Yes, you can have a red-hot jobs market and a recession

Published Mon, Jun 5 20232:48 PM EDTUpdated Mon, Jun 5 20234:29 PM EDT

The U.S. jobs market is still sizzling and the economy is heading for a recession: Both things can be true. May's nonfarm payrolls growth again stunned Wall Street, with the count climbing by 339,000, well ahead of Wall Street estimates that have consistently undershot the report since January 2022. Investors partied Friday after the report's release, as expectations grew that the employment picture is strong but not so much that the Federal Reserve will need to raise interest rates again. However, there's an old adage on the Street that when it comes to recessions, the jobs market is always the last to know. With a spate of Fed tightening already in the pipeline and filtering its way through the economy, a recession either later this year or early in 2024 is still very much in play. "Strength in payrolls today does not guarantee strength tomorrow, and policy changes have no impact on the labor market for many months," Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a client note Monday. Fed officials frequently cite the "long and variable lags" of monetary-policy moves. That's an important consideration as the central bank has boosted rates by 5 percentage points since March 2022 . Such moves are not thought to have a real impact for a year to 18 months or longer. "That's why we are horrified when analysts, commentators and Fed officials cite very recent data as grounds for further rate hikes," Shepherdson added. "Policy lags are long and real, and the payroll numbers for any given month, or even a few months together, are just not reliable indicators of the state of the contemporaneous labor market, never mind the future." Trouble signs Moreover, the jobs report wasn't all rosy. Along with the impressive beat on the headline payrolls number came a surprising 310,000 drop on the household survey that pushed the unemployment rate up 0.3 percentage point to 3.7%. The total of those considered unemployed also jumped by 440,000. Though the household survey historically has been more volatile than the establishment count, it nevertheless showed potential cracks. "You had contradictory indications. You had the employment numbers showing a big creation of jobs but the household survey showing an equally large reduction of jobs," said Komal Sri-Kumar, president of Sri-Kumar Global Strategies. "The employment numbers may not be giving you sufficient indication of what is happening." Sri-Kumar is expecting a "deep but short" recession to hit later this year that will push policymakers back into an easing stance after the fastest pace of rate hikes in more than 40 years. Fed tightening is just one factor expected to contribute to an economic slowdown and a potential contraction. The central bank specifically has targeted a slowdown in the labor market in its quest to bring down inflation. But the rate hikes also are expected to hit credit and lending conditions, both of which also could be affected by troubles this year in regional banks. Services and manufacturing both hit Despite the continuous climb in payrolls, labor productivity has been poor. The first quarter saw a stunning 2.1% drop for productivity that combined with a 4.2% rise in unit labor costs, providing twin pressures for a wobbly economy. Negative readings on productivity often correlate with recessions. And Monday brought another reminder of dark clouds ahead, as the ISM services index registered a disappointing reading of 50.3, which is just barely above the 50 level representing expansion in the sector. The sub-indexes showed the reading was even uglier than the headline with considerable declines in backlogs, new orders and employment pointing to weakening conditions. Services spending is about double that of the goods in the $25.5 trillion U.S. economy, so the current readings are troubling. "In contrast to the strength of payroll employment growth last month, the fall in the ISM services index to a five-month low of 50.3 in May, from 51.9, suggests the economy is barreling towards recession," wrote Andrew Hunter, deputy chief U.S. economist at Capital Economics. The weak services reading comes with an ISM manufacturing reading — most recently at 46.9 — in contraction for seven straight months. Taken together, the two readings point to gross domestic product growth declining at a 1% annualized pace, Hunter said. Combined with a recent surge in the trade deficit due to lagging exports, lower business investment and declining consumption, growth likely "will be barely above zero in the second quarter," he added. It wouldn't be that unusual for payrolls to grow heading into a recession. For virtually all of the recessions since World War II, jobs were never a leading indicator, not turning negative until the downturn actually occurred. To be sure, though, the current level of strength would be unusual for a recession. DataTrek Research noted that the 0.3% jobs gain as a percentage of the workforce is consistent with expansions, not contractions, providing hope for investors that the economy at least isn't facing major trouble anytime soon. "Friday's report of 339,000 jobs added in May pushes back the starting point of any future US recession. Since 1980, a contraction has not started for 6-12 months after such a reading," DataTrek co-founder Nicholas Colas wrote. The Atlanta Fed's GDPNow tracker of data is pointing to second-quarter growth of 2%. However, the tool has been volatile for that period, falling to as low as 1.7% and as high as 2.9%.