So far this year, the 10-year Treasury yield has risen from 1.52% to 1.93%. This increase has been accompanied by broadly lower equity markets, with value outperforming growth and international stocks outpacing their U.S. counterparts.
However, investors could be forgiven for being just a little skeptical about this move higher in rates and associated rotation to less expensive equity sectors. Long-term interest rates have been in a downward trend for more than 40 years. Fundamental economic conditions do favor further increases in long-term interest rates and the Federal Reserve is sounding more hawkish than in many years. Still, investors need to consider two critical questions, namely, whether economic conditions will continue to support higher rates and whether the Federal Reserve has the fortitude to engineer them, given inevitable economic and market shocks and potential political blowback.
The Inflation-Plus Expansion
On the first issue, last week’s economic data pointed to continued steady growth with inflation still tracking well above the Fed’s 2% target.
Crucially, provided another dangerous variant doesn’t take over, the impact of the pandemic appears to be fading. The number of confirmed cases has fallen from a daily average of 807,000 in the second week of January to just 296,000 in the latest week, while the ratio of fatalities to cases lagged 18 days is running at roughly 25% of the rate in prior pandemic surges.
Moreover, despite the Omicron surge, PMI data show that both the manufacturing and services sectors grew in January, although at a slower pace than in December. In addition, light-vehicle sales jumped from an annualized 12.5 million units in December to a seven-month high of 15.0 million units in January. Heavy truck sales were equally impressive, rising from an annualized 464,000 units in December to 525,000 in January. The auto industry continues to operate under extreme supply constraints and with very low inventories. However, it is gradually managing to ramp up production and sales, a trend that is likely to continue all year.
Leisure, travel, entertainment and restaurants were badly impacted by Omicron in January. However, high-frequency data show some improvement in air travel, hotel occupancy and restaurant reservations going into February. Given all of this, we expect to see little change in real GDP in the first-quarter but a roughly 5% bounce in the second quarter and continued steady, although slowing, growth for the rest of the year.
Importantly, the economic impact of the Omicron surge does not appear to have been severe enough or lasted long enough to change the narrative of an extreme excess demand for labor.
Last Friday’s January jobs report was full of distortions, including major changes to seasonal factors in the establishment survey, significant changes in population estimates in the household survey and the impact of the Omicron surge during the survey week. However, revised payroll figures showed steady strong job gains of between 400,000 and 700,000 each month since last May.
In addition, other data show a huge 4.4 million gap between the number of job openings at the end of December (10.9 million) and the number of unemployed workers in the second week in January (6.5 million). Surveys also show that both businesses and workers are very aware of the labor shortage. The National Federation of Independent Business monthly job survey showed a near-record 47% of businesses having at least one position they couldn’t fill and a 48-year record high of 50% reporting that they had increased compensation. The January Conference Board Consumer Survey showed 55% of respondents claiming jobs were plentiful in their local area compared to just 11% who said they were hard to get.
Nor is the labor shortage likely to wind down any time soon. In the January jobs report, 1.8 million people reported that they were not in the labor force due to the pandemic, up from an average of 1.2 million in the prior three months. However, this is far below the 4.7 million of a year earlier and the return of these workers to the labor force, as the pandemic winds down, can only partially satisfy the current demand for labor.