which has really helped to prop up the economy. Second, as the record-high federal deficit indicates, there has been a tremendous amount of fiscal spending (the Infrastructure Investment and Jobs Act of 2021, the Chips and Science Act of 2022, the Inflation Reduction Act of 2022, as well as substantially higher defense spending due to all the geopolitical uncertainty) which is currently pumping hundreds of billions of dollars into the US economy annually. Finally, interest rates that are on average about 4% higher than 3 years ago means that the US Treasury is today paying an incremental $200 billion in interest income to investors, which is also sloshing around in the economy. All of this incremental spending in aggregate has held off the magnitude of economic weakness that most other parts of the world such as the EU and China have experienced and are still experiencing.

Footnotes

[1] Inflation has dropped from a high of 8.9% to 3.0% currently as measured by the consumer price index (CPI) or 7.1% to 2.5% as measured by personal consumption expenditures (PCE) in the US. Excluding typically volatile food and energy costs, inflation as measured by CPI and PCE are currently 3.3% and 2.9%, respectively.

[2] Even if one goes back another thirty years, the average unemployment rate remains at 5.9%. This value is fairly robust across recent history.

[3] We don’t want to go much further back than 5 years prior to the pandemic (without making a population adjustment) because of population growth. If we were to go twenty years back, for example, the total job listings averaged about 4.1 million, but the average population was also smaller.

[4] An x% delinquency rate means that x% of total credit card payments due are overdue by 90+ days.

[5] The Fed slowed this rolloff of Treasuries and mortgage securities to $60B beginning June 2024.

[6] These are Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta, and Tesla.

[7] There have been discussions among investors about the tech sector possibly being artificially inflated by a bubble, but the tech sector’s fundamentals have been consistent with the returns disparity. For example, tech sector earnings grew 22% in the 1st quarter of 2024 (YoY), while earnings for the remainder of the S&P 500 grew 4%.