At first glance, a 700-point rally on one month of softer wage data, like we had on Friday, might seem like a bit of a stretch. But markets are smarter than that. What they're really sensing is that a slowdown is setting in, one that may give the Fed pause sooner than later.
This will be as confusing on the way down as it was on the way up, because of inflation. During the boom, inflation actually outstripped growth, but both were growing sharply. Just compare nominal (actual) GDP growth, on the left below, with real GDP growth, on the right, which subtracts out the inflation rate.
The first three quarters of 2020 start out pretty similar, before inflation sets in. This is the "mission accomplished" phase of stimulus, when the massive Fed and fiscal efforts helped the economy sharply rebound from the pandemic cliff:
Nominal Real
Q1 2020: -3.1% -4.6%
Q2 2020: -30.9 -29.9
Q3 2020: 40.1 35.3
But by the end of 2020, as the next data show, inflation is already running above trend. By the first quarter of 2021, it's hitting roughly 5%--double historical norms, as you can see below between the big gap between nominal (actual) growth on the left (in red), and what's left after inflation in "real" growth on the right:
Q4 2020: 6.6 3.9
Q1 2021: 11.7 6.3
Q2 2021: 13.8 7.0
This climaxed with nominal GDP soaring above 14% at the end of 2021, the same quarter that the Fed was predicting only three quarter-point rate hikes for last year. (As we now know, we ended up with four times that much). Notice how because of inflation the third-quarter growth rate seemed like "only" 2.7% when the headline number was reported. That completely masked the real story, and is another reason the Fed wound up way behind the ball.
By the first half of last year, as we all know, inflation had more than outstripped nominal growth (running at a roughly 9% pace by mid-year), leaving real growth "negative" and prompting all the recession confusion. The economy was actually overheating back then, which was triggering the negative numbers; it was not slowing.
Q3 2021: 9.0 2.7
Q4 2021: 14.3 7.0
Q1 2022: 6.6 -1.6
Q2 2022: 8.5 -0.6
In the third quarter, as inflation started to recede somewhat, nominal GDP was 7.7% and real was 3.2%. We won't get fourth quarter figures until later this month, but the Atlanta Fed's tracker has it running around 3.8%. So in nominal terms, the growth rate has already slowed by half from its peak; forward-looking indicators imply it will collapse completely within the next year or so.
Plus, as Alan Blinder pointed out in The Wall Street Journal last week, inflation in the second half of last year was already back to 2.5% annualized (or 3.7% on the Fed's preferred measure). Bond markets have already receded from pricing 3.5% annual inflation over the next five years back in March, before the Fed started aggressively hiking rates, to below 2.2%, currently.
And that's not all; the manufacturing ISM--a leading indicator of inflation--shows priced paid have completely collapsed, falling below 40 to the lowest level since the pandemic first hit in April 2020. We learned that last Wednesday; little wonder that by the time the ISM services gauge--which is supposed to be the stalwart--was released on Friday, markets reacted hugely to its surprise contraction last month.
In fact, stocks were up more after that report hit at 10 a.m. Eastern than they were after the jobs report crossed at 8:30 a.m. And the reason is simple; ISM is a leading indicator, while jobs are coincident and wages are lagging. So the fact that wage growth already slowed last month to a 3.6% annualized rate was priming the market for a more dovish Fed; the ISM report just sealed the deal.
What we are witnessing is a broad-based slowing of the economy from unsustainably hot levels to something much, much cooler. The yield curves are signaling a sharp downturn in the next 12 months or so. If inflation stays moribund, the "real" GDP reports might seem comfortably high, but don't be misled; this is an economy on the precipice unless the Fed quickly changes course.
See you at 1 p.m!
Kelly