For a market with a one-track mind, Friday’s massive nonfarm payrolls miss is ostensibly good news. On its face, it means the Fed’s tapering of emergency bond buys is all but certain to be delayed and investors can count on easy money for longer. But a closer look at the August jobs report reveals an alarming picture and a deepening policy predicament.
Policy makers and economists are loath to use the word “stagflation.” It conjures up images associated with the 1970s—sky-high prices, flailing economic growth, high unemployment, and a weak stock market. Federal Reserve Chairman Jerome Powell and many economists across Wall Street share the view that rising inflation is transitory. The marked slowdown in hiring is similarly framed as temporary and due to rising Covid-19 infections and hospitalization rates, meaning use of the S-word is hyperbolic.
But what if prices keep rising and growth really is stalling—regardless of the reasons why? Or, perhaps, especially because of the reasons why. If the pandemic itself isn’t temporary, why should investors keep expecting price pressures to recede and economic growth to persist?
One way to read the August employment report is that it reflects the worst of both worlds. That is to say while the relatively dismal nonfarm payrolls increase of 235,000—half a million short of Wall Street’s estimate—seems to give the Fed breathing room when it comes to reducing its $120 billion in monthly Treasury and mortgage-backed securities purchases, that dovish take is complicated by the report’s details.
We highlight two under-the-hood metrics. First, labor-force participation was unchanged in August from July. At 61.7%, participation remains well below the 63.3% prepandemic rate (which was already historically low). Economists expected to see an uptick there, if small, as some 11 million workers eyed the looming expiration of enhanced unemployment benefits. With the extra $300 a week disappearing at the beginning of September, the idea was that at least some of the unemployed would begin looking for work and thus get counted in the labor force, if not in payrolls. Yet a net zero re-entered in August.
Second, wages unexpectedly shot higher again in August. Put it all together and it looks like stagflation may already be here, even if the problem is coming from the supply side to effectively cap growth.
Another way of reading the jobs report is that it doesn’t matter. Hiring is still solid when you look at the three-month average, and September is when workers return, economists say.
But September isn’t going to be a panacea. “September likely will be weak too, and we’re becoming nervous about the prospects for a decent revival in October,” says Ian Shepherdson, chief economist at Pantheon Macroeconomics.
One defining characteristic of the 1970s was cost-push inflation, when wages—employers’ biggest cost—and overall consumer prices chased each other higher, says Peter Boockvar, chief investment officer at Bleakley Advisory Group. “We are beginning to see tinders of a wage-price spiral,” he says, pointing to a 0.6% rise in average hourly earnings from July, a 4.3% increase in wages from a year earlier, and comments on Thursday from the National Federation of Independent Business report on small businesses.
“Owners are raising compensation in an attempt to attract workers and these costs are being passed on to consumers through price hikes for goods and services, creating inflation pressures,” says NFIB chief economist Bill Dunkelberg. A “staggering” 50% of small-business owners reported jobs they can’t fill, a record high for the 48-year-old survey, he says.
The current mix of rising prices and slowing growth doesn’t necessarily mean investors need to break out the bell bottoms. But the point is that prices aren’t slowing as the Fed and many economists have predicted, and a drop-off in hiring no matter the reason is a threat to economic and earnings growth, and stock market gains.
“We’re stretching the limits of what this economy can do,” Boockvar says, noting that while the 5.2% unemployment rate may be above the prepandemic 50-year low of 3.5%, it is still well below the 30-year average. “The fallacy in the Fed’s thinking is that their definition of ‘substantial further progress’ [for the labor market] is based on a pre-Covid world. That world doesn’t exist anymore.”
Tolerating high inflation for the sake of more labor market improvement may thus be self-defeating. While persistent wage gains at present clips are enough to transform transitory inflation into something stickier—evidenced in booming shelter prices—those wage gains are still not enough for most people to keep up with broader price inflation. That’s how monetary policy, intended to be easy, actually becomes restrictive, says Boockvar.
To that point, economists have already begun slashing gross domestic product estimates. Following the August jobs data, Oxford Economics revised its third-quarter inflation-adjusted GDP forecast to just 2.7% from 6.5%. Morgan Stanley on Thursday cut its estimate to 2.9% from 6.5%.
What’s an investor to do in the presence of rising inflation, sagging growth, and a Fed caught in a jam? Steve Wyett, chief investment strategist at BOK Financial, says he is underweight U.S. Treasuries and overweight equities, but with more in international than domestic stocks. He likes Europe and Japan and emerging markets outside of China, and sees more upside for large-cap value than growth stocks.
Boockvar, for his part, says his client portfolios are slanted toward inflation protection. That means precious metals, energy and agricultural commodities, and stocks. Like Wyett, he is more bullish on international than domestic, with a preference for Japan, Singapore and South Korea.
The bottom line: Investors need to square the impact of stagflationary forces and high stock valuations. Something has to give, it seems, and it is probably not going to be the Fed.
Write to Lisa Beilfuss at lisa.beilfuss@barrons.com
