Good morning. We have an inflation report coming this morning and a Federal Reserve meeting and press conference on Wednesday, so it seemed like a good time for a somewhat more systematic look at the economy. We take one below. Email us: robert.armstrong@ft.com & ethan.wu@ft.com.
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Normalisation vs recession
The economy is particularly hard to read right now, and has been so for a while. We have mostly been offering a “strong at the core, weak at the margins” read of it recently. Most other views out there fall into opposing camps. Some observers note the surprising strength of the economy, say recession is nowhere in sight, see inflation as sticky and bang on about higher rates for longer. Others think we are practically in a recession already and that deflation and rate cuts are right around the corner. Where on that spectrum are we?
Back in early February, we wrote a piece called “The enigmatic economy”, presenting the indicators we looked at, and what they were saying, as follows (spot the typo):
What has happened since? Just about everything in the economy has slowed over the past four months. Very few indicators are strong in the sense that they show accelerating growth. The key distinction, therefore, is between two kinds of slowing. Some indicators are slowing gently and remain at or above historical averages, suggesting normalisation from unsustainably hot pandemic levels. Others are bouncing back from periods of sustained weakness. After 500bp of Fed rate tightening, these are signs of remarkable resilience. But still other indicators look like they are falling outright, in a way consistent with recession.
So while we are sticking with a three-part schema, we have renamed the groups to reflect the fact that we are mostly making distinctions among flavours of deceleration:
Seen from on high, this is a picture of sturdiness. The economy is simmering down, but a bit at a time, rather than facing a vicious crunch. Employment, wages and spending are all still consistent with a return-to-normal story. Supporting all three is a remarkable run of expanding payrolls, an average monthly gain of 370,000 jobs since 2022. This has slowed to an average of 280,000 jobs over the past three months — still far above the 180,000 average monthly gains of the 2010-19 expansion.
S&P 500 profits, which have shrunk 6 per cent since the peak a year ago, are 34 per cent higher than December 2019. That’s a 9 per cent annual growth rate, at the high end of the normal historical range. Even a few worrying soft spots such as housing and Big Tech earnings have levelled out a bit. Although services spending growth, as measured by ISM PMIs, has slowed for four months (and is now just shy of contraction), real services spending levels look consistent with normalisation, a return to something resembling pre-pandemic growth:
Credit conditions, which we’ve called “mixed” above, look fine now but might get worse. Corporate credit spreads are surprisingly tight and the junk debt market is breathing new life. But the Fed’s senior loan officer survey, a forward-looking measure of credit conditions, looks bad. Bank lending to commercial and industrial businesses has also contracted for four months. Here’s C&I loans in year-over-year terms:
If the economy is sturdy, what accounts for “faltering” stuff: the evident struggles of low-income consumers, weak real retail sales and a screeching slowdown in manufacturing and shipping? Pandemic imbalances and inequality. After every household bought an air fryer, two Peletons and a half-dozen game consoles during the pandemic, a goods recession was probably a fait accompli. Real goods spending is flat, but an inventory build-up combined with flat demand means the supply side has to shrink. Shipping, manufacturing and retail sales (which is growing slower than prices) are thus all stumbling. Here are US manufacturing ISM PMIs:
Low-income consumers are struggling in an otherwise resilient economy because of the structural ugliness that is inequality. As we’ve written, a more equal income distribution would help growth, but it remains entirely (if regrettably) possible for most consumers to be spending merrily while the bottom quintile suffers.
Unhedged, then, is firmly on the side of those who think recession is still a ways off, inflation is likely to stay above target for a while and rates will be higher for longer. That does not, however, mean we think the Fed should raise rates this week. The standard points apply: 500bp is a lot of tightening, and monetary policy works on a lag. We see little harm in raising rates more incrementally, say by staggering rate increases at every other meeting. The resilience of the US economy has surprised most everyone, us included. But it is slowing, and there is no need to keep using the monetary sledgehammer. A chisel might do.
We could be wrong, and we will continue to scan the horizon for signs of recession. In particular, we will be waiting to see if falling profits cause job cuts. In principle, margin compression spurs companies to cut costs, especially facilities and jobs. So far, many dismissals have been concentrated in sectors that swelled during the pandemic. Any change in that pattern will be important. We’re also watching to see if the pain in the most vulnerable parts of the economy spreads. Will a rise in delinquencies for the bottom income decile, or defaults in the most leveraged decile of companies, spread to the next layer up? (Armstrong & Wu)
One good read
The FT’s excellent Silvio Berlusconi obituary.
Source: Economy - ft.com
