Cracks In The US Labour Market Could Pressure Equities

• The latest US labour market data showed a further slowdown in labour income. This will likely drag down consumption growth and, from mid-year, push unemployment higher.
• Meanwhile the TINA (there is no alternative) rally is likely to continue, helped by low yields and the Fed’s willingness to provide additional support if needed.

Businesses Unimpressed by Phase 1 US-China Trade Deal

The most recent US non-farm payroll (NFP) was weaker than expectations with headline at 145K compared to forecasts of 160K.  More importantly, it showed further weakening of the labour market, whether payrolls, wages, or hours worked (Chart 1). This is consistent with data signalling weak business demand, for instance poor capital goods orders as well as C-suite pessimism for 2020 as indicated in Deloitte’s survey of North American CFOs.

 Chart 1: Employees Wage Income YoY

NFP, wages and hours worked growth continued to slow in December.

 

The labour market data is in line with the slide in capex and employment growth that started in Q1 2019, following the previous summer’s escalation in the US-China trade war.  This has generated substantial policy uncertainty. Capex has then been held back for fear having idle capacity that cannot easily be managed. Meanwhile, the fear of hiring workers only to have to fire them with severance pay is holding employment back. So the ups-and-downs of the negotiations are making managers cautious on all fronts.

The lack of capex and hiring off the back the October announcement of the Phase 1 deal suggest businesses don’t see it as a game changer. This makes sense as implementation remains uncertain and the deal fails to address bigger picture issues in the China/US relationship. In addition, there is much uncertainty on the 2020 elections that could see a win by a candidate perceived to be anti-business.

 

Business Weakness Spreading to Households

Because of the nature of the shock hitting the US economy, demand weaknesses so far have been mainly concentrated in the corporate sector.  However, this weakness is now slowly seeping into the household sector through the labour market. Not only employment but also wages and hours worked are slowing, which makes for slower growth in the wage bill (employment times hours worked times wages) that is the main source of income for most households.

Historically, wage bill and consumption growth have been strongly correlated (Chart 2).  The latest labour data suggests that consumption growth is likely to slide further.  With consumption representing 70% of US GDP, with a mild capex contraction and an expansion in real estate investment too small to make a difference, GDP growth is likely to slow.

Chart 2: Consumption and Wage Income

The ongoing slowdown in wage income (wages times employment) is likely to drag down consumption growth.

 

SPX to Hit New Highs In Short Term

Market reaction to the  data has been positive as it would be consistent with TINA (there is no alternative) –  a market regime where low yields as well as mediocre growth and inflation support strong valuations. Low inflation is a key driver of the regime as it allows the central bank to provide support to markets if the economy falters or financial conditions tighten.

While weak wage and employment growth make for weak consumption, they also suggest continued inflation underperformance.   This creates scope for the Fed to ease policy and for now markets are being driven much more by expectations of central bank support than by expectations of strong growth.  The latest wage print suggests that the TINA regime has further to go and that the S&P could reach new highs.

The TINA rally could last until investors become concerned that earnings growth won’t catch up with valuations  and/or the Fed’s ability to support the economy – about a couple of quarters. Crude calculations suggest unemployment could start rising around mid-year. Historically, once unemployment starts rising, the move quickly gathers momentum: in effect the US economy has not gone through soft landing since WWII (Chart 3). The Sahm recession indicator for instance shows that an increase in unemployment by 50 bp relative to its 12m low almost always signals a recession.

Chart 3: Actual & LT Unemployment Rates, %

 

It is likely that once unemployment starts rising the Fed will ease, but in my view, this may not have much impact on demand for goods and services as yields are already low and a decade of ultraloose monetary policy has likely weakened its effectiveness (more on this in a later post).   And once the market realizes that Fed easing is not having much impact on the economy, the Fed put is likely to lose its potency, which would very likely end the rally, sometime over the summer/early fall.