Macro Indicators for Reluctant Rally Participants

Summary

• In this note, I discuss the key drivers of the ongoing rally, that has left some investors unenthusiastic.
• I list a few key indicators that make me think the rally has further to go, at least for the next few months.
• Longer term, my optimism is tempered by signs of inflation persistence.

Market Implications

• The rally could have further to run, until a recovery in energy prices exposes strong underlying inflation dynamics.

An Unconvincing Rally

The equity rally is broadening beyond large AI-linked stocks: the equal weighted SPX has started to catch up to the SPX (Chart 1). Yet several investors are participating in the rally because ‘they cannot ignore the price’ action, rather than out of strong conviction.

Investors’ limited enthusiasm is understandable, in view of the many unresolved macro issues. Investors’ dilemma is summed by the low ERP (Equity Risk Premium, the difference between SPX earnings yields and 10-year yields), that is back to the levels prevailing in the early 2000s (Chart 2).

There are two possible interpretations of this development. The first is optimistic: The Federal Reserve (Fed) is likely to engineer a soft landing and relatively low macro headline risks justify a low ERP. 

On the other hand, the pessimists view the ERP as mispriced with earnings yields too low in view of limited earnings growth prospects, and 10-year yields too high in view of a forthcoming deep recession.

I side more with the optimists, at least for 2023. Growth is strong, falling energy prices are hiding strong inflation dynamics, and the Fed is dovish. That said, I could be wrong. So here are the key indicators driving my conviction up or down.

Real Household Income Is Looking Up

In the short run, real growth momentum is driven by the strength of the feedback loop between demand, in the US mainly consumption, and supply. Higher employment feeds into higher household income and consumption, that in turn, feeds into higher production and employment. A key indicator of this feedback loop is the growth in real household income excluding transfers (i.e., income momentum in the absence of government support – Chart 3). 

Real household income growth excluding transfers is currently positive and accelerating. By contrast, in all recessions since the mid-1960s except the COVID-19 pandemic, its growth was slowing. In addition, ahead of all recessions except the 1981-82 and the pandemic recessions, its growth was also slowing. 

Employment-to-Population Ratio Signals Recovery

Another indicator of economic momentum is labour market tightness, that is better captured by the EPOP (Employment-to-Population Ratio) than unemployment. This is because unemployment is a fuzzier concept—based on a surveyed households’ statement that they are looking for a job—than employment that is directly observable. Unsurprisingly, the coefficient of variation of unemployment is larger than that of the EPOP, by a factor of 15!

Chart 4 shows unemployment and prime age EPOP as 10-year z-scores to consider LT trend changes. For the 2020-23 period, I have computed the z-scores based on pre-pandemic standard deviation and mean.  

Currently, the EPOP is rising. In z-score the prime age EPOP is close to the 1995 high, which reflects that prime age participation rates have recovered to above pre-pandemic levels. Though prime age participation remains below the peak of the mid-to-late 1990s.

Forward Looking Spending Is Ambiguous

Over the past decade, ‘soft’ opinion based survey data has increasingly decoupled from hard data directly measuring demand and supply (Partisan Bias, Economic Expectations, and Household Spending). Nevertheless, it is still possible to get a sense of economic agents’ outlook by examining forward looking spending, namely consumer durables and residential and non-residential investment.

Because consumer durables purchases ‘lock’ spending for the lifespan of the goods purchased, they tend to be driven by expectations of future income. For instance, luxury car purchases involve higher depreciation and maintenance costs than those associated with a cheaper car, for the duration of the ownership of the car. Up to the GFC, consumer confidence and durable goods purchases were strongly correlated (Chart 5). However, since the GFC the correlation has weakened.

The correlation was further weakened during the pandemic by exceptional government transfers, that saw durables purchases rise well above trend. It is therefore striking that, despite the very large pandemic spending, durable goods purchases have recovered. This must signal a positive outlook on the part of consumers. 

Similarly, the data on investment reflects household and business views on the outlook.  However, recent data is ambiguous in part due to pandemic excesses. For instance, the Fed’s extreme easing triggered a mini residential real estate boom-bust cycle, with residential investment growing faster in Q2 2021 than during the 2004 peak (Chart 6). 

This peak was followed by a sharp slowdown and contraction, even before the Fed hinted at tightening in Q4 2021. But the contraction is easing, as recent data on housing starts suggests that QoQ residential investment growth will be positive this quarter. The fast recovery, however, reflects in part a lack of supply of existing homes, as strong balance sheets have allowed would-be home sellers to wait for better market conditions.

The recovery in non-residential capex is equally ambiguous (Chart 7). Software spending has continued to grow at an impressive pace. By contrast, spending on computers has been weak, in part due to excesses during the pandemic. And while spending on structures has made an impressive turnaround, it has been largely driven by government subsidies.

Wage-Price Feedback Loop Signals Inflation Persistence

Finally, I am less optimistic on inflation than on growth. This is because a feedback loop between wages and prices is firmly established. Wages and prices tend to track closely when inflation is high, though this was not the case in the 1970s due to income policies that constrained wage growth (Chart 8). 

With the end of income policies in the late 1970s, however, wages and prices tracked closely until the mid-1990s, when lower inflation expectations led to the decoupling of wages and prices, due to ‘rational inattention’ (BIS’s The two-regime view of inflation).

Since 2021, a feedback loop between wages and prices has been established. This can be seen with wage growth slowing by much less than inflation, likely due to workers trying—and succeeding—to recoup past wage losses.

This suggests strong inflation persistence (i.e., reducing inflation back to target is likely to require a recession). The Fed, however, is much more focused on employment than inflation, and is unlikely to embark on more aggressive policies until the evidence of inflation persistence is unescapable.

Market Consequences

In January I expected to see a ‘Goldilocks’ combination of falling inflation and positive growth surprises to be ended around mid-year by higher energy prices and a more hawkish Fed.  Neither happened: Energy prices are lower and the Fed turned out more dovish than I expected, in part due to the banking crisis, which I did not foresee either. 

That said, Viresh expects the oil market to get undersupplied towards end-year. Until then, I do not see the two rate hikes planned by the Fed this year as likely to break the risk market rally. Of course, if the data changes I will change my views.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)