“Employment is the last leg to fall.”
This is a common phrase you might come by when you’re listening to the financial news or reading the paper. It’s a small – but important – part of macroeconomics. When we have conversations about these topics, it’s important to put them into context. Every week and month there is data released that paint a picture of where we were last month, where we are today, and where we might be going in the future. As investors, our job is to navigate the always-changing environment, and data like this inform us which way to point the sails.
If you live in Southern California, you know how beautiful it is most of the year. 70°F and sunny, a slight breeze, and a cloud or two. If you’re from San Diego, you mostly experience a “coastal desert” climate. According to CA.gov, “a coastal desert receives small amounts of rain and has high but not as extreme temperatures as an inland desert.” If you’re from Orange County, you mostly experience a “Mediterranean” climate where summers and winters are cool. There are frequent summer fogs, and rain occurs predominately in winter. As of recently, we’ve been experiencing some extreme heat. And yes, above 85°F is extreme to us. Oddly enough though, we’ve had muggy summer rain the last couple of days, which as I just mentioned is not particularly common for our climate. However, the weather and climate are different. How they change over time informs us of the seasons.
In economics, secular and cyclical trends exist. The data that exists within these trends carry important information about the economy as a whole. So, what’s the difference?
Secular Trends
Secular trends are forces that shift over a very long-time horizon and can’t be interrupted by intermediate forces. A secular trend is likely to continue to move in the same direction for the foreseeable future. An example of this is population. California is the most populous state in the U.S.. If residents of California began to move to other states due to exogenous forces, you might not notice any changes in California for a couple of years. In a decade or two, those changes become more obvious. Perhaps cheaper homes, fewer job opportunities, or no longer the most populous state.
Cyclical Trends
Cyclical trends are fluctuations in the economy that exist over top secular trends in the economy. A cyclical trend occurs on average over a 6 – 18-month time horizon where asset prices tend to follow the direction of economic growth. Where we can see cyclical trends today are in the labor market, wages, spending, and manufacturing.
At the end of the day, the economy is defined by who is working and how productive the individuals working are.
Unemployment Rate
At the beginning of September, the U.S. unemployment data was released. The unemployment rate ticked upwards from 3.5% to 3.7% for the month of August. The U.S. added roughly 315,000 new jobs, but still less than the 526,000 new jobs added in July. Why is this important? Well, the Federal Reserve wants to see unemployment gradually increase to signal that their interest rate increases are working.
But how are the two connected?
You, The Consumer
If you consume more goods, there needs to be more manufacturing to produce those goods. In order for those goods to be made, you need to employ a workforce. The greater workforce you employ, the more wages the workforce demands. With an income stream, you tend to consume. This cycle occurs in an upwardly trending economy. The opposite occurs in a downwardly trending economy. The makeup of how these parts of the economy is functioning defines the trend the economy is in.
With inflation at decade highs, the growth of real income has deteriorated. With lower borrowing rates behind us, real consumption has wavered. With slowing consumption comes weaker production growth, therefore weighing on employment as fewer goods are needed. So, the tick upward in unemployment seems to be following the cyclical trend of the other parts of the economy.
Still, how does this relate to what the Federal Reserve wants to see?
The Almighty Fed
Well, let’s look at the housing market. The housing market is a long leading indicator because it is very sensitive to changes in available borrowing and interest rates. Recently, we have seen a slowdown in the purchases and sale of homes, and prices have only moderately come down. This makes sense when we look at inflation since the cost of housing makes up a significant portion of that figure and inflation is clearly still elevated.
During the pandemic mortgage rates were at record lows, therefore, demand for homes was at a record high. When you buy a new home, you have to wait for it to be built. We can see that from the Housing Starts and Construction Spending data. Once you move in you probably want to furnish it, so you look for goods to make it yours – this data appears as New Orders. Your consumption is reflected by the demand for employees to manufacture those products – unemployment decreases, and wages rise.
The cyclical trend during the pandemic has changed directions – and signs are now pointing toward a shift in the overall secular trend of the economy. This so far, is logical considering Gross Domestic Product (GDP) growth has been negative from preliminary readings.
Today, mortgage rates have zoomed higher due, in part, to the Federal Reserve’s rate hikes. We have seen a decline in New Orders as well as Housing Starts for new homes. When sales begin to come down, retailers no longer need to maintain a large inventory of items (new homes), which we have seen with companies like Target (TGT) and Walmart (WMT). The decline of inventories and new orders indicates future production will be lesser down the road since consumers no longer have the same demand for the current things.
If you can see where this is going, then we’re almost full circle.
As production comes down, there will be less work for current employees which hurts the company’s balance sheets. Hiring is one of the most tedious and expensive parts of a business, so companies will keep their labor force until they no longer can afford it, or no longer need them. This can be seen by a decrease in Average Hourly Earnings and eventually an increase in unemployment.
Now the circle is complete. Beginning with the Federal Reserve raising rates, which constrains money flow for borrowers, pushing rates higher across the board, which weakens demand for homes, and slows demand for goods, resulting in slower manufacturing growth which causes employers to cut back on hiring. Employment is the last leg to fall.
What Does This Mean?
So far, the answer is unclear. Unemployment is still historically strong and signs of the Federal Reserve achieving a soft landing by not killing the labor market seem feasible. This can also be seen in the Labor Force Participation data improving for the month of August, signaling that more people are joining the workforce despite the weakening economy. Perhaps giving Jerome Powell some hope that they can pull it off.
However, it would be naïve to ignore the Federal Reserve’s pledge to keep rates elevated until they see a change in the data. As we just discussed, the data we’ve covered has already happened in the economy or is currently happening. We’re beginning to see the impact of the rate hikes that occurred earlier in the year, today. The concern moving forward is that if the Federal Reserve is waiting for a clearer shift in the data – based on their own actions months ago – they could overdo it.
This goes to show that secular trends take time to form, and outside forces have little impact in the short term. Cyclical trends on the other hand occur more quickly and inform us of the momentum in the economy. Just like here in Southern California, the changes occurring in the day-to-day weather give us an idea of where the seasons are headed, but the climate of our location dictates what that weather is likely to be. As investors, we must be able to identify these shifting trends to come to logical conclusions and position our sails to navigate our always-changing environment.
Kenneth Wolin
Portfolio Administrator