How Long Will Labor Market, Corporate Earnings Hold Up?

In the next few months, we’ll learn how well household spending and corporate earnings hold up following the most aggressive monetary tightening in 50 years.

The Federal Reserve had to tighten monetary policy more in 2022 than it and most investors expected. Higher household wealth and a very tight labor market fueled consumer spending and inflation.

The Fed tightened so aggressively that treasury bonds had their worst year ever.

Though stock indexes declined by double-digit percentages, corporate earnings held up. Stock prices declined because they were revalued in light of higher interest rates. When the return from a risk-free investment such as treasury bills rises, the prices of riskier assets such as stocks decline.

But there are signs household spending and corporate earnings finally are eroding.

Wage increases in 2022 were strong compared to the last couple of decades, but they lagged inflation. Consumers dipped into savings to maintain their spending. Bear market rallies in stocks in the last half of 2022 also helped support spending, as did a mid-year decline in energy prices.

But the ability to dip into savings is exhausted or close to it, and many of the other supports for high spending are fading.

The labor market is showing the first signs of becoming less favorable to workers. Businesses are reporting fewer problems hiring and retaining workers. Job openings have stopped increasing, and continuing unemployment claims are rising. Compensation is increasing at a lower rate.

Market prices indicate most investors believe inflation soon will tumble to the Fed’s target, and the Fed will resume a loose monetary policy by mid-2023. Markets expect interest rates to begin declining by the second half of the year.

I think that’s optimistic. The supply chain problems and other temporary issues that caused part of 2022’s inflation have been reduced. But most of the inflation is from demand far exceeding supply.

In addition, global trends that kept a ceiling on inflation the last few decades have either peaked or are reversing. These trends include a global labor glut, expanding free trade and globalization, business-friendly tax and regulatory policies in many developed countries, and tepid antitrust enforcement.

New mandates for climate-change measures will increase costs for businesses and put upward pressure on inflation.

Demand for goods and services must decline for inflation to fall to the Fed’s target, which means household incomes must fall.

Economic growth, the labor market and inflation slow after the Fed tightens monetary policy, but with lags. Inflation often doesn’t bottom until after we’re in a recession.

As demand falls, so should corporate earnings. As I wrote previously, higher interest rates were the primary cause of lower stock prices in 2022. Reduced earnings should cause further stock price declines.

Fed Chairman Jerome Powell and other Fed officials say they’re determined to bring inflation much closer to the 2% to 2.5% target. They aren’t going to repeat the practice of the last few decades of reducing interest rates whenever stock prices decline.

I think the Fed will maintain a tight monetary policy longer than the markets expect, so the stock market low still is ahead of us, unless inflation falls more rapidly than I anticipate.

The important questions are: How far must demand decline to reduce inflation, and will the Fed tolerate the consequences of a serious recession if one is needed to bring inflation to its target?

The data indicate bringing inflation to the target will take more demand destruction than the markets anticipate. Fed officials say they’ll tolerate a recession to reach their inflation target.

The first half of 2023 remains a good time to hold cash and other conservative investments and invest with some funds that can be flexible, including selling short.