The employment numbers are misleading, the looming banking crisis and why inflation will fall

For most of last week (ending April 5^th), financial markets were worried about the upcoming jobs report, and when markets are worried, indexes go down. But after Friday morning’s “strong” (at first glance) employment report, these markets breathed a sigh of relief and reversed much of the week’s losses. Still, the week ended with lower prices in both the equity and fixed income markets. For the week Nasdaq: -0.8%, S&P 500: -1.0%, and Dow Jones Industrials: -2.3%. Perhaps the market is catching on to the problems in the manufacturing sector that we have been talking about for several months; thus, highlighting the underperformance of the Dow Jones Industrials.

The employment problem

The chart below shows that prior to March 2022 Non-Farm Payrolls (NFP) and the Quarterly Census of Employment and Wages (QCEW
CEW
) were compatible with each other. Then they diverged, and the cumulative difference is that NFP shows five million more jobs. We find it odd that the BLS revised its original number down for 11 months in 2023. The QCEW report says that in the 11 months ending last December, average monthly wage growth was +130K, not the +230K claimed from the NFP reports. In fact, this has been confirmed by economists at the Philadelphia Federal Reserve (see here).

And let’s not forget the numbers produced in the NFP reports by the Birth/Death (B/D) model, a number usually somewhere close to +100K added to the NFP to compensate for long-term small business growth that is not explored in determining NFP number. According to Rosenberg Research, the B/D “surge” created nearly half (1.36 million) of NFP jobs (2.75 million) in the year ended February. Rosenberg also says that new business “births” fell by -4.4% in the year ended February, while business “deaths” increased by +24.1%. Thus, even the lower job growth forecast of +130K per month from the QCEW looks suspect.

In past blogs, we have commented on the large discrepancies between NFP and the sister Household Survey (HS) data, which shows negative job growth so far in 2024. A closer look at the QCEW data reveals that for the year ending in February, jobs full-time jobs decreased (-284K), while part-time jobs increased (+921K). According to Rosenberg Research, the full/part-time problem is even worse than the QCEW suggests. They show -1.3 million full time job losses in the last year! Whichever is correct, negative numbers are not good here!

Also, while the BLS counts full-time and part-time work as equal, logic tells us something different. The fact that full-time jobs are disappearing shows a weakening economy despite the headline NFP figures.

More on the coming CRE/banking crisis

We’ve discussed the brewing crisis in commercial real estate lending in our last few blogs. As noted last week:

Delinquencies on leveraged loans now exceed 6% (normal is <3%). This level is approaching the levels seen in the recessions of '01, '08 and '20. According to Moody's, office vacancies are at a record high. Commercial real estate (CRE) prices are in free fall. According to Rosenberg Research, 29% of all CRE and 56% of office loans are now negative equity. Malls are struggling and multi-family housing is being redeveloped (rents are falling).

The pace of CRE foreclosures began with several cases in Q4. First there were several large CRE foreclosures in San Francisco. But the pace picked up quickly in the first quarter, and now that we’re entering the second quarter, it seems like significant CRE foreclosures are happening on an almost daily basis. The sub-heading of this section, viz. Impending CRE/banking crisisis relevant for two reasons: First, as the chart shows, banks hold half of CRE debt.

As a result, we expect loan loss provisions (which are subtracted from the bank’s earnings and possibly capital) to grow rapidly as the quarter and year unfold. As was the case with New York Community Bank
NYCB
(NYCB) in the fourth quarter of last year, one or two major loan defaults can have a huge impact on a bank’s financial health. After that fourth quarter report, with the help of former Treasury Secretary Mnuchin, NYCB successfully raised additional capital. However, as CRE foreclosures multiply, which they appear to be doing, opportunities to raise capital will diminish.

As they have done in every banking crisis this century, if it looks like financial markets will become disorderly or that there are significant withdrawals at banks reporting large CRE losses, the Federal Reserve will very likely open a special “credit facility” where banks can to pledge collateral (perhaps even the non-performing ones) and obtain the necessary liquidity at special interest rates and terms, just as they did on March 23 when Silicon Valley Bank and Signature Bank failed.

Nevertheless, with the spread of the CRE crisis, a recession is inevitable.

Inflation and the Fed

All Fed speakers recently have emphasized that they need to see more progress on inflation before they are willing to start cutting rates. As a result, interest rates rose.

Note in the chart that the 10-year Treasury yield has risen from an interim low of 3.79% on December 26^th to 4.38% at the close on Friday (April 5^th). The next release of the Consumer Price Index (CPI) is on Wednesday, April 10^th. If this report turns out to be “hotter” than expected, as the readings in January and February were, interest rates could jump even higher and, no doubt, stocks would likely wobble. However, we don’t think this will happen because shelter spending, which accounts for more than 35% of the CPI index, is lagged in the CPI calculation (so we already know how it will be affected).

Rent increases have been falling rapidly in early 2023 and have been negative since last May (according to the National Rent Index chart shown above). Because the CPI calculation methodology uses lagged rent data, high rent increases in 2022 had a significant impact on the annual calculation (what the Fed appears to be fixated on). But note that in the spring of 2023, these rents were falling rapidly and turned negative in the June-December period. So if anything, rents, with a 35%+ weight in the index, will have a neutral to negative impact on the CPI in 2025. This is the main reason we shouldn’t worry about a spike in CPI inflation . Still, the Federal Reserve seems worried, and that’s what matters when it comes to markets.

One positive (dovish) note coming from Fed Chairman Powell is that in his last public appearance, he repeated his remark after the press conference that the Fed would “cut” rates this year. With full-time jobs shrinking, existing home sales weak (mortgage rates high!), industrial production nearly down, and real retail sales stagnant, we think the Fed would be wise to cut rates sooner rather than later. Nevertheless, the market odds of a rate cut at the May meeting are microscopic, and in June it is now just 50.8%, almost even odds (see chart).

Final thoughts

Employment values, while strong on the surface, seem to have a very soft underbelly. Full-time jobs are disappearing, and from mid-2022, the divergence between the headline NFP (which is the only number the media is discussing) and the quarterly Employment and Wages Census, which used to closely track NFP, is now breathtaking. The fact that almost all first revisions to the NFP have been negative since early 2023 may lead one to question the reliability of the current NFP methodology. And as you can imagine, there are some who cry “manipulation.”

With rapidly growing problems with corporate investment loans and the fact that banks hold half of all corporate investment loans, the banking system may be approaching another crisis. Losses as a percentage of NPLs are sure to rise significantly as the year progresses. As a result, we expect “capital” problems in the banking system as this unfolds, and in such a scenario, as they have done throughout the century, we expect the Fed to “save the day” again.

While the Federal Reserve has now convinced financial markets that interest rates will be “higher for longer,” causing rates to retrace half of their decline in Q4/23, Powell has also played a “dove,” saying several times publicly , that the Fed “will be cutting rates in 2024.” However, market odds on Friday (April 5^th) fell to 51% for the June rate cut. On Thursday they were 59%, so the “strong” NFP number took more wind out of the “June Rate Cut” sail.

However, our view is, given the CRE issues and their impending impact on the banks, and the positive impact that falling rents will soon have on CPI inflation, we believe that an earlier and faster rate cut would be optimal politics. Unfortunately, we have no influence over the FOMC.

(Joshua Barone and Eugene Hoover contributed to this blog.)