Co-Head of Investments Jeff Klingelhofer suggests the stubbornly strong labor market will weaken and tip the U.S. economy into recession. But when?
How Much Longer Can the U.S. Avoid a Recession?
I’m Jeff Klingelhofer, co-head of investments at Thornburg Investment Management. Today, I want to focus on the question of recession: will it happen and if so, when?
We have seen the classic signals of a deep recession. Things like an inverted yield curve and a sharp drop in the index of leading economic indicators. Today, these recession signals remain highly concerning though many have showed signs of recent improvement. And if we do manage to skirt a recession, this is the only time in economic history where these signals have flashed red, and we’ve dodged the recessionary bullet.
So, why is this?
Well, the answer is simple. The incredible strength of the labor market, along with remaining elevated consumer covid savings means we have avoided a recession. This labor market strength has been the thorn in the Federal Reserve’s side as it has supported consumer spending and demand even as prices have risen. Despite the rising cost of underlying labor, company revenues have increased in excess of the cost of labor which means companies have been willing to continue to hire and retain workers. Thus far, higher rates are not immediately transmitting into the economy to destroy demand and bring down prices.
Even though consumers have and continue to draw down savings, they continue to spend despite higher prices. I would argue that where we have come from is not one of the greatest economic experiments of human history. It’s one of the greatest social experiments in human history. Because what it has led to is the feeling among workers that this labor market is likely to continue forever, we are all entitled to a source of cheap and easy borrowing, and this has allowed us all to live beyond our means. Companies have taken on debt at very cheap levels, governments have run huge deficits and consumers have consumed well beyond their own income levels. This has caused a distortion in the unskilled labor market in which employees now require more than 8, 10 or $15 an hour. Wages have jumped to 18 to 20 bucks an hour everywhere from fast food restaurants to hotels to call centers, which translates into higher prices for your Frappuccino. The underlying labor market continues to be incredibly, incredibly strong. The resulting challenge is that this strength points towards not only the inflation we have had but the likelihood that we will continue to have this inflation going forward.
But eventually, even this stubbornly strong labor market will show signs of weakening and tip the U.S. economy into recession. We continue to believe that will happen later this year or early 2024. What’s important from an investment perspective is that our expected timing does not align with market behavior. We don’t think the market is appropriately discounting recession in either the consumer or business space, which could lead to market dislocations and opportunities for investors.
Consumers are still protected with excess savings and higher wages because business revenues are still strong and rising faster than employment costs. However, all of this is slowly unwinding; thus, this virtuous circle is beginning to work in reverse. We see delinquency rates on credit cards, autos and even home mortgages running higher than we have in a long time – we’re seeing the low-income consumer become strapped as real wages fail to keep pace with inflation, and covid savings are depleted.
As the labor market begins to soften, stresses on consumers and businesses will increase, pushing growth in corporate revenue and consumption back to trend. The result will almost certainly be a recession in late 2023 or early 2024. The question then becomes if and when the Fed pivots in response – a topic we can dive into next time.
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