Perspectives: Time to pivot from worrying about inflation to worrying about employment?

David Jane

Premier Miton Macro Thematic Multi Asset Team

Labouring a key point

Last year inflation was the dominant issue for financial markets. While inflation will remain a key issue for the next decade, as we have discussed, in the near term more important is employment.

The US employment growth has been exceptionally strong since the lows of April 2020, although total employment has only recently exceeded the 2019 levels. Unemployment is back at the low levels seen in 2019. The labour market is undoubtedly tight, seeing constrained supply, in part because many people left the labour market in recent years.

US unemployment rate % since 2000

Source: Bloomberg, data from 01.09.2000 to 01.09.2022

The issue in the current year is that for inflation to fall back to the levels the markets expect, the US needs to avoid a wage price spiral. This is unlikely given the strength of employment currently and the recent pick up in wage growth. It follows that markets must be expecting a material weakening of employment markets, and hence a decline in overall economic activity.

A conundrum for markets

If the US avoids a recession, it is because wages and inflation remain high, which implies higher bond yields and lower bond valuations. If that comes with wages growing faster than prices, it also may mean lower company profits. The market may prefer a short, shallow recession, leading to weakening employment, not too much damage to company profits and lower interest rates. This could be the hoped-for Fed interest rate pivot scenario.

This is the reason the Fed is monitoring employment as one of the key metrics when setting interest rate policy. However, employment is well known to be a lagging indicator. The economy is likely to be in recession well before employment weakens materially. The worry is that considerable damage will have been done prior to any monetary policy easing from the Fed.

The long and short of it

We are of the view that the recession will be short but relatively hard. This follows from our broad world view of the declining waves of weak economic activity followed by inflation, post the lockdown driven recession and inflation spike. However, inflation may settle at a higher level and growth at a lower level than the past, because of prevailing raw material and energy shortages and trending deglobalization.

We retain an ongoing cautious stance on risk assets in general, awaiting greater clarity on the company profit outlook for equities and the inflation outlook for bonds. What may confound this approach is the possibility that Fed policy may divide into two branches. We have already seen this in the UK, where the Bank of England has both been raising rates (to control inflation), while simultaneously expanding QE (to avert a crisis in the pensions industry).

We could potentially see continued high US interest rates and this year both employment and liquidity levels both need careful monitoring.

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