2023 Theme & Tension: US Goods vs. Services Inflation
As we move closer to 2023 we will begin introducing some themes that we think will have some legs in 2023. One of the most important will be whether we can get US service-based business activity to moderately cool in the same manner as the manufacturing sector.
And can we do so without manufacturing businesses entering a full blown recession.
It is a big question and could be said to be a primary determinant of whether we are able to achieve the much discussed "soft landing."
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Many market participants - and their favorite AI algorithms - are waiting not-very-patiently for the US inflation data this week.
As ever, that is the one data point that rises above all others.
But there was an interesting data point this past week that indicates both where we are as an economy and also some of the work still to be done in the new year.
It provides a great snapshot of the finely balanced predicament we referenced in our introduction. For both these reasons we thought we could quickly highlight what is going on and what to watch for going forward.....
The Institute of Supply Management came out with their Purchasing Manager's Index for Services. This is a bit in the weeds but it is basically a composite index of how the non-manufacturing portion of the US economy is doing.
So, how are businesses that sell services (not stuff) doing?
The answer is quite simple:
Very well! US Services business activity remains quite high.
The US ISM Services Index came in elevated and above expectations. It was 56.5 vs an expected 53.3 and showed high and above expectations expansion.
Any number over 50 signals growth and suggests this part of the economy is expanding and doing so more than the previous month.
In short, this demonstrates - again - the continued strength and resilience of the US economy.
It is the blue line here:
This is great but presents a challenge as we look forward to 2023.
Regrettably, this tension was quickly reflected by the US stock market, which did not like this data point. The S&P 500 declined by 1.8% that day and demonstrated that investors are still fearful of an overheating economy that forces the Federal Reserve to raise interest rates further.
As with the jobs number last week, really good news is still very bad for the stock market.
And that is the challenge for the US central bank and for investors at present.
Housing is a great example.
The process goes something like: The Fed raises interest rates -> mortgage rates rise with them -> people struggle to borrow as much capital on their income -> house prices cool as a result -> fewer houses get built -> less demand for lumber.
But the non manufacturing businesses services part of the economy is still growing, especially and uncomfortably for the Federal Reserve, when it comes to salaries and employment.
Here is this divergence graphically represented by the Wall Street Journal:
Impressive divergence.
Most significantly, the ISM Services number re-energizes and re-emphasizes the costs of the "transitory" inflation debate that the Federal Reserve foolishly engaged in:
The cost of goods has come down. Chair Powell and the other Governors were correct in 2021 that they could achieve that quickly and somewhat directly.
But after rising for months, inflation in goods prices has now filtered down into services inflation.
These prices are still rising. Services based businesses are growing strongly and are struggling over employees, material and above all, consumer demand.
In some respects, this is obvious to many consumers. Thanks to the concerted action by the US Federal Reserve goods are slowly getting less expensive (gasoline! chicken breasts! even air travel) and certainly not heading higher.
Meanwhile, however, a lot of service based prices are still rising.
One way to think about this is the drive for unionization and strikes at service based businesses such as Starbucks, railroads, or, most recently, the New York Times.
And good luck getting a plumber or an HVAC tech to give you a deal.....
This is called a "wage-price spiral" and demonstrates both the problem and the stickiness inherent once a higher inflation regime becomes established and then entrenched.
It also reminds us of why we didn't want to be here in the first place:
Once you allow high inflation to become entrenched you find it is both hard to curb and also very politically unpleasant. It involves telling people who are struggling to live on their eroding income already that, for the good of society, they should take one for the team and not ask for higher wages.
That is a tough ask for any central banker.
The good news is there is at least some relief for a lot of consumers struggling to stretch their paychecks and straining to make their household budgets work.
For more information there, let us turn to the next story.....
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