Puzzling US unemployment trends
If you have been paying attention to US job openings over recent months, you may be wondering why, as the number of job openings have trended lower, employment numbers have managed to remain strong. Your confusion is warranted. Historically when job openings have declined, unemployment has followed suit and risen. However, this time, it is different.
It is different because of what is called the job-workers gap. The job-workers gap measures the difference between labour demand and labour supply, and as you can see in Figure 1 below, the measure reached a record high of 3.7% in 2022. Indicating that the demand for labour currently far exceeds the available supply of labour. Which leads us to believe that the US economy is currently at full employment.
Figure 1 – The US jobs-workers gap reached a record high in 2022
When an economy is at full employment, there are no additional workers available to take up new work, which leads to a vertical labour supply curve – as illustrated by the “L-Supply” line in Figure 2. When the labour supply curve is vertical and job openings decline, as seen by the leftward shift of the demand curve in Figure 2, the number of people employed does not change. The economy remains at full employment as the number of jobs on offer remains greater than the number of people looking for work. The only aspects that change is a reduction in the number of job openings while wage growth decreases.
Given that the US job-workers gap is at such high levels, we believe that it will take some time for falling economic activity to have enough of an impact to reduce the gap to equilibrium levels. Therefore, in the coming months the majority of US workers who lose their job will probably not struggle much to find new work, and the economy will remain at full employment.
Figure 2 – Falling labour demand lowers job openings
What does this mean for financial markets?
Potentially what is even more important than US employment numbers, is what they tell us about the outlook of both the US economy and financial markets. The vertical supply curve does not only apply to labour supply, but also to the supply of goods and services. Therefore, as monetary policy tightens falling demand will largely drive down inflation and output without driving down employment. This is exactly the result that the US Federal Reserve (“Fed”) was hoping for. One in which the economy enters a period of benign disinflation without falling into a recession.
Pleasingly the latest inflation data confirms this is the case. As seen in Figure 3 below US core CPI has declined from its mid-2022 highs while US unemployment has remained steady. A positive outcome for the Fed, as its fight against inflation begins to prove successful. This is a story that we expect equity markets will rally on.
Figure 3 – Goods prices should decline further
Many investors will be caught off guard
However, it will be at this point, when many investors will have wrongly assumed that a soft landing is guaranteed, that a recession will set in. A result of continued Fed tightening is that the aggregate demand curve will fall by enough to reach the kink in the aggregate supply curve. However, as we have mentioned in the past, to keep demand at this exact point will prove difficult as this is inherently an unstable equilibrium. Any further decline in demand will lead to rapidly falling output and rising unemployment – see Figure 4.
At some point, likely in 2024, the protracted decline in job openings will become so low that workers will begin to worry that should they lose their job, they will not be able to find another. At the same time, pandemic savings will finally be depleted, forcing individuals to begin saving again and removing spend from the economy.
This will be compounded by a softer housing market. Based on the Case-Shiller index, US home prices have already fallen by 7.4% from their peak. We expect that home prices will continue to fall, creating a negative wealth effect. This trend will be exacerbated by the higher -rate mortgages that new homeowners will have to face, placing further downward pressure on the housing market as well as consumer spending.
Finally, as we surmised last month, evidence is emerging that banks are tightening their lending standards. Notably, small businesses are reporting increased difficulty in obtaining credit according to a recent NFIB survey. This behaviour is especially evident among smaller banks. A banking sector that is reluctant to lend will further weigh on the economy.
Figure 4 – Relationship between inflation and unemployment
The US Dollar is still overvalued
Since October last year the US Dollar Index (“DXY”) has fallen 5.6%. Despite this, it remains 5.9% higher than it was prior to the pandemic, and 26% above its 2014 levels. The DXY is trading 18% above its Purchasing Power Parity (“PPP”) implied level, which has typically been a reliable guide of the long-term returns of the currency. Given its relative strength and heightened valuation we believe it will weaken over the coming years, with only a short period of reprieve granted by the 2024 recession.
While the USD typically moves inversely to global growth, the USD’s performance during the 2024 recession will depend on how severe the economic downturn is. If it is mild, as we expect, then the USD may not experience material upside as the Fed has substantial scope to cut rates, potentially more so than other central banks. However, if the recession is severe the USD will strengthen as capital flows into safe-haven assets, such as US Treasuries. This would be a similar event to what occurred during the 2008 financial crisis.
In our January Market Synopsis, we wrote that we expected equity markets to rally in the first half of the year as the possibility of a soft landing increased. However, despite appearing more possible, we stated that we did not believe a soft landing would materialise due to the difficulty in keeping the economy at the kink in the aggregate supply curve. We stated that it would be at this point equities would begin to turn downwards as the reality of a delayed recession taking hold in 2024 became undeniable.
In the months since, the S&P 500 has moved up 8% as inflation numbers have improved and the US economy remains at full employment. However, stresses in the banking sector have ratcheted up the likelihood of a 2024 recession. In fact, the economic downturn may now be marginally sooner than initially expected given the tighter lending standards and thus withdrawal of cash from the economy.
As a result, where we once saw near term upside in global equities, we believe the outlook has now shifted to a more neutral stance and expect the upward momentum in equity markets to slow. Of course, once markets do begin to dip, we typically find that we are presented with a greater number of opportunities to acquire good businesses at underappreciated levels.