Doomscrolling the Economy: The Bad News [2022 Economy Series Part II]
Introduction
The market continues to swirl with seeming contradictions: a strong jobs report is actually bad because the Fed will hike rates even more; zero CPI inflation and falling gas demand in July is good because we are getting prices under control although it could mean people are spending less, and more.
Last time we discussed the high points of the economic data and why we may not be in a recession. This time we turn a bit dour and examine the flip side — which economic indicators are flashing red and why we should be worried going forward. The bad news is mostly around the labor market and consumption— so far strength in this area of the economy (jobs, wages, spending) has pushed up consumption and acted to counteract higher imports and lower inventories. But there are signs that consumption could be near a precipice, as the combination of consumer fears, stretched savings, price increases, and more could result in consumers pulling back in spending and plunging the economy downwards. Join us as we dive deeper into these potential red flags.
The Bad
1. Cracks in the Labor Market: Participation
Wait, didn’t you just say last time that the labor market was showing resilience and this was a good signal? I did, but despite how resolute the labor market has been, there are cracks at the seams. Inflation and expectations of slower forward growth [1] have consequences on the demand for labor. Companies might engage in hiring freezes, lay off part of the workforce [2], or reduce or eliminate raises. Workers may simply drop out of the labor force, either retiring early or being “discouraged”. All this acts to potentially lower production (GDP). These cracks in the labor market might not lead to economic disaster; they can still reverse or be a blip, but we should remain vigilant.
The first crack is on labor force participation, which measures what percent of the population is actually working. The below graph looks at this participation rate (in orange) and compares it to an unemployment rate that includes discouraged workers and other workers who want to be in the labor force (to account for those who have dropped out but want back in) [3].
What we see from this data that the pandemic had a large impact on labor: lots of people left the workforce and the unemployment rate increased. Since then, many people have been able to find jobs and those workers that were discouraged or otherwise also found opportunities, as shown by the declining blue line. Lately, the gains in employment have reduced, but are being offset by the decline in the participation rate. Compared to pre-pandemic, about 1% less Americans are in the labor force. And looking at the trend in the orange line, this metric has stagnated in 2022 and declined from the peak. So while there are opportunities for those looking, many more Americans just are not looking anymore for several reasons: exhaustion, early retirement, long COVID, and more. If the participation rate cannot climb to the previous status quo, this means it will have a long-term impact on US output.
2. Labor Market Crack II: Job Availability
Another point of concern in the economic data has been around job availability and hiring freezes. As fears over an economic slowdown mount and as firms are delivering weaker earnings [4], this has put pressure on many companies, especially in tech, to reduce headcount to maintain their bottom line or in anticipation of lower demand. In effect, this can become a self-fulfilling prophecy to a bad economy: firms believe that the economy is slowing so reduce headcount which then results in increased unemployment, lower savings, and decreased output.
To demonstrate, the graph above looks at the rate of job openings in America and Google News searches for “hiring freezes” and “layoffs” [5,6]. Job openings have recovered above and beyond their pre-pandemic average owing to “The Great Resignation” increasing employee turnover. But relatively, job openings have started to drop, and it does not look like a “return to normal” is a sufficient explanation. In fact, news searches (and by proxy reports) of layoffs and hiring freezes have also picked up in the last few months, concurrent with a slowdown in job openings. These two metrics became similarly negatively correlated during the initial stages of the COVID pandemic and the ensuing recession. This data on job openings might presage tough earnings conditions for firms and herald bad news for the labor market and eventually output/GDP.
As a high growth sector that is especially sensitive to interest rates and discretionary consumer spending, the tech sector has seen more pain — lower earnings growth, lower valuations [7], more hiring freezes — relative to the rest of the economy. A deterioration in tech labor lowering tech output is particularly damaging for the US economy. Tech not only makes up 8% of US GDP [5], but as the below graph shows, has comprised roughly a quarter of US GDP growth in the last five years.
3. Labor Market Crack III: Wages and Inflation
In the previous article in this series, we discussed how wages have grown in the US across all sectors and how core inflation was moderating. The latest inflation report was also good news with no inflation for the month of July. However, a more concerning picture emerges when we look at how wages have kept up with inflation. Ideally, we expect workers’ incomes to go up with at least the rate of inflation in the consumer basket. If that is not the case, workers will see their take home pay go down and those people living paycheck-to-paycheck can go into debt or bankruptcy.
The above graph [3,8] looks at the data on wage growth and inflation in different periods of recent American economic history. Pre-financial crisis, wage growth was north of 4% and inflation was ~3%, resulting in a 1.2% real growth in workers’ median wages. Post-crisis until 2020, though wage growth dropped to 2.8%, inflation was also lower, resulting in a similar 1.3% real wage growth. Since 2021, the picture has changed: average inflation has been 7.3% while wage growth has been 4.6%. People are earning more, but their expenses are growing at an even faster rate (negative 2.7% real wage growth).
This negative real wage growth can have consequences down the road. Workers can be forced out of the job market — through bankruptcy, foreclosure, etc. — since they cannot afford their previous lifestyle. Worker dissatisfaction and worsening conditions can lead to productivity losses. Furthermore, some firms view outsourcing as a solution to local inflation [9]. While preserving profits, this approach can worsen the US employment situation.
4. Less Money, Mo’ Problems: Savings and Debt
One of the next logical consequences of negative real wage growth is the effect on peoples’ savings. Many workers have families, long-term leases, subscriptions, and other commitments that they are unlikely to quickly abandon in the face of higher prices relative to income. People can’t just take their children out of private school immediately, or move to a lower income neighborhood in a few months, or give up their previous lifestyle rapidly. Furthermore, lower income individuals living paycheck-to-paycheck often have little recourse in cutting expenses. So, a lower amount of pay net of expenses can hit savings and can lead to debt and bankruptcy.
The graph below [10] demonstrates the effects inflation is having on savings. Before COVID, Americans on average saved ~$65 a week (7.5% of their paychecks) net of taxes and expenses. While COVID did lead to higher savings, this has since reversed. This year, inflation has made wages worth less, and Americans are saving less (5.3% of their paychecks): the net result is a ~30% drop in weekly real savings to $48.
The above data, combined with consumption continuing to rise means that people on average are not yet radically cutting costs despite less savings. For those with already low weekly savings, this means that some Americans are being forced to dip into their bank accounts to fund expenses and others are racking up debt. In fact, a recent study found that Americans’ bank savings balances dropped by $9,000 this year [11].
On top of this, there is evidence that debt and bankruptcies are beginning to rise. The below graph [10, 12] looks at the ratio of credit card debt to the annualized savings from wages that American households bring in. It also includes data on new bankruptcies and foreclosures for consumers. Prior to the pandemic, Americans on average had credit card debt at ~150% of annual savings. While the lockdowns and working from home did allow deleveraging, the average household has much more credit card debt relative to their savings (~180%). Concurrently, bankruptcies and foreclosures, while markedly lower during the pandemic, have started to rise again. This cannot fully be argued as a “return to normal”; real earnings continue to slide and the debt ratio has exceeded its pre-pandemic average significantly.
5. Consumer Sentiment
Consumers are spending more and not drastically changing their lifestyles, but how do they feel about the economy and their prospects? As we said in the last article, the persistent bright point in the GDP data has been the growth in the consumption of goods and services. Increased savings, raises, prices, and product availability certainly drive some consumption decisions. Evidence also shows that consumer confidence and sentiment is also a key predictor of consumption [13]. Consumer confidence is important because how individuals feel about the economy, their job prospects, and their wealth has a material impact on how much they buy and what they buy. For example, a family might have a lot of new cash on hand, but if they fear a recession or job loss, they might spend less and mainly on staples to “ride out” the bad times. Like some of the other metrics we have looked at, consumer confidence can be a self-fulfilling prophecy, where lower spending because of the expectation of bad times does indeed create those bad times.
This data above from the University of Michigan [14] measures exactly that, polling consumers on a regular basis on how positive they feel on the economy, longer term prospects, financial health, and more. The “current conditions” index measures how consumers feel about the current economy and their current situation, while the “expected conditions” index measures what they expect about the future. The grey bars indicate the last three recessions.
As expected, drops in sentiment, especially on current conditions, happen during a recession as consumers cut spending and consumption drops. What is interesting is that during recessions, the gap between current and expected conditions indices narrows — consumers have a more stable view of the longer future, and how they feel now or for the immediate future is more volatile and drives some of the declines in spending. In 2022, we have seen not just a continuing deterioration in consumer sentiment, but the gap between current and expected conditions continues to be narrow. So far, consumption has squeaked by, but further economic bad news may cause people to start spending less. [Note: in the recent August release, sentiment has picked up slightly, but the 3-month moving average remains in decline].
6. PPI vs. CPI: Cost-Push Inflation
A lot of the headlines have been about CPI, or the Consumer Price Index, a generally accepted measure of inflation. However, an equally important gauge of inflation is the PPI, or Producer Price Index. This measures the costs that producers pay for their goods. A big driver of inflation has been, the Ukraine War’s effect on energy prices aside, the persistent global supply chain problems. Issues in sourcing materials, shipping goods, navigating local COVID restrictions, etc. have resulted in bottlenecks that have driven up costs to deliver products on time. The effect of this is “cost-push inflation”, where firms face higher costs to produce goods and render services, and pass some of these increased costs along to end-consumers. So, an increase in the PPI leads to an increase in CPI.
We can actually see this if we run a regression on the change in CPI versus a number of PPI variables [10]. Taking the “core” CPI and PPI numbers (removing volatile food and energy costs), we can set the month-over-month change in core CPI as the “y” and look at how the change in core PPI in the same month, previous month, and up to 6 months back (the “x’s”) can predict the CPI change. As the table shows, the change in PPI in the same month, last month, and 2 months ago all statistically significantly predict part of the change in CPI in a given month.
This lagging effect of PPI on CPI is important because when PPI is significantly higher than CPI, we can expect that there are still inflationary effects to come that will hit the goods and services consumers buy. As the graph below shows [10], this is the case in 2022. Measured on a year-over-year core PPI inflation remains above core CPI inflation. While the gap between the two has narrowed as of late, this still means that PPI can exert upward pressure on CPI and the prices consumers pay, especially given that PPI increases from months ago still have an effect today. This can mean that the July inflation data was but a temporary reprieve from a year of persistently high price increases.
Conclusion
To contrast with the message from the previous article, there are legitimate points of concern in the economy. High inflation and the volume of pessimistic news have truly tested the resolve of consumers to keep spending and remain solvent. There are certainly signs that inflationary pressures are abating, but they might just drop to a lower high relative to the past and continue to sting consumers for the foreseeable future. Remember that lower inflation still means prices are going up, and it will take a while for wages to catch up with where prices have risen to, and in that time consumers will still have to deal with lower savings, higher expenses, and more debt.
But all is not lost! As I said previously, the thing about the US economy is that it is vast and interconnected and that there is lots of data to look at. Since we have covered the good and the bad of the data, next time we will look at the mixed data — areas where it is unclear what the economic impacts are of certain metrics. This is not to say we have no idea, just that the picture is complicated and needs more exploration. After this, we will collate all this analysis and try to answer the question of whether we are in a recession and finally discuss what this all means for the tech sector.
