Jobs and the economy are a lot stronger than we think
Jobs and the economy are a lot stronger than we think
One of the biggest concerns that central banks have at the moment is just how hot the jobs market really is. There are a lot of different theories to explain why jobs are so strong. But they all don’t matter at the moment because the reality of markets is that strong jobs mean wage inflation is coming and that’s what central banks are really worried about, particularly in developed markets.
There are two main components of inflation — goods and services. We’ve started to see goods inflation moderate over the past few months which is understandable.
Goods supply chains were disrupted by the pandemic lockdowns and it took time to get things back on track. Goods inflation might actually lead to oversupply and eventually some type of deflation. Markets move in cycles and smart entrepreneurs around the world will be doing their best to fill gaps.
All eyes on wages
But services inflation is harder to tackle, particularly when the jobs market is very tight. In the US, UK, Canada and Australia, the jobs market is extremely strong. Things are also strong in Europe.
We’ve started to see layoffs in some parts of the US market, particularly in technology. But they might not be completely reflective of the overall jobs market. Tech was in a bubble, driven by zero rates and that bubble has burst, so it makes sense for job losses in that particular industry.
Outside of tech, the jobs market remains extremely strong. The US economy added 517k jobs in January which blew away expectations. The unemployment rate across most of the developed world is between 3-4% which reflects a natural bottom.
Strong jobs, driven by a strong economy, is the single most important relationship to watch in 2023. Central banks are worried because once wage inflation starts to creep in, it’s very hard to reverse.
Economies like Europe and Australia which have strong employment laws protecting employee rights (which is a good thing) end up having longer cycles of wage inflation. It turns into a spiral…high inflation causing wage increases which causes more inflation.
The spiral is the biggest risk.
The Reserve Bank of Australia this week noted “Given the importance of avoiding a prices-wages spiral, the Board will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.”
The biggest secret in markets is that central banks want to cause unemployment. They can’t explicitly say it, but they want firms to shed staff and provide redundancy to the labour market. They can’t go on record and say it, due to the political fallout, but policy is very much set at the moment to destroy jobs just enough to limit wages from spiralling out of control.
Implications of a strong jobs market
While most of the market is focused on the effect (rising rates), our primary focus is on the cause (strong jobs, strong economy). Interest rate rises, framed as a response to inflation, are actually a response to a strong jobs market which is driven by a much stronger than expected economy.
Central banks initially saw the post pandemic inflation as transitory which was sensible. They thought that goods inflation would moderate, which is happening. Where they missed the mark is on the economy’s resilience and jobs market strength. That is why they are now in panic mode playing catchup. The wage spiral only occurs when the economy is strong, not weak.
We see two things happening over the next six to twelve months:
The global economy will withstand interest rate increases and it will take time for the jobs market to weaken. Rates will need to stay high for a longer period of time, but eventually, the spiral will be broken. It will come at a cost, it will be a tussle, but it will happen.
The stronger than expected economy and likely wage growth will offset higher rates and provide a cushion. But eventually firms will look to labour alternatives and a way of managing rising staff costs, which will usher in the next wave of innovation. We wrote about this last week in our outlook on AI.
Microsoft and Google are now completely entrenched in an AI war to determine who will dominate the transition of workplace and enterprise resource management to AI. The market smashed Alphabet (Google) stock this week following their AI launch, a reflection of just how important the AI commercialisation path is to the future of work, wage productivity and ultimately inflation and interest rates.
Markets in the near term
While short term interest rates are rising, medium to long term bond yields have barely moved since October last year. The US 10 year bond yield is steady within the 3.40-3.90% range which means that the market doesn’t see goods inflation blowing out but is also unsure on how sticky services inflation and the wage spiral will be.
Equally in Australia, despite another rate rise this week and a policy outlook statement which doesn’t indicate an imminent pause (like Canada), the yield on 2 year Aussie bonds is basically flat and within recent range.
Markets are going into a narrow trading range awaiting more cues from central banks, primarily on the back of job numbers. We think that the next few months will be a wait and see approach, without much direction.
The one big thing we continue to look out for is a large shock to the system. Rising rates have so far been absorbed, but as Warren Buffett says, when the tide goes out you see who has been swimming naked.
In the absence of shocks, the underlying economy remains strong, jobs remain tight and disruptive forces are working in the background to impact the future of work and productivity.
Each week we use classical artwork in our thumbnail links as a source of inspiration. See this week’s artwork here.