It is no secret that investors are steadfastly watching inflation numbers. During a recent client seminar, I spent a good amount of time reviewing leading indicators that point to an expected decline in inflation. However, the “hard” data of CPI and PCE have not yet reflected the leading indicators, as many components within CPI and PCE are lagging. For example, Shelter costs (i.e. housing), which make up 1/3 of CPI increased by +0.7% in August, whereas the NAHB Housing Market Index fell for the ninth straight month. The Case Shiller Home Price Index also declined for 3 consecutive monthly prints on a Year-over-Year growth basis. Anecdotally, the weak housing market that many homeowners have experienced has yet to be reflected in the CPI figure.
Ultimately, this divergence between leading indicators and hard data cannot diverge indefinitely. However, in the short term, this still leaves investors off-balance, as the next Inflation readings scheduled for October 13, November 10, and December 13 remain extremely uncertain. The big question is whether the markets can shrug off a disappointingly hotter inflation number simply being equipped with the expectation that this divergence will eventually narrow. Perhaps the more important question is whether the Fed can refrain from recalibrating interest rates higher when they have telegraphed that elevated CPI & PCE inflation data are what they are basing future rate hike decisions on.
As investors, we may often feel tempted to invest according to how things “should” happen. One may be thinking, “If I can see that the real-time inflation data is cooling, then the Fed must be able to see that too, regardless of what the CPI and PCE data prints!” And although that may be true, we recommend investors to invest according to the playbook that the Fed has put forth. Therefore, whether we like it or not, CPI and PCE are what matters, and portfolios should be defensively positioned to reflect the uncertainty of what may come.
Bad News Is Good News
Going forward, we believe inflation will not be the only metric that the Fed focuses on. Even if inflation begins cooling, part of the Fed’s dual mandate is for sustainable employment. Currently, with record-low unemployment numbers, scarcely available workers, and plentiful job vacancies, we have seen wage growth increases that add fuel to the inflation fire. Therefore, as odd as it may seem, the Fed would prefer to see more layoffs, less job openings and pricing power on wages to shift back to employers. Hence, what may seem like bad news, would be good news for the market as it would further embolden the expectation that the Fed has succeeded in cooling the economy. Unemployment and labor figures are inherently lagging indicators for the economy, as much of the incoming data is stale upon arrival. That being said, below are the figures that we feel are most relevant for the Fed.
Unemployment Rate: In the last Fed meeting, fed officials expected the unemployment rate to rise to 4.4% next year, up from 3.5% in September 2022. This still leaves the unemployment figure at historically low levels and therefore implies that the Fed is expecting a soft landing when it comes to correcting the labor market. Should we achieve the uptick in unemployment faster than expected, we would expect that the Fed would be less aggressive with their policy tightening. However, we feel the unemployment rate could remain stubbornly low. Even with a slowing economy, employers may refrain from laying off workers (ie. labour hoarding) as there is a fear of not being able to get those workers back. Labour hoarding has been seen in previous recessionary cycles and it could happen this time around as it has been extremely difficult to get workers over the past year and the prevalent view is that any pending recession will only be shallow and short lived.
Job Openings: Because the unemployment rate may be late in proving a weakening labour market, investors can watch for a drop in job postings to signal a lower demand for workers. This figure is tracked by the Job Opening and Labor Turnover Survey (JOLTS). Estimates are released each month approximately six weeks after the reference month, so there is a tremendous delay here. Last week, the JOLTS figure reported the largest ever drop in job openings, with a 1.1million or 10% drop. This brought the key ratio of ‘# of job openings / # workers’ to 1.67 from 1.97 in a single month. Again, this is bad news for workers that is interpreted as “good” news for the markets.
Due to the 6 week lag for the JOLTS, a more predictive measure of job openings may be The Conference Board Help Wanted Online Index (HWOL). The HWOL index measures the change in advertised online job vacancies and comes out 3 weeks ahead of JOLTS. As one can see in the chart below, the direction and trend of both measures are very close, therefore HWOL should serve as a good leading indicator for JOLTS.
There have been many interesting reports being published that speak towards the accuracy of job opening data. Some surmise that the number of job openings is inflated due to multiple listings across different regions for the same job that allows for remote work. Further, a working paper by the Fed described that the outsized job opening figure (JOLTS) potentially comes from firms looking to poach workers from competitors and is not necessarily an incremental job vacancy. Hence, as the economy cools and businesses take down their “poaching” listings, the JOLTS figure could come back down to earth at a much faster than expected speed.
In the end, we remind investors that the Fed is assigned a dual mandate of price and employment stability. Markets should be taking their cues from both figures, and this could make for expectations to be beat or missed and potentially adding to volatile price action. At the moment, it appears that the trends for labor seem to be cooling along with inflation. Should this continue, we expect the market to feel increasingly positive.