Chart of the Week : U.S Employment Cost Index

Click to download this week's full edition of Macro Chartmania.

The market narrative machine is fascinating. In 2022, the bear market narrative was « inflation shock, rates shock and recession shock ». For 2023, the market narrative is rather bullish. Analysts expect that inflation will move lower but will remain sticky, that a mild recession will affect most of the developed economies and that central banks will hike a little further (probably until the start of the second quarter) before pausing for the rest of the year. It is certainly too early to know the steepness of the recession and whether the United States will manage to avoid it. This is an ongoing debate among economists.

But there are early signs inflation is finally receding, at least in the United States. This is not the case in the United Kingdom where the October CPI reached 11.1% year-over-year, for instance. In the United States, higher wages reflecting Covid unbalances, worker shortage and tight labor market partially explained the increase in prices. This is now reversing. In just the last several weeks, we have seen major layoff announcements from the tech sector (Meta, Stripe, Paypal, Microsoft, Amazon etc.). But this is not just a technology story. We have seen layoffs in other sectors of the economy, from the real estate promoter Redfin and the trucking giant C.H. Robinson among many others.

To understand why layoffs are starting now, we need to first understand the sequence of the economy. Employment is a well-known lagging indicator. In the past, it has already happened that job losses started only with a lag of several months after the economy entered into a recession (job losses started 8 months after the official start of the 1974 recession, for instance). But some sectors of the economy are more sensitive than others to higher interest rates, which can help predict whether or not we will face massive layoffs. This is the case of the housing market especially (we used to say that the housing market is the business cycle in the United States). With the cooling of the housing market which started in early 2022, the consumption of things associated with home buying are also going down - with a lag. Think home appliances, home-building tools etc. The housing slowdown is spreading into the rest of the economy. This puts pressure on big durable goods and thus on the industry that moves these goods around the world. This explains why C.H. Robinson fired 650 employees one week ago. This is only the beginning, in our view.

Mass layoff to come means that the drop in wage increases, which has just started, will continue in the coming months. In the below chart, we have plotted the National Federation of Independent Business (NFIB) compensation plans and the Employment Cost Index. Only a net 23 % of small businesses plan to raise compensation in the next three months. This is much lower than a few months ago (when it was at a cycle peak of 32 %). Compensation practices of small businesses tend to lead to broader wage and salary growth. Therefore, we can expect that the Employment Cost Index, which has started to decelerate recently, will continue moving downwards, likely well below 4% going into 2023. This could ultimately ease inflationary pressures and open the door to a slower pace of Fed rate hikes. This echoes comments from Fed Vice Chair Lael Brainard earlier this week : “It will probably be appropriate soon to move to a slower pace of increases.”