The battle in Ukraine continued to dominate trading this week as investors grappled with the competing risks that sanctions, rising oil prices and disrupted trade introduce to global growth. Closer to home, Federal Reserve Chairman Jerome Powell delivered his semi-annual testimony to Congress. While Powell characterized the economic effects from the Ukrainian war as being highly uncertain at this time, he made it clear that the Fed is focused on the inflationary factors and remains on track to raise rates in March. Powell did take the unusual step of basically telling the market the size of the rate increase by stating that he supported a 0.25% increase at the Fed’s next meeting – this from an institution that normally prides itself on subtlety. That news relieved many investors, some of whom had been bracing for a larger, 0.50% increase. This week’s crop of economic reports showed ongoing U.S. economic momentum through February. The economy added 678K jobs for the month, crushing estimates of 440K. Demand for goods remained strong with factory floors posting solid new orders. The service sector also expanded during the month despite on-going supply chain and labor challenges. Markets fell for the week, but not drastically so given Russia’s escalation in Ukraine. The S&P 500 declined just -1.27% on the week.
Jobs Crush Expectations
The Bureau of Labor Statistics laid down a monster February jobs report. Nonfarm payrolls added 678K for the month, pushing the unemployment rate down to 3.80%. The gains were broad-based with the Covid-battered leisure and hospitality sector leading the way with 179K new hires. Also posting notable gains were professional and business services (95K), healthcare (64K), construction (60K), transportation and warehousing (48K). The labor force participation rate, a closely watched metric indicating worker engagement, also moved higher to 62.30%. That’s just 1.1 percentage points below the February 2020 pre-pandemic level. Despite the unemployment rate ticking closer to the 50-year low of 3.5% observed just prior to the pandemic, wages barely budged in February. Average hourly wages rose just 1 cent an hour or 0.03%. That’s well below estimates of 0.50%. On year-over-year basis, wages were higher by 5.13%, which is less than costs are rising on workers. Anecdotally, the labor market remains very tight, with many businesses struggling to find and hold onto workers as they quit in pursuit of higher wages elsewhere. As the month-to-month and year-over-year wage growth figures show, this is not being borne out at an aggregate level, however, and with personal saving rates now below pre-pandemic levels, there is very little cushion before either the consumer must begin cutting back on their consumption (bad for GDP) or there will be mounting pressure to increase wages (bad for inflation).
Factory Floors Continue to Rack Up Orders
It was full steam ahead for factories as the ISM Manufacturing Index rose to 58.6 in February. That was up from January’s 57.6. Readings above 50 indicate expansion in the manufacturing sector while numbers below indicate contraction. The outlook for business remained exceptionally bright with factories reporting strong order growth with the forward-looking new orders sub-index increasing to 61.7, up from 57.9 in January. Those new orders will take some time to fill as the order backlogs and labor shortages throw a wrench in factory activity. The ISM’s gauge of unfinished work rose to 65 in February, up from 56.4 the previous month. The 8.6 percentage point increase is the largest increase since January 2011. A tight labor market also made it hard for factories to hold on to workers. A higher than normal quit rate and early retirements pushed the survey’s measure of factory employment down to 52.9 from 54.5 in January. Based on February’s survey, manufacturing looked to be on solid footing for 2022, but Russia’s invasion of Ukraine could throw a wrench in things given that they both factor in the global commodity market.
Service Sector Growth Slows
Supply chain disruptions, capacity constraints, inflation, logistical challenges, and labor shortages all weighed on the services sector in February. The ISM Services Index slipped to 56.5, down from 59.9 in January. Unlike the manufacturing sector, business slowed as the measure of new orders received by businesses slipped to a reading of 56.1 from 61.7 the prior month. The measure for employment in the services industry also dropped in February, falling to 48.5 from 52.3 in January. The drop was driven by businesses losing people to early retirement, leaving for higher paying jobs, or leaving for jobs that allow the flexibility to work from home. While the new order, business activity and employment sub-indices comprising the broader index were lower, the rest were higher and given that service jobs were the largest contributor to February’s jobs report, the service ISM should be just fine.
Last week, markets reacted philosophically to the end of nearly eighty years of peace in Europe and its implications for globalization, free trade and global economic efficiency. This week, it was far more pragmatic, focusing on the war’s impact on oil prices, inflation and interest rates. As a major oil producer, Russia’s ability or willingness to freely supply oil to the market weighs heavily on the global price paid, and as the tensions with the West have mounted, so too has the price of oil. Brent crude briefly topped $116/barrel this week for the first time since 2014, and WTI has risen over 85% on a year-over-year basis. Oil prices had, until recently been driven primarily by demand factors, but the Russian invasion threatens its supply. This new condition drastically changes the inflation chessboard on which the Fed must now begin moving its pieces. As was noted in a research piece from MarketDesk on Friday, periods where oil prices rise greater than 85% yoy tend to be associated with future recessions. The sample size is small, so one must be careful in extrapolating the statistical significance of this observation, but the inflation picture was one thing when it was driven purely by demand – where raising interest rates could reduce marginal consumption and cool prices. It is another when you have high inflation you need to desperately deal with, you raise rates, demand cools, but prices still stay high because the supply of a key commodity is constrained. That scenario begins to look a lot more like the 70’s where we had low growth, high inflation and a supply shock due to the conflict with Iran – not so fondly remembered as stagflation. The good news is that the demand factors weighing on inflation are almost certainly the greater force at present. For that reason the Fed’s decision to raise rates makes sense, but the path for the Fed going forward is far more precarious than it was prior to Russia going on its rampage