Goldilocks And The Four Bears

By Benjamin Picton, senior macro strategist at Rabobank

Today is the Labor Day holiday in the United States, so expect a fairly quiet and illiquid trading day in the markets. That does give us a lovely opportunity to talk about the Americans while they are enjoying some time off though, and particularly to talk about the US non-farm payroll figures released last Friday. It’s fair to say that from the perspective of the Fed and the Biden administration, non-farm read as a bit of a Goldilocks moment. According to the survey, the labor market appears not too hot, not too cold, but just right. Employment rose by more than expected (187k vs 170k on the Bloomberg survey), participation rose, the unemployment rate lifted from historic lows of 3.5% to 3.8% and wage pressures were less acute than anticipated at just 0.2% for the month. All-in-all, the survey gave the impression that maybe the Fed has managed to pull a rabbit out of its hat and set the economy on a glide path for the much touted “soft landing”. This is particularly the case given that the non-farm survey came hot on the heels of the JOLTS report earlier in the week, which showed half a million fewer job vacancies than the participants in the Bloomberg survey were expecting.

Now to introduce the bears and perhaps predictably one of them is us, because we remain unconvinced that the benign labor market data does actually presage a soft landing in the USA. Our resident Fed watcher, Philip Marey, has pushed back his US recession forecast to 4Q23/1Q24 as the flow of data remains unexpectedly resilient, but a recession is still very much our base-case view and has been since 2022. I’ll draw on my high school calculus to illustrate some of our thinking behind this point: The slope of a curve approaches zero as you approach a point of stationarity. As such, it only stands to reason that we would start to see more moderate growth and labor market outcomes as we approach that stationary point for GDP or labor market curves, so what we are really saying is that we are closing in on the point of inflection where the flow of data is at risk of deteriorating at an accelerating pace once we go past it. Capiche?

Our wet-blanketry didn’t seem to move the market on Friday though. Despite higher bond yields, the S&P500 was up 0.18% for the day, but there was an interesting divergence between the Dow Jones (+0.33%) and the duration-sensitive NASDAQ (-0.02%) that seems to reflect the ~6bps steepening in the 2’s10’s to close the week. Are equity markets finally beginning to accept the higher for longer narrative? If they are, nobody seems to have told bond traders yet. The 2’s10’s is still heavily inverted at -70, so we are going to have to see a lot more curve steepening in the months ahead to reconcile financial markets with Fed speak, and that probably suggests continued pressure on long duration equities that most metrics tell us are substantially overvalued. That implies that we would need to see a selloff in the long-end that could coincide with our expected recession. Usually this would be dismissed as an impossibility, but in a market where central bankers openly admit that they have no roadmap to suit the times, the appropriate fairy tale may actually be Alice In Wonderland, where you need to be able to imagine six impossible things before breakfast.

Returning to my original metaphor, bear number two is Europe. Rabobank has recently changed our growth forecast to feature -0.1% GDP predictions for both Q3 and Q4 of 2023. That means that we are now expecting (another) technical recession for the second half of this year. To compound the bad news, we had a Eurozone CPI figure released last week that seemed to suggest more of that pesky stickiness in price pressures. Headline CPI moved not a jot to remain at 5.3% in August, and core inflation declined only moderately to 5.3% from 5.5% a month earlier. The fall in core inflation is certainly welcome, but people actually pay headline prices, not just core prices, and there’s still a long way to go to reach the 2% target with base effects providing less help in the months ahead, and energy prices rising again. It’s no stretch to say the road ahead looks very rocky.

Indeed, with war in Ukraine still raging, a painful and costly energy transition underway and the German manufacturing sector increasingly saying that “somebody (China) has been sleeping in MY bed!”, it might be more fitting to describe the European experience via a darker, more gothic (possibly Romanian) fairy tale of the kind that gives small children nightmares. This feeds into our expectation that we will see no more rate rises from the ECB, despite their attempts to scare us at Jackson Hole and their forecast that inflation will get nowhere near the 2% target until 2025.

Bear number three is China itself, and this is the bear that looms over all others. The travails of the Chinese real estate sector are by now well known, and the world seems to be waking up to the fact that the Chinese central government has a very different perspective on the morality of economic stimulus measures than we do here in the West. As Michael Every pointed out last week China values production, not consumption, and this is reflected in the reticence to target households with cash handouts that pose the sinister moral threat of perhaps being spent on blue jeans, Coca-Cola or Barbie dolls. Instead we have seen piecemeal stimulus efforts in the form of cuts to the reserve requirement ratio, the prime rate, the 7-day reverse repo rate and the 1-year MLF rate all aimed at increasing investment in new housing stock. There has also been confirmation recently that the central government has directed Chinese banks to pass interest rate cuts through to existing borrowers for the first time since the financial crisis of 2008, and conjecture that Chinese banks have been asked to loosen their definition of prime borrowers (that sounds like an idea borrowed from the West).

The focus on real production is welcome news to us here in China’s quarry (Australia), where our economic fortunes are heavily dictated by demand for bulk commodities. Chinese economic jitters have spread to this part of the world by way of substantial weakening in both the Australian and New Zealand dollars in the month of August. That raises risks of importing inflation, but we expect the RBA will gloss over this at outgoing Governor Phil Lowe’s final monetary policy meeting tomorrow, after which he will be saying “somebody has been sitting in MY chair”. The RBA will instead point to recent signs of softening in labor markets and timely inflation indicators as sufficient justification to remain on hold. With official rates of just 4.10% and the Bloomberg survey suggesting Q2 growth of 0.3% this week, it’s tempting to suggest that the RBA also may have engineered a soft landing, but beware the fourth bear, a bonus bear of sorts that we here in Australia call the Drop Bear. It is known to come out of nowhere…