Too soon to declare a Fed triumph
Two-thirds of the way into 2023 the US Federal Reserve (“Fed”) has made marked progress in quelling the overheating US economy. Core CPI excluding shelter and used cars has fallen from a high of 7.1% in mid-2022 to just 0.6% now – see Figure 1. All while US unemployment has managed to remain relatively unchanged.
Figure 1 – Inflation falls while unemployment remains strong
Just last Friday US unemployment did unexpectedly increase from 3.5% to 3.8%. However, if one looks a little deeper, you will see that this was the result of the labour force participation rate increasing from 62.6% to 62.8%. Indicating that the increase in the unemployment rate was in fact the result of an increase in labour supply and not an increase in workers losing their jobs.
While falling inflation and a resilient labour market could appear to be markers of a job well done, we believe that it is precisely at this point that a hard landing could occur. Why? The US jobs-workers gap, which measures the difference between labour demand and labour supply, is currently in a surplus, meaning that there are more jobs available than workers. This surplus has allowed the Fed to hike rates without increasing unemployment, as any workers who lose their jobs can quickly find another one.
However, as you can see in Figure 2, this gap which peaked in 2021 is more than halfway back down to its pre-pandemic levels. Currently, there are 1.5 job openings per unemployed worker, compared to 1.2 openings in 2019. At some point in 2024, we expect the impact of Fed rate hikes to have fully worked its way through the US economy, depleting the surplus in the jobs-workers gap. Once this excess demand (that kept the economy out of a recession) is depleted, any further decline in aggregate demand will start pushing up unemployment.
Figure 2 – The US jobs-workers gap is 60% down from 2021
Is the risk of a second wave of inflation still present?
Since the start of 2022, job openings have consistently trended downward, and it is likely that they will continue to do so. However, there is a small chance that job openings begin to rise again. As you can see in Figure 3, the prime-age labour force participation rate (age 25-54) has climbed above pre-pandemic levels, a result of the labour supply growing faster than the working-age population. Given that the prime-age participation rate cannot grow much further, and in fact, is more likely to decline, job openings could start to rise again. Thus, even if labour demand decelerates, labour supply could decelerate even more.
Figure 3 – Prime-age labour force participation is higher than in 2019
An increase in job openings would lead to a reacceleration in wage growth and a second wave of inflation. The Fed would be forced to quickly stamp this out with further rate hikes forcing the US economy into a deeper recession than if the economy had simply drifted into one. Having said that, we maintain that while this scenario is possible, it is unlikely.
Finding the middle ground
When there is slack in an economy, the central bank can keep rates below their neutral level without worrying about inflation rising. This is what we witnessed for many years prior to the pandemic. However, once the economy reaches full employment, as it is now, any deviation from the neutral rate can quickly lead to the economy either under or overheating.
In other words, that middle ground becomes a lot harder to find. This is especially true because the neutral rate cannot be observed directly, and the effects of monetary policy are felt after long lags. As a result, periods of full employment typically lead to lower equity returns than when unemployment is high, as can be seen in Figure 4.
Figure 4 – Surprisingly equities do poorly when unemployment is low
The true source of China’s economic woes
Market commentators typically identify excessive debt and an overdependence on real estate as the source of China’s lagging growth. While the problems are valid, they are only symptoms of China’s real issue: An extremely high savings rate. China’s savings are 45% of GDP, by far the highest of any large economy – see Figure 5.
High savings are typically seen as a good thing, providing the capital needed for a country to expand their productive capacity. However, when an economy cannot convert its savings into productive investments, savings become a source of weak demand and chronic unemployment.
Figure 5 – China’s very high national savings
[/vc_column_text][vc_column_text]Two decades ago, China had plenty of worthwhile projects to invest in, ranging from road infrastructure and factories to residential buildings. However, as time went by the pipeline of worthwhile projects diminished, and China became increasingly dependent on real estate construction to drive GDP growth. This was exacerbated by the unattractive deposit rates offered by banks and the widespread belief that shares were too risky. As a result, Chinese households were forced to buy apartments to earn a decent return on their savings.
Now though, the growth in house prices has been flat-to down for the past three months and the average property developer’s bond is trading at just 32 cents to the dollar – see Figure 6.
With the property sector seemingly in free fall, Chinese authorities provided RMB 1.88 trillion in financing late last year to enable developers to complete the construction of pre-sold houses. Unfortunately, this and other stimulus measures have done little to buoy the confidence of households as mortgage debt continues to shrink and the percentage of households expecting home prices to rise tumbles to a near-record low.
Figure 6 – Property developer bond prices continue to fall
The Japanfication of China
It is quite possible that China’s housing market has begun a multi-decade slide, similar to what Japan experienced in the early 1990s. Just like Japan three decades ago, Chinese homes are extremely overvalued relative to rents and there has simply been far too much construction. The oversupply of residential properties is further exacerbated by China’s shrinking working-age population, which the UN expects will be 62% smaller before the century is over.
However, China does not have to face the same fate as Japan did three decades ago. 1990s Japan had an output-per-hour worked roughly 70% of US levels, whereas China is just 20% of US levels. Thus, even with a shrinking labour force, China could still grow its GDP by raising its productivity levels towards those of a developed economy. To achieve this, China will need to make structural reforms that enhance its economic efficiency. At present, it is far from clear whether they will do so.
Unlike many of the world’s economies, China’s immediate risk is deflation and not inflation. The result of excess savings keeps inflation low as supply consistently exceeds demand. It follows that Chinese regulators need to implement proactive fiscal stimulus. Unfortunately, up until now, their one-at-a-time piecemeal approach has been reactive. Figure 7 depicts how China’s combined credit and fiscal spending impulse continues to fall and is now at anaemic levels.
Figure 7 – The current piecemeal stimulus is insignificant
The government’s reluctance to stimulate the economy stems from its desire to avoid aggravating structural economic imbalances such as elevated indebtedness, real estate excesses, and financial speculation. We believe policymakers have been able to avoid providing more forceful stimulus because the property sector has not driven unemployment to levels high enough to where they are forced to act. An increase in youth unemployment is simply not enough to convince reluctant policymakers.
If the economy continues to slow, we do expect authorities to eventually ramp up stimulus, focusing on boosting support for high-tech industries, implementing a debt resolution plan for Local Government Financing Vehicles, expanding financing for EVs, and encouraging higher birth rates through more generous family-support measures. Whether these measures will arrive in time remains to be seen.
As both the US labour market and inflation continue to cool in tandem, it is clear the Fed’s rate hikes are having the desired effect. However, this also raises the risk of a recession as unemployment starts to become a near-term risk. This view is compounded by the reluctance of Chinese policymakers to meaningfully stimulate their economy, at least until the Chinese labour market shows signs of distress. Our timeline remains unchanged, we continue to anticipate a recession in 2024 and favour a more defensive allocation in the coming three to six months. The decision, however, remains highly data-dependent.