A Tightrope Economy: Employment Weakness and Fed's Dilemma

by Hubert Marleau, Market Economist, Palos Management

September 6, 2024

Until now, Goldilocks conditions have been in place, producing a revised 3.0% annualised GDP increase in Q2 and generating a probable 2.0% in Q3. Yet growth has become a clear concern for the stock market in terms of employment data, pushing speculators to sell oil and copper down to $68 a barrel and $4 a pound respectively. Indeed, the overall tone of employment has deteriorated because fewer industries are hiring, jobs are harder to find, and fewer workers are quitting their current jobs for better ones. Moreover, the Fed’s Beige Book has reported that certain businesses are lowering employment through attrition, filling only necessary positions, and reducing hours, including shifts. Various surveys are confirming these isolated observations.

Firstly, the August ISM Manufacturing employment gauge managed to print a bit better than July’s 43.4 at 46.0, but is still in contraction territory; while the ISM Services employment measure fell to 50.2 from 51.1, suggesting low employment increases in this sector of the economy.

Secondly, employers reduced job postings to 7.7 million in July, only 700,000 more than the number of unemployed workers, effectively turning the openings-to-unemployed ratio into a perfect match at 1.07, indicating that this “immaculate disinflation” barometer is finally normal.

Thirdly, U.S. businesses generated just 99,000 new jobs in August, according to paycheque company ADP, to mark the smallest increase since 2021 - significantly less than the forecast gain of 140,000.

Fourthly, the Labor Department reported that the unemployment rate had ticked down to 4.2%, yet employers created 142,000 jobs in August weaker than expected, although it had revised down the summertime hiring by 86.000.

Given employment’s lacklustre performance, a soft landing can now only happen if the Fed decides to cut its policy rates (5.25- 5.50%) by as much as 200 bps over the next 9 months to where the neutral rate stands, which I set precisely at 3.50%, failing which the labour market may get cooler than most participants on the policy-setting Federal Open Market Committee want. The neutral rate, which neither stimulates nor restricts the economy, is officially estimated by the Fed to be between 2.5% and 3.5%. In this connection, the San Francisco Fed President and Chicago Fed President offered a similar argument, saying essentially that high real interest rates going into a slowing economy were unhealthy for the labour market and that multiple cuts were needed.

Interestingly, they may get additional help from a key growth factor that is often neglected by the media: productivity. Indeed, things may be different this time around. The morose outlook for further employment increases might bring neither recessionary conditions nor derail the path of the economy away from continued growth. Contrary to historical patterns, the job market is not collapsing. Far from it. The rise in the unemployment rate has been due to a low pace of hiring as opposed to a rise in the pace of firing: a fact buttressed by the Labor Department itself, which reported that the rate of layoffs had stayed near record lows, as confirmed in last week's drop in jobless claims.

Indeed, reluctance to fire workers stems from workers’ productivity, which has been more than good, rising by a revised annual rate of 2.5% in Q2 with encouraging prospects, given the extraordinary amount of capital being spent on automation, robotics and AI. The NY Fed’s Nowcasting model is even predicting that the annualised growth of the economy for Q3 and Q4 will be 2.6% and 2.2% respectively. Coincidentally, the yield curve, which has been sending dire warnings about the economy lately, has uninverted itself suggesting a healthier outlook.

On Friday, 10-year bond yields (3.72%) were 5 bps higher than 2-year notes. The carry costs of the two maturities are bound to steepen more with the forthcoming policy cuts, making the cost of financing the economy less onerous; while the average return for the index in the 12 months following initial uninversion of the yield curve is historically a gain of 12%, dating back to 1980, according to Dow Jones Market Data.

Meanwhile, the S&P 500 closed at 5408 on Friday, registering a loss of 200 points or 3.5% for the week. Perhaps a good entry point because the Fed will soon be on a rescue mission to shore up the economy.

1. Everything Is Dismally Political:

   I do not trust opinions based solely on partisan position or political affiliation, and am concerned about the manner of how tariffs, price controls, regulations, deficit spending, and corporate taxes are being treated by all political parties. Many policies they propose are positively foolhardy. I have expressed my dislike of tariffs and of price controls in the past, suggesting that both can generate inflation, create supply shortages and reduce product quality. Rational thought shows that corporations are not guilty of price gouging. Nor do they produce certain products when their comparative advantage does not exist. I find, therefore, that political complaints and advocacies are not supported either by empirical evidence or theoretical validity, unless national security is threatened; and devoutly hope that the American people are not foolish enough to give either party full control of Congress and the White House.

2. Tips and Steel:

Both Trump and Harris are ludicrously agreed that tips should be exempt from taxes, and equally ludicrously - that Nippon Steel should be prevented from buying US Steel.

As for the latter, I didn't know that Japan was a security risk. Wow! Why would anyone want to block such a deal on national security grounds, given that the land of the rising sun is a major ally, a staunch supporter, and, geopolitically, an indispensable far-east necessity of the US? It’s almost as if Canada had refused Cleveland-Cliffs, for similarly absurd reasons, from buying the Canadian steel maker Stelco for geopolitical considerations. US Steel may have an iconic history, but it’s at the tail end of a long list of steel producers. According to David Burritt, its CEO, the company simply does not have the money to revitalise the American rust belt; which is precisely why the $2.7 billion that Nippon has committed to invest in improving operations would not only be transformative, but prevent the closing of mills in the midwestern U.S.

Meanwhile investors should note that not all the steelworkers are against the acquisition; indeed some have rallied in support of the sale. In the end, once the political interference is out of the way, the regulatory review will likely support the transaction.

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