“It was the best of times, it was the worst of times…”
Today, investors can probably relate to the bewilderment that Charles Dickens’ iconic sentence from Tale of Two Cities so poetically captured.
Investors are confused. Since early June US bond yields have gyrated like a drunken sailor, first soaring, then collapsing, and then surging higher again this past week.
Importantly, the oscillations in bond markets do not reflect increased uncertainty about inflation. Longer-dated expectations of inflation have been steadily falling over the past month. Rather, bond investors have become more uncertain about future growth. In turn, they have rapidly shifted their views about Fed tightening, with sharp moves over the past few weeks in two-year Treasury yields whipsawing the bond market.
Why is that now the case? The answer resides in our tale of two economies—expenditures versus income measures of GDP.
Gross domestic product (GDP) is determined by looking either at all final sales (expenditures) or all final income (wages, profits, and government tax receipts). Over time, with minor adjustments for data collection discrepancies, the two approaches are roughly the same. And that makes sense, insofar as all expenditures are someone’s income.
But, at times, the incoming data can reveal some significant divergence between expenditures and income. Now is one of those times. And that is giving economists and investors headaches as they try to figure out which series is more likely to prevail.
Consider the following. In the first half of 2022 it appears that US real GDP fell at about a 1% rate. That is based on the reported -1.6% decline in first quarter output and an estimate based on the Federal Reserve Bank of Atlanta’s widely followed ‘GDPNow’ figure for the just-concluded second quarter.
Yet employment growth (a key component of household income) has been robust in the first half of 2022, rising about 2% over the past six months. Average hourly earnings area also up.
The upshot is an unusually large discrepancy between the two series. That, in turn, suggests that once better data arrive and revisions are published, the two figures will converge.
But that is not all that is at work. Recall, that the decline in first quarter real GDP reflected surging imports (which subtract from GDP) and inventory adjustments. In contrast, final demand in the first three months of 2022 was strong. So some of the observed divergence between GDP growth and the labor market goes away.
But the same is not true for the second quarter. Based on the GDPNow arithmetic, consumer spending slowed sharply in the April-June quarter and business investment spending fell at a -15% rate. Yet jobs and wages growth remained robust, as we learned again this past Friday in the June employment report. How is that possible?
The answer is that part of the disconnect between income (which also reflects continued strong corporate profits growth) and expenditures can be explained by high inflation, which erodes the purchasing power of households and firms. Inflation-adjusted wages are falling, crimping spending.
Moreover, consumer spending is probably also softening following sharp declines in household savings rates over the past 18 months to below pre-pandemic levels, leaving many Americans in a more constrained financial position. Similarly, falling prices for financial assets are eroding household net worth and weakening consumer confidence. They also raise the cost of capital for firms, which helps explain reported weakness in capital expenditures.
Indeed, broad financial conditions have recently tightened according to the Federal Reserve Bank of Chicago’s weekly measure. Within the Chicago Fed’s index, the measure that captures the tendency of households and firms to deleverage (i.e., reduce expenditures based on borrowing) has now jumped to its tightest reading in a decade. That suggests that spending on durables such as cars and housing is peaking.
The upshot is that real (inflation-adjusted) household and business expenditures are probably now running weaker than household or business nominal income growth (accounted for by job and wage gains, as well as profits growth). For many people, their income is not keeping up with prices just as borrowing conditions and credit appetite are worsening.
From the perspective of US monetary policy, however, inflation remains too high, and any slowing of demand is too modest and too recent to dissuade the Fed from its tightening stance. Later this month the Fed is likely to hike rates another three quarters of a percentage point, followed by a further half point increase in September.
Nevertheless, the tale of two economies provides investors with signposts about what to watch for over the remainder of the summer. As the second quarter corporate profits season kicks off with a slew of banks reporting this week, investors will be keen to see if those financial services firms are beginning to tighten credit conditions, indicating weaker credit demand, or increasing provisioning against potential loan losses. If so, they would confirm and exacerbate the tightening of financial conditions already underway.
Analysts will also be on the lookout for signs that retailers and other consumer firms are reporting weakness in sales or rising inventories. Investors will pay close attention to corporate profits’ guidance over the remainder of the year, given that the consensus of company analysts continues to forecast accelerating S&P500 earnings over the next few quarters despite signs of weaker growth, falling commodity prices, and a stronger US dollar—factors that usually erode profitability.
Still, it will take longer for the ‘tale of two economies’ to fully play out. A record gap between job openings and job seekers, weak productivity growth, and a shortage of skilled workers suggest that weakness in the labor market will lag the slowing of demand. Jobs growth is apt to continue for longer and layoffs are likely to arrive later than usual until hiring intentions slow. A resilient labor market will tend to mask weakness in expenditures, making both the business cycle and the likely stance of Fed policy tougher to read.
Wild swings in bond and stock markets will probably continue. But beneath that uncertainty is the ‘known-known’ that the Federal Reserve is determined to bring demand down, in line with supply, to slow inflation. Investors puzzled by the tale of two economies would therefore be wise to anticipate the end game, namely that weakness in expenditures will prevail over (lagging) strength in the labor market.