Viewpoints

The resiliency of the corporate sector has been one of the surprises in 2022. Despite a volatile and uneven economy and a series of interest rate hikes from the Federal Reserve, the corporate sector has maintained record profitability and near-record profit margins. The high-profit margins may be the biggest surprise as it confirms that cost increases have been passed along and not absorbed. That dynamic makes the Fed's job of slowing inflation much more difficult, as it shows an "acceptance" of price increases.

In 2021, real operating profit margins for nonfinancial companies stood at 15.7%, the highest level since the mid-1960s. Surprisingly, companies simultaneously passed along the higher costs of materials, supplies, and labor and lifted margins in the process. And the spread of 275 basis points between final prices and total unit costs was the second widest since the 1960s.

Real operating margins have remained relatively high in the first half of 2022. At 15.5%, real profit margins for nonfinancial companies are still 300 basis points above the levels that were in place before the pandemic.

Q3 data on profit margins are not yet available. But, the price and wage data suggest margins held up if not expanded. To be sure, core consumer prices of 6.4% annualized and core producer finished goods prices of 7% were 100 to 175 basis points over the increase in wages for non-supervisory private workers. Firms' total unit costs were probably lifted somewhat due to rising finance costs.

High-profit margins help to explain why job growth has continued to be so strong this year. Companies added over 1 million workers in the third quarter, about the same number as in the prior quarter. That robust pace of hiring is not something that one would expect if companies, in the aggregate, were experiencing intense downward pressure on margins from rising costs.

Policymakers will never publicly admit this, but the Fed wants an environment where companies cannot pass along cost increases into final prices. That would lead to a decline in margins, a typical outcome during slower growth periods or recessions, eventually forcing cost cuts, including layoffs, less demand, and slower inflation.

Policymakers place a lot of emphasis on inflation expectations, but that is a "soft-data" measure of what people would like to see or expect versus what they are doing or accepting, as is captured in the "hard data" measure of companies' profit margins. Near-record high-profit margins indicate the Fed's job of fighting inflation is far from over, raising the risk that official rates have to go much higher than is shown in policymakers' dot plots or future prices.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

To quote Mark Twain, "The report of my death was an exaggeration." I just have not had anything to say that tickled my fancy as I have watched the Fed drive the US economy toward a recession, which I think will commence in Q1:2023, as it tries to compensate for the policy error it committed in 2020-2021. Although I believe a 2023 recession is inevitable, I also believe that it will be a relatively mild one because the latest data available suggest that the balance sheets of households, nonfinancial corporations and commercial banks are in good shape. Admittedly, the latest data available are somewhat dated, being Q2:2022 for households and nonfinancial corporations and Q1:2022 for commercial banks.

Let's start with households. Plotted in Chart 1 are quarterly values of domestic deposits plus money market funds held by households as a percent of the dollar amount of household loans outstanding. As of Q2:2022, household deposit/money market fund assets were 101.0% of the amount of their outstanding loans. In Q4:2007, the peak in the business cycle before entering the Great Recession, this ratio was only 57.0%. Thus, households are cash rich as we slip into the next recession.

Investors should be cautious of a policy pause or pivot as it might bring short-term gain at the expense of long-term pain. No one is better than Mr. Volcker at knowing that quick pivots or reversals in the fight against inflation don't end well. Mr. Volcker abandoned his inflation fight in early 1980 following the sharp plunge in the economy (at the time, it was the sharpest one-quarter drop in GDP in the post-war period) associated with the imposition of credit controls.

After lifting official rates by more than 1000 basis points over several months, Volcker dropped them equally fast, only to resume his inflation fight later in the year. Volcker eventually raised official rates to higher highs in the next two years, underscoring the critical point of inflation cycles; that they do not die quickly or easily.

Nowadays, there is nothing on the horizon that would trigger an economic decline equal to that of the 1980's drop. But that's not the critical point. Killing inflation cycles require a significant reset of economic and financial conditions following a fundamental tightening of monetary policy. The sharp two-day rally in equities this week based on the slightest hint of a policy pause shows investors' risk-taking appetite is alive and well. If that is still alive, so is the economy's growth and inflation appetite.

Yet, it is hard to deny that things are lining up for Fed Powell to pause at some point. For example, prices paid diffusion indices from the Institute of Supply Management for manufacturing and the service sector provides a snapshot of cost pressures. Both price measures fell to their lowest levels in roughly two years in September.

Yet, it is worth noting that diffusion indexes track the breadth of increases (or decreases) and do not distinguish the magnitude of change. So while cost pressures have subsided, they have not disappeared completely. Also, the service sector's price index at 68% remains elevated, which has to do with two things: services use fewer commodities than manufacturing, and labor is a more significant part of their cost. Since the inflation cycle is increasingly becoming a service sector phenomenon, rising labor costs remain the biggest wild card for the inflation cycle.

The number of job openings stood at 10 million in August, off 1.1 million from July, but still far above pre-pandemic levels. And, with 1.7 job openings for every unemployed worker, companies, especially in the service sector, will need to pay up to attract labor.

Tightness in the labor markets will not be an obstacle for Fed Powell to pause after the Fed follows through on hiking rates at the next two meetings, as suggested in the latest policymakers' projections. Yet, it does create the risk of a pickup of inflation and higher official rates later. That's because, without sufficient slack in the labor markets, companies would still face the same labor cost conditions as they do today, raising the prospect of an extended inflation cycle.

Inflation cycles are not linear, nor do they end in a day, week, or month. It takes time to stop and reverse. Policymakers say they must maintain restrictive policy rates for some time to kill inflation. Yet, will politics and investors let them?

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

State real GDP growth ranged widely in 2022: Q2. 40 states saw declines, with Wyoming’s -4.8 percent rate the lowest. However, there were also a number of increases, led by Tezas’s 1.8 percent. The diversity can be best illustrated by noting that Connecticut, a state will very little in common with Wyoming, saw a comparable decline (-4.7 percent). Moreover, West Virginia, like Wyoming heavily dependent on coal production, had a 1.4 percent growth rate. Some of the price increases were also interesting: North Dakota’s current-dollar GDP rose at a spectacular 30.5 percent rate, while its real output fell at a 0.7 percent rate, meaning that the state’s GDP deflator rose at a rate above 31 percent—obviously, a reflection of the spring surge in oil prices.

Looking at industry contributions, major sources of declines were construction, nondurable goods manufacturing, and wholesale trade (all three down in every state). A large pickup in accommodations and food services was arithmetically responsible for Hawaii being one of the few states with a real GDP increase.

State personal income and GDP are now reported in the same release. Q2 growth rates ranged from 10.9 percent in North Dakota (oil prices again at work) to Connecticut’s 2.2 percent.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Consumer price inflation is at its highest rate in decades, yet some equity managers are screaming that deflation is the most significant risk. Is deflation a credible risk, or are these prognostications a spurious call for a Fed pivot? It's the latter.

First, the US has never recorded one year of deflation in core consumer prices in the sixty-plus years that the Bureau of Labor Statistics has collected data. Think about that. There have been several years of high unemployment, with the jobless rate exceeding 8% and a few at 10%-plus. Also, the US experienced record wealth losses following sharp drops in equity and real estate prices, abrupt drops in commodity prices, and near-collapse in the banking system in 2008-09, and not one year of a decline in consumer prices. That does not mean the future risk is zero. Still, going from high to negative inflation in months has to be exceptionally low. Also, economic and financial conditions would have to get significantly worse, above and beyond what has happened in the past, for a prolonged period before deflation risks would be the dominant worry.

Second, many equity managers form their opinion on inflation/deflation risks based on changes in commodity prices, especially energy. But, commodity prices are inputs into the production process and have a small weight in the overall cost of operations. Also, the US uses more commodities than it produces, so a fall in commodity prices is usually bullish for growth as it frees up cash flow and increases demand (and prices) in other areas.

Third, it is surprising that some equity managers view deflation as bullish for equities. Price is what companies get for their goods and services. A broad decline in final goods and service prices equates to less revenue and slimmer margins for many companies as firms can't cover or offset the cost of labor and other things. Some of the lowest operating profit margins on record occurred during low consumer price readings. Those periods happened against relatively high unemployment, which is not the case nowadays. So it's hard to see how deflation is bullish for equities, especially in the current environment of job openings exceeding the number of jobless by a factor of two, pushing up the cost of labor.

Fourth, the primary motivation of portfolio managers' deflation calls appears to be a campaign to pressure the fed to stop and eventually reverse the rise in official and market interest rates. Higher interest rates are a double whammy for equities as they hit growth and earnings and reduce the market multiple, or what people will be willing to pay for future profits.

Suppose the Fed keeps on the current path of raising official rates to get consumer price inflation back to 2%. In that case, equity PMs might eventually get the policy reversal they are presenting with their spurious calls about deflation risks. But that path will be rocky, with sharp declines in operating earnings, corporate bankruptcies, and a rise in credit default rates. The risk of the latter occurring is much higher than the risk of deflation, which is not a friendly environment for risk assets.

Deflation is not the magic wand to turn the equity market fortunes around, but that doesn't mean some PMs won't stop talking about it.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

The Federal Reserve Bank of Philadelphia's state coincident indexes in August were more dispersed, and generally softer, than in recent months, though the general pattern still shows substantive growth. A full 15 states recorded declines from July, with West Virginia down .84 percent. Four states, all in the South had increases above .5 percent, with South Carolina's .59 percent the highest. At the three-month horizon, four states declined, with West Virginia and Montana off by more than one percent. At the top, only North Dakota and Massachusetts had gains over 2 percent. Over the past 12 months, Massachusetts's index was up more than 10 percent, and 28 other states had increase of at least 5 percent. Mississippi was the only state with its index increasing less than 3 percent over this period.

Yet again, the independently estimated national figures of growth over the last 3 (.85 percent) and 12 (5.14 percent) months look weaker than the state figures would imply.

Connecticut and Hawaii remain the only states that have not yet passed their pre-pandemic peaks in this series.

State labor market results in August were somewhat less robust than in July, with less widespread monthly job growth and some increases in unemployment rates. Only 10 states saw statistically significant increases in payrolls, with Alaska and Kentucky both up 1.4 percent, while Mississippi saw a .7 percent drop. No state saw a numerical gain larger than Kentucky's 26,700. Over the last 12 months, every state (and DC) saw a gain in payrolls, though in 4 cases the increases were not deemed to be statistically significant. Texas's 5.7 increase was the largest, while Nevada's 5.0 percent was second, while 2 other very large states (Florida and New York) had gains above 4 1/2 percent , as did Georgia and New Jersey. Mississippi and New Hampshire were the only states with (not statistically significant) gains of less than 1 ½ percent.

A full 16 states experienced statistically significant increases in their unemployment rates in August, with the rates in Maryland, Connecticut, and New York all up .4 percentage point (New Jersey's rose .3 percent). Minnesota had the lowest unemployment rate (1.9 percent) and Alaska the highest (4.6 percent) among states—DC's rate was 5.1 percent. There appears to be substantial divergence between state and national seasonal adjustments.in the household survey. New Jersey was the sole state to report labor force growth, seasonally adjusted, higher than the brisk national gain of .48 percent.

Due to a drop in its labor force, Puerto Rico's unemployment rate edged down to 5.8 percent, setting another new record low. The island did gain 5,500 jobs to reach a nine-year high.

Puerto Rico's labor market also showed some improvement. The island gained 7,500 jobs (.8 percent) in July, and the unemployment rate fell to 5.9 percent—another record low for this series, which starts in 1976, and the first time the rate has been under 6 percent. However, the drop in the unemployment rate from June to July was an artifact of a decline in the labor force, as resident employment declined.