Companies boost capital spending despite recession fear

• In recent weeks, many big companies have released earnings reports that were disappointing. This flurry of bad news contributed to the decline in equity prices. The poor earnings reports reflected many factors, including tighter margins due to a sharp rise in commodity prices, rising labor costs and shortages of labor, persistent and worsening supply chain disruption, and in some cases weaker customer demand. 

Yet another factor was increased capital spending, which ate into earnings. It has been reported that companies are investing in revising their supply chain design, in part to diversify and to strengthen supply chain resilience. Some analysts see this as the start of a process of deglobalization. Others, like me, see it as part of a pivot toward a more resilient and diverse type of globalization. Either way, it costs money. Moreover, this type of investment, unlike others, does not necessarily improve productivity. In fact, it might result in supply chains that are a bit more costly and no more productive. But at least they will be more resilient when future shocks emerge. 

In the United States, the earnings reports of the 500 companies in the S&P500 Index indicated that capital expenditures increased by 20% in the first quarter of this year versus a year earlier. In an atmosphere with increasing concern about the risk of recession, a sudden surge in investment would ordinarily be unusual. Moreover, as investment surged in the first quarter, real GDP declined. That is why one might assume that, in part, this surge is driven by noncyclical factors such as the risk of supply chain disruption. After the experiences of the past few years, businesses are likely focused on assuring future resilience through diversification. 

There are press reports that some companies are investing in reshoring some parts of their supply chains for fear of disruption overseas and fear of protectionist trade policies at home. The risk is that such investment, propelled by fear of government policies on both sides of the ocean, could result in higher costs and lower efficiency, both of which would be damaging to consumer purchasing power and would do nothing to alleviate inflationary pressures.

US trade policy in Asia is shifting

• The United States has been on a bit of a roller coaster when it comes to trade policy in Asia. In the past decade, the Obama Administration negotiated the Trans-Pacific Partnership (TPP), a free trade agreement of 11 Pacific Rim nations including Japan, Canada, and Mexico. On its first week in office, the Trump Administration withdrew from the TPP. Then, the other members revived the agreement, renaming it the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP). When the Biden Administration came in, it was first noncommittal, then said it will not rejoin the CPTPP, and said it will introduce a new framework for trade in the region. Meanwhile, the Regional Comprehensive Economic Partnership (RCEP), a free trade agreement among Asia/Pacific countries with China in the lead, was implemented. That is where things stand now as President Biden sets off on a trip to Asia.

During his trip, Biden will promote the Indo-Pacific Economic Framework (IPEF), which is not a free trade agreement. Rather, it is meant as a set of policies and tools to boost trade and economic cooperation in the region. In part, this is a political decision by the administration. The notion of free trade is now toxic in American politics. There appears to be a bipartisan view that past free trade agreements had a large net negative impact on jobs and wages, although the empirical evidence is scanty. The Biden Administration is attempting to obtain the benefits of increased trade under the radar screen. For example, rather than directly remove the Trump-era tariffs on China, it has offered increased exemptions from those tariffs. Still, tariff reduction is being debated within the administration. 

Biden also likely has a political goal. That is to boost the influence of the United States in the region as an offset to rising Chinese power. The TPP was meant to do this in addition to the shift of US military resources into the region. Meanwhile, China, in addition to leading implementation of the RCEP, has asked to join the CPTPP. This would require China to agree to labor standards that it might otherwise shy away from. For now, it seems unlikely that China will be invited to join. 

As for the IPEF, the administration says it will focus on harmonization of standards for digital products, supply chain resiliency, labor standards, regulatory harmonization, and climate change. Recall that the TPP had harmonized labor standards. Meanwhile, it is not clear what the IPEF will mean for existing tariffs and other trade barriers. Other Asian countries are disappointed that the United States will not join the CPTPP. However, some are evidently pleased that the United States is renewing engagement in the region. Japan, South Korea, Singapore, and the Philippines have expressed interest in the IPEF. On the other hand, it is reported that Indonesia and India have reservations. India did not join the RCEP when invited.  

China’s economy decelerates sharply

• In April, the performance of the Chinese economy was grim, with multiple indicators showing far greater weakness than many analysts had anticipated. It was, of course, well known that the lockdowns in multiple cities would stifle economic activity, but it turns out that the impact of the lockdowns was more onerous than expected. 

The most notable indicator was retail sales. In April, retail sales were down 11.1% from a year earlier, the worst performance since March 2020 and much lower than investors had expected. This follows a 3.5% decline in March. Some categories of goods saw an especially sharp decline in purchases. These included jewelry (down 26.7%), apparel (down 22.8%), cosmetics (down 22.3%), furniture (down 14%), telecoms (down 21.8%), and automotive (down 31.6%). The volume of vehicles sold was down 47.6% from a year earlier. Naturally, it is reasonable to assume that retail sales were down far more sharply in cities that were in lockdown, such as Shanghai. 

The lockdowns not only led consumers to stay home and not shop. They also had a negative impact on employment. The headline unemployment rate, which is not necessarily a fully accurate reflection of the state of the job market, increased by 0.3 percentage points to 6.1% in April, the highest since March 2020. The unemployment rate in China’s 31 largest cities increased from 6% in March to 6.7% in April. China’s unemployment rate for those between 16 and 24 years old hit a record high of 18.2%. Lockdowns and virus-related restrictions have led to some job losses and restraints on hiring. Moreover, private sector hiring will likely only resume once businesses are confident in a restoration of demand. China’s Premier has already expressed considerable concern about high unemployment. Historically, high unemployment has often presaged social unrest in China. 

Meanwhile, industrial production fell 2.9% in April versus a year earlier, with manufacturing output down 4.6%. Automotive production was down 31.8%. Investors had expected a modest increase. This was the first annual decline in industrial production since March 2020. The decline was heavily influenced by the lockdown in Shanghai where, it is reported, industrial activity largely halted in April. The reduction in manufacturing activity contributed to the loss of jobs. 

Fixed asset investment fell 0.82% from March to April but was up 6.8% in the first four months of the year versus a year earlier. Private sector investment was up 5.1% in the first four months. However, property sector investment fell 2.7% in the first four months of the year versus a year earlier. That reflects the deep troubles facing the property development sector. Notably, property sales volume fell 39% in April versus a year earlier. The weakness in the property market is expected to remain for some time to come. 

Meanwhile, although most of the major central banks in the world tighten monetary policy, China’s central bank is going in the opposite direction. With the Chinese economy having slowed considerably, and with inflation remaining under control, the central bank wants to boost credit market activity to revive the economy. As such, last week it announced that it cut the main mortgage interest rate by the largest amount on record. The 15-basis-point cut is meant to boost demand in the troubled property sector. 

Notably, the weakness of the property sector was, in part, engineered by the government. That is, a year ago the government deemed the level of debt issued by property developers to be excessive and dangerous. It also deemed the amount of property sector activity as a share of GDP to be excessive. Consequently, it placed restrictions on the ability of developers to issue new debt or roll over existing debt. This brought some developers close to default and led to the current downturn in property market activity. And yet it is now clear that the government is concerned lest the slowdown have more onerous economic consequences. Moreover, property prices have suffered, which is important given that much household wealth is tied up in residential property. Thus, rather than allow developers to resume their old ways, the government is attempting to boost demand for property. 

Yet, so long as lockdowns remain, it is hard to see how this easing of credit market conditions will make much difference. Moreover, if the government retains its goal of reducing the size of the property market so as to boost other sectors, this action is not consistent with that goal. In recent decades, an excessive share of economic activity came from property development, infrastructure investment, investment in heavy industry, and exports rather than consumer spending. The government has talked about boosting consumer demand in order to create a more normal and sustainable economic model. But little has been done to achieve this goal. When the economy has run into trouble, the government has periodically attempted to boost property sector or infrastructure investment.

European inflation worsens

• Inflation in the 19-member Eurozone stabilized in April, with consumer prices up 7.6% from a year earlier, the same as in March. Prices were up 0.6% from the previous month, the lowest monthly inflation in three months. When volatile food and energy prices are excluded, core prices were up 3.5% from a year earlier and up 1% from the previous month. Energy prices fell 4% from March to April, but food prices were up 1.9% while unprocessed food was up 2.8%. Thus, although weaker energy prices suppressed core prices, this was more than offset by the surge in food prices. The latter reflects the onerous impact of the war on Ukraine exports of grain and other key agricultural commodities. 

In the Eurozone’s largest economies, inflation was relatively tame in April. From March to April, prices were up 0.7% in Germany, up 0.5% in France, up 0.4% in Italy, and down 0.3% in Spain. Smaller peripheral countries, however, experienced sharp increases in consumer prices. For example, prices were up 2.4% in Portugal, 2.7% in Croatia, 4.1% in Estonia, and 2% in Greece. In these countries, food is a larger share of the consumer basket than in the larger economies. This likely explains the higher inflation. 

Going forward, the European Central Bank (ECB) has signaled a likelihood that it will soon start to raise interest rates. With energy prices now falling and with Europe’s economy decelerating, inflation might now be peaking. If so, the ECB will likely take a gradual approach to monetary policy tightening. The leadership of the ECB has expressed concern that excessive monetary tightening could lead to a recession. 

• Inflation continued to accelerate in the United Kingdom in April. Consumer prices were up 9% versus a year earlier, the highest rate in 40 years and significantly higher than in the Eurozone or the United States. In Europe, the only countries with inflation higher than in the United Kingdom are those in Eastern Europe. Prices were up 2.5% from the previous month, the biggest monthly gain in 31 years. When volatile food and energy prices are excluded, core prices were up 6.2% from a year earlier and up 0.7% from the previous month.

In part, Britain’s inflation in April was fueled by the sharp rise in global food prices. In addition, the United Kingdom is also experiencing sharp increases in wages that likely contributed to rising inflation. Plus, the decline in the value of the pound likely added to the cost of imports. The Bank of England (BOE) has embarked on an aggressive program of monetary policy tightening. BOE Governor Andrew Bailey said that inflation will likely get worse before it gets better, and that British inflation is largely caused by factors outside the BOE’s control. The BOE is in a difficult position as it attempts to quell inflationary pressure even as the economy appears to be decelerating. Notably, house price inflation decelerated in March, suggesting that higher borrowing costs are eating into housing demand. Meanwhile, the government is promising additional support to lower income and retired households to help them deal with higher energy prices.

US inflation decelerates

• US inflation decelerated slightly in April, with consumer prices up 8.3% from a year earlier versus an 8.5% increase in the previous month. Moreover, prices were up only 0.3% from the previous month, the lowest monthly rate of inflation since August 2021. While welcome, this deceleration was less than many investors had anticipated. Moreover, the decline in monthly inflation was entirely due to a 2.7% decline in energy prices from the previous month. When volatile food and energy prices are excluded, core prices were up 6.2% from a year earlier, down from 6.5% in March, and up 0.6% in April from the previous month. The latter figure is a relatively high number that shook investors, especially since core price inflation in March had been relatively muted. What happened?

In April, core goods prices were up only 0.2% from the previous month, partly due to a 0.8% decline in apparel prices and a 0.4% decline in used car prices. Rather, the surge in core prices was due to services. Nonenergy service prices were up a sharp 0.7% from the previous month, heavily driven by an 18.6% monthly increase in airline fares. As I write this from an airplane, I can say with confidence that the government numbers are likely accurate. Lately, purchasing plane tickets has involved a high degree of sticker shock. In addition, the cost of shelter, including the imputed rental cost of owner-occupied housing, increased 0.5% from the previous month. If airline fares and shelter are excluded, then core prices were up only 0.3% from March to April. In other words, the surge in core prices was fairly concentrated in two categories. 

Another interesting aspect of the report is that the divergence between prices of goods and services continued, to some degree. Recall that, in the past year, a combination of surging demand for consumer goods and pandemic-related constraints on production and transportation of goods led to a surge in the prices of goods, especially durable goods. Meanwhile, prices of services were relatively tame. In April, prices of durable goods were up 14% from a year earlier but up only 0.1% from the previous month. Prices of nondurables were up 12.8% from a year earlier but down 0.2% from the previous month—the latter figure due to the drop in energy prices. Finally, service prices were up 5.4% from a year earlier and up 0.8% from the previous month. This tells us that, over the past year, goods prices surged while services prices did not. However, in the past month, goods prices were tame while service prices surged—in large part due to people traveling again on airplanes. 

What does all of this tell us about the outlook for inflation? The answer is that we could be at a pivot point in which inflation decelerates, but it is likely too soon to tell. Still, one piece of evidence pointing in that direction is that wages appear to be decelerating, possibly due to an easing of the tightness of the job market. Average hourly earnings of private sector workers were up 0.3% from March to April and up 4.2% from a year earlier. That latter figure was the second slowest since August 2021. This means that wage acceleration, long feared, is not playing a role in boosting inflation. Moreover, decelerating wages might lead companies to implement more modest price increases. On the other hand, there remain other factors that continue to drive inflation, especially supply chain disruption that has been worsened by the war in Ukraine and the lockdowns in China. Another important driver of inflation has been the price of oil, which has lately come down. This is largely due to the Chinese lockdowns that led investors to expect much slower growth of demand in China. 

Russia and the West play cat and mouse

• Russia and the West are playing a game of cat and mouse, each trying to outfox the other. Russia wants to punish Western countries for sanctions by imposing energy-related sanctions of its own, thereby discouraging the West from taking further steps to punish Russia. The West wants to restrict the financial ability of Russia to wage war against Ukraine, in part by reducing the amount of money it sends to Russia for energy. 

Last week, a new idea was floated by Italian Prime Minister Draghi, himself a distinguished economist and former head of the European Central Bank. After discussing his idea with US President Biden, he publicly talked about creating a cartel of oil consumers. After his meeting with Biden, Draghi said, “We are both dissatisfied with the way things work, in terms of oil for the US and in terms of gas for Europe. Prices don’t have any relationship with supply and demand.” He said that he would like to cap the price that Europe pays for gas “to reduce the financial help we are giving” to Russia and, therefore, to the war effort. He said that similar thinking could be applied to the market for oil. He said that “the idea is to create a cartel of buyers, or to persuade the big producers, and OPEC in particular, to increase production, which is perhaps the preferred path. On both paths, there’s a lot of work to do.” 

Draghi also noted that the surge in energy prices had contributed to higher inflation in both the United States and Europe. Stifling energy prices by creating a buyer’s cartel could help alleviate inflationary pressures. One obstacle to implementing Draghi’s idea is that there is no unanimity among members of the European Union. There is strong resistance in central Europe. Unanimity is required for the European Union to do almost anything. However, Draghi suggested that, rather than have the European Union implement such a policy, it could be done on a voluntary basis by a coalition of countries with like interests. Such a “cartel” could offset the combined power of Russia and members of OPEC. If this cartel of consumers chose to cap prices, producing countries would have little choice to but accept those prices lest they lose a significant volume of sales. Success, however, would require that the cartel of consumers have critical mass. That is, it must account for a sufficiently large share of purchasers. It wasn’t clear, but it seems that Draghi’s idea would be directed only at Russia and not at other energy producers. 

Meanwhile, Russia is taking steps to discourage European countries from doing more to punish Russia. Last week Gazprom, Russia’s main state-owned producer of natural gas, said that it will cut off shipments of gas through a major pipeline. This will be the second time that it has shut down gas flows through a particular pipeline. Germany’s economy minister said that “it is becoming evident once again that Russia is using energy as a weapon.” The price of gas in Europe surged in response to the Russian action. This means more revenue for Russia. For Germany, higher gas prices mean higher electricity prices, thereby creating a political issue for the government. Clearly, Russia is telling the German government that, unless it holds back on further energy-related sanctions, it can expect higher utility prices. Although the pipeline in question is not well used at the moment, it is often used to supply gas when shortages emerge. Thus, today’s action is not immediately impactful. Rather, it is a warning. Russia’s action comes as Germany and other European countries are attempting to take steps to wean themselves from Russian gas by seeking alternative sources. Germany, for example, has pledged to significantly boost investment in facilities to receive liquid natural gas from outside Europe. 

More on the impact of China’s crisis

• As written in these pages recently, there is growing concern about the potential global impact of the current crisis in China. Lockdowns in roughly 70 cities have caused a sizable decline in both demand and supply and there is not yet any end in sight. Meanwhile, several bits of data and analysis provide more light on what is happening:
  • The Chinese government reported that, in April, exports were up 3.9% from a year earlier, when evaluated in US dollars at current exchange rates. This was the slowest growth in two years and much slower than the 14.7% growth found in March. Imports were unchanged. Interestingly, exports to the United States increased 9.4% while imports from the United States fell 1.2%. The latter fact will not be welcomed by US trade negotiators who are trying to hold China to the commitments made in the so-called “phase one” agreement made in early 2020. That deal required China to dramatically increase imports from the United States in exchange for US forbearance on new tariffs. The Biden Administration is considering reducing some existing tariffs on imports from China. Politically, this will be more difficult if China is not boosting purchases from the United States. 
    
    Meanwhile, many observers had differing views on why China’s exports suddenly decelerated. The conventional wisdom is that the lockdowns, especially in Shanghai, disrupted production and distribution of exportable goods, thereby resulting in weak exports. This is certainly the case. Yet some observers suggested that, in part, the deceleration reflected weakening global demand. For example, there is a widespread view that the surge in global investment in technology is coming to an end, especially as the pandemic ends. The recent weakness of technology stocks reflects this viewpoint. In addition, accelerating inflation in Europe and North America is eating into consumer purchasing power. Consumers must spend more on energy and food and, therefore, less on other things such as electronics, toys, apparel, and appliances. Finally, the weakness of Chinese imports likely reflected lockdown-related supply chain disruption. If factories are running below capacity, then they require fewer imported inputs than otherwise. 
  • OPEC downgraded its forecast for global oil consumption this year, in part because of the situation in China. It also alluded to the war in Ukraine and its impact on oil prices. However, global prices have lately come down, most likely due to expectations of weakened demand in China.
  • The global price of copper has fallen, hitting an eight-month low recently. With the Chinese renminbi depreciating, the Chinese cost of purchasing copper has risen. Among the reasons cited for the decline in copper prices are the property market slowdown in China, the war in Ukraine, and an expectation that the global economy will decelerate this year. The sharp decline in copper prices began in April, during the Shanghai lockdown. 
    
  • The cost of shipping containers out of China has fallen about 20% since March. With Shanghai in lockdown, its port (which is the world’s busiest) has been operating well below capacity, with some capacity shifting to other ports. This is consistent with the already reported sharp slowdown in Chinese export growth. Meanwhile, the world’s major container shippers have announced that about a third of their Asian sailings have been cancelled through the remainder of the first half of this year. A decline in capacity should help to stabilize costs. On the other hand, when COVID-19–related restrictions are eventually lifted, expect a big increase in shipping costs as backlogs develop. 
    
  • In April, new bank lending in China fell sharply from the previous month, according to the People’s Bank of China (PBOC). The decline was attributed by the PBOC to the lockdowns that had a negative impact on overall economic activity as well as social interaction. The uncertainty created by the lockdowns, including uncertainty about how long they will last, likely caused some businesses to delay projects and, therefore, borrowing. Household borrowing for mortgages was down sharply, with potential buyers unable to visit properties for inspection. The PBOC also said that “enterprises, especially small, medium-sized and micro enterprises, had more operating difficulties, and demand for effective financing decreased significantly.” The reduction in credit will suppress economic activity and could lead the PBOC to ease monetary policy further. Already in late April, it reduced the required reserve ratio for commercial banks. 
    
  • The lockdowns are disrupting food distribution. The result has been that the prices of fresh vegetables in China are up about 24% from a year earlier. That is much higher than the 17% increase reported for the previous month. This contributed to the considerable acceleration in consumer price inflation in April along with a war-related surge in energy prices. The result is a stark reduction in consumer purchasing power. 
    
  • Foreign companies are becoming wary of sustaining operations in China under current conditions. Surveys of foreign companies operating in China suggest increased consideration of diversifying supply chains away from China. Some Chinese officials are starting to warn that the COVID-19 policy must take account of the concerns of foreign companies, which are important to China’s economy. Vice Premier Hu Chunhua said that there should be an effort to stabilize foreign investment. Foreign invested enterprises currently account for about 40% of China’s trade. 
    
    Meanwhile, the European Chamber in China has completed a survey of nearly 400 European companies that are active in China. The results are grim reading, both in terms of the impact of the lockdowns on European companies and in terms of how the lockdowns are affecting company thinking on future investments and operations.
    
    The survey found that 58% of companies expect a decline in revenues in 2022 versus previous expectations. In addition, more than half of those expecting a decline anticipate that revenue will decline more than 10% from previous forecasts. Also, 23% of respondents said that, as a result of the COVID-19 policy, they are “considering shifting current or planned investments in China to other markets.” Moreover, 40% of respondents said that China is a “significantly less attractive” destination for investment as a result of the current COVID-19 policy. Among industries where a large majority of respondent expressed this view were transportation, logistics, and distribution; pharmaceuticals; and aerospace and aviation. Finally, roughly half of respondents said that supply chains have been “severely compromised” as a result of the current policy.  
    
    The results of this survey demonstrate the considerable impact of the current policy on global companies. The respondents were also asked to opine on the Chinese policy itself. Some 77% of respondents said that the policy needs to change. Although China has vaccinated a large share of the population, it has not allowed use of imported mRNA vaccines that are known to be far more effective than the Chinese vaccine. In the survey, 82% of respondents said that China should allow foreign vaccines while 91% said the government should focus on vaccinating more people. In addition, 82% of respondents believe that the government should allow those infected who have no or mild symptoms to quarantine at home rather than in government facilities.
    
    The impact of the sentiments expressed by these European company executives will likely become more impactful the longer the lockdowns continue. A belief that the policy environment will not quickly reverse could lead more companies to gradually shift resources elsewhere. Although the government is likely aware of this sentiment, it is not clear if it will have any impact on policy. 

US monetary policy is now completely reversed

Everyone expected that the Federal Reserve would raise its benchmark interest rate by 50-basis points last week. It did. And yet equity prices soared following the Fed’s unsurprising announcement. Why? Perhaps it was Wall Street offering a sigh of relief. There must have been some apprehension that the Fed would surprise everyone and raise the rate only 25-basis points. The market would likely have plunged if this had happened. There were some analysts who predicted a 75-basis point increase. That might have shaken investors as it would have indicated the Fed is more worried about inflation than it has let on. Instead, last week’s action was the Goldilocks action: not too much, not too little, just right.  Moreover, Fed Chairman Powell said that “if higher rates are required, we won’t hesitate to deliver them.” In addition, he said that “there is a broad sense on the committee that additional 50-basis point increases should be on the table at the next couple of meetings.” 

The Fed’s action and Powell’s words signaled that the Fed is not only concerned about inflation. Rather, the Fed believes the economy is strong enough to whether a significant boost to borrowing costs—at least for now. That, in turn, likely means a good environment for corporate profitability. Powell offered a favorable assessment about the state of the US economy. 

Meanwhile, bond yields initially fell as investors absorbed information suggesting that inflation will be brought under control. The yield on the 10-year bond fell less than the yield on the two-year bond, thereby slightly steepening the yield curve. This signals a lessened perception of recession risk. Still, many past episodes of monetary tightening did, in fact, presage recession. US Treasury Secretary Yellen, Powell’s predecessor as Fed Chair, said that the Fed will need to be “skillful and also lucky” to avoid a recession.

Prior to last week’s announcement, bond yields had increased sharply ever since the Fed indicated that it intends to reduce the size of its asset portfolio. Interestingly, despite a rise in bond yields, there has lately been a reduction in the breakeven rate, which is an indicator of bond investor expectations of inflation. Thus, yields have risen because of an expectation of an increase in the available supply of government bonds. At the same time, it appears that investors are increasingly shying away from more risky assets such as distressed debt.  The value of junk bonds trading in the United States that are below 70 cents to the dollar has doubled this year. This is likely a direct result of Fed action. 

The Fed’s action came following a 40-basis point increase in the Indian central bank’s benchmark interest rate. That action, the first such increase in four years, was likely intended to fight inflation as well as avert substantial capital outflows that would lead to severe currency depreciation. India had been a lonely holdout among emerging economies in not raising interest rates in recent months.  

US labor market and productivity trends

• The latest employment report from the US government offers some conflicting information. On the one hand, the establishment report found strong job growth, more so than analysts anticipated and more than the ADP survey predicted. Markets greeted this news as affirming their view of a strong economy bedeviled by inflation. This justifies the Fed’s choice of a rapid tightening of monetary policy. On the other hand, the separate survey of households found a sharp decline in participation and the size of the labor force as well as a decline in employment. That left the unemployment unchanged at 3.6%, a fact that was also well received by investors. 

Let’s look at the details: there are two reports published by the government; one based on a survey of establishments, the other based on a survey of households. The establishment survey found that 428,000 jobs were created in April, a robust number.  This was the 12th consecutive month of job gains in excess of 400,000. Moreover, unlike early in the pandemic recovery, job growth was not simply skewed toward leisure and hospitality. Rather, it was broad based across a range of industries. Moreover, the strength of job growth might seem surprising given that the economy is at full employment and that participation did not rise in April. 

Among the interesting aspects of the report was a very modest 2,000 increase in construction employment. This likely reflected a shortage of construction workers, partly due to a paucity of immigration. This shortage has contributed to higher home prices as builders are unable to attract sufficient workers. On the other hand, manufacturing employment was up a strong 55,000. In addition, there was strong growth of transportation and warehousing (up 52,000), finance (up 35,000), professional and business services (up 41,000), education and health services (up 59,000), and leisure and hospitality (up 78,000). 

The establishment report also found that although average hourly wages were up 5.5% in April from a year earlier, not much changed in the past seven months. In addition, hourly earnings were up only 0.3% from the previous month, the second lowest rate of increase in the past year. In other words, wages do not appear to be accelerating, although they are growing at a robust pace. Yet that pace remains below the rate of inflation, meaning that real (inflation-adjusted) wages are declining, rendering less purchasing power for consumers. The wage behavior is surprising given the evident tightness of the job market and the shortage of workers.

The separate survey of households, which includes data on self-employment, was a bit of a shocker, although one-month changes can often be statistical noise. The survey found a decline in participation and employment in April. It also found that the unemployment rate remained steady at 3.6%. 

Investors saw this report as likely reinforcing the intention of the Federal Reserve to tighten monetary policy, but not offering a reason to tighten more dramatically. Bond yields increased while equity prices fell slightly after release of the report.

• One of the interesting stories in the pandemic era has been the acceleration in productivity growth, where productivity is defined as output per hour worked. This increase was, in part, driven by the switch toward remote interaction, thereby requiring more use of information technology. The big IT investment helped to boost worker productivity. The good thing about productivity gains is that they can offset wage gains, thereby suppressing inflationary pressure. 

Yet we learned this week that, in the United States, productivity declined sharply in the first quarter of 2022. Non-farm business productivity fell 7.5% from the fourth quarter of 2021 to the first quarter of 2022, the biggest single decline since 1947.  Productivity was down 0.6% from a year earlier. This followed a very robust 4.5% increase in productivity in 2021 versus 2020. 

What happened in the first quarter? Deconstructing the report, we learned that hours worked were up 5.5% while output was down 2.4%.  Yet the decline in output, as we learned from the first quarter GDP report, was largely due to a sudden decline in inventories and sudden weakness in exports. If these items are excluded, then final domestic demand grew. In other words, the productivity number is, to some extent, distorted by one-off factors. Productivity might have declined, but not nearly by that much.  

The government also reported a stunning increase in unit labor costs (ULC). ULC is a measure of the labor cost of producing an addition unit of output. ULC is calculated by dividing labor costs by productivity. If labor costs rise and productivity declines, then ULC rises. In the first quarter, hourly compensation was up 3.2% from the previous quarter and up 6.5% from a year earlier. The result is that unit labor costs were up 11.6% from the previous quarter and up 7.2% from a year earlier. Normally, this would be cause for concern. A sharp rise in ULC augurs higher inflation. Yet given the distorting impact of a sharp decline in inventories, these numbers should be taken with a grain of salt. Not surprisingly, much of the press coverage has been relatively hysterical, suggesting that the surge in ULC means bad news on the inflation front. Interestingly, productivity in the manufacturing sector was up modestly in the first quarter while unit labor costs increased modestly.

Purchasing managers’ indices and the global economy

• The global manufacturing industry suffered a deceleration in activity in April, according to the latest purchasing managers’ indices (PMIs) from IHS Markit. In fact, growth of activity in the global industry hit the lowest level since August 2020, largely due to a sizable lockdown-related slowdown in China.

PMIs are forward-looking indicators meant to signal the direction of activity in the manufacturing industry. They are composed of sub-indices such as output, new orders, export orders, employment, pricing, inventories, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa. 

The global PMI fell from 52.9 in March to 52.2 in April, the lowest since August 2020.  The deceleration was driven by an absolute decline in output and a deceleration in new orders and employment. In addition, the global sub-indices for input and output prices indicated an acceleration of inflation in April, likely the result of disruption from the war in Ukraine as well as lockdowns in China. Of the 20 countries analyzed, the highest PMIs were in the Netherlands, United States, Australia, Austria, and Canada. The lowest PMIs were in China, Mexico, Myanmar, Taiwan, and Brazil. Only China and Mexico had PMIs below 50 indicating declining activity. 

The most notable PMI report came from China. There, the manufacturing PMI fell from 48.1 in March to 46.0 in April, a level indicating a rapid decline in activity and the lowest PMI since the start of the pandemic. The sub-index for output fell at the steepest pace since February 2020 when China was largely locked down. It fell from 49.5 in March to 44.4 in April. There was also a sharp decline in new orders, dropping from 48.8 in March to 42.6 in April. Export orders fell to the lowest level since June 2020. In addition, the time it takes for inputs to be delivered to manufacturers increased sharply, indicating renewed supply chain trouble. Some companies reported the cancellation of orders due to difficulty in producing and transporting products. Despite this, there was an increase in backlogs. 

All these difficulties were entirely due to the imposition of severe restrictions on activity meant to quell transmission of the virus, including the severe lockdown in Shanghai, China’s financial hub. Although survey respondents indicated optimism over the long-term, they also expressed concern about how long current restrictions would last. This remains unknown.

The troubles in China, as well as the war in Ukraine, led to a sharp decline in the manufacturing PMI for neighboring Taiwan. There, the PMI fell from 54.1 in March to 51.7 in April, a level indicating modest growth in activity. The sub-indices for output and employment indicated a decline. The sub-index for new orders showed no direction while the sub-index for export orders declined sharply. Only the sub-indices for delivery times and inventories improved. The health of Taiwan’s manufacturing sector is a good indicator for the global technology industry. The decline in Taiwan’s PMI shows how the lockdowns in China are affecting this key industry.

The lockdowns in China also affected Japanese manufacturing, but not as much. Japan’s manufacturing PMI fell from 54.1 in March to 53.5 in April. This indicates a healthy rate of growth. Output was mostly unchanged as were new domestic orders. However, export orders dropped sharply, mainly due to the situation in China. That, and the war in Ukraine, added to supply chain disruption. The survey found a sharp decline in business confidence among Japanese manufacturers.

Growth of manufacturing activity remains strong in the United States and Europe, although there was a sizable deceleration in Europe in April. In the eurozone, the manufacturing PMI fell from 56.5 in March to 55.5 in April, a 15-month low but still a number indicating strong growth. The decline in the eurozone was largely due to supply chain disruption which led to soaring input prices and shortages. This was especially true in Germany which saw a very sharp decline in its PMI to a 20-month low.  German automakers have been disrupted by lack of access to components made in Ukraine. France, Italy, and Spain faced less difficulty. Although the overall PMI for the eurozone remained healthy, the sub-index for output showed no increase in production.

Finally, the US manufacturing sector performed well in April. The manufacturing PMI increased from 58.8 in March to 59.2 in April, the highest level in seven months and one indicating rapid growth in activity. Evidently, the United States has not been as badly affected by events in Ukraine and China as other parts of the world. In April, there was strong growth of output, new orders, export orders, employment, and business confidence. Markit commented that “demand from consumers and businesses is proving encouragingly robust despite severe inflationary pressures, which intensified further during April.” Markit concluded that growth of economic activity in the second quarter is likely to be good, even as inflation gets worse. 

• The latest purchasing managers’ indices (PMIs) for services in major countries demonstrates that the pattern of growth in this industry is hugely influenced by how governments react to the pandemic. Economic restrictions prevent people from going to restaurants and theaters, while easing of restrictions has the opposite effect. In China, the services PMI fell to the second lowest level on record in April, indicating a collapse in activity largely due to the various lockdowns that are currently in place. In the eurozone, however, the continued removal of government restrictions led to an acceleration in services activity in April, with the eurozone services PMI at 57.7, an eight-month high and a level reflecting rapid growth in activity.  In the United States, growth of services remained strong but declined somewhat, hitting 55.6 in April, following a rapid surge in March. In India, services activity grew very rapidly following further removal of restrictions. The April PMI was 57.9. 

Let’s focus on China. The services PMI for China fell from 42.0 in March to 36.2 in April, the second lowest on record and a level indicating a catastrophic decline in activity. This was entirely due to lockdowns that limited mobility and production. The sub-indices indicate a decline on both the demand and supply side of the services industry. There was a decline in output and a severe decline in new orders. Travel restrictions meant a paucity of export orders. Employment fell modestly and backlogs of work increased as the pandemic had a negative impact on supply chain efficiency. Input prices were up but output prices fell. The latter meant that service enterprises, facing limited demand, were compelled to cut prices in order to attract sales. Interestingly, the sub-index for business sentiment was positive, meaning that businesses were optimistic that the current crisis will ultimately pass. Meanwhile, the weakness of both the services and manufacturing PMIs (the latter was 46.0 in April) bode poorly for GDP growth in the second quarter.  

Russia and the European Union wrestle over energy

• As the war in Ukraine continues with no end in sight, European leaders are looking for ways to further tighten sanctions on the Russian economy. The financial sanctions have been impactful, driving up Russian inflation, reducing expected Russia GDP, and creating shortages of consumer products for Russian consumers. Yet the sanctions have not stopped Russia from waging war. Moreover, there are reports that President Putin has given up hope of reaching a peace settlement with Ukraine. Now, his goal is said to be a complete takeover of Ukraine, regardless of how long it takes. Putin’s ability to wage war will depend, in part, on his ability to generate revenues from energy. And that is where the European Union is looking to make a difference. 

It is reported that EU leaders are considering new measures aimed at Russia’s energy sector. Although there is not sufficient support within the European Union to simply ban imports of Russian oil and gas, there are other ideas on the table. This includes placing a cap on the price that the European Union would be willing to pay for Russian oil. Russia would likely accept the European Union’s price, thereby allowing for a sizable decline in foreign currency revenues. That, in turn, could put further downward pressure on the value of the ruble.

Another reported idea involves imposing a steep tariff on Russian oil but not on oil imported from other countries. This would also likely force Russia to lower the price it charges Europe, but it would mean a higher price paid by European consumers. However, the revenue from the tariff could be used for fiscal support to offset these higher prices. 

These measures can be considered preferable to a ban or partial ban on Russian oil, which would have the effect of significantly raising the price Europeans pay for imported oil without any offsetting revenue. The main goal, of course, is to deny revenue to Russia while, at the same time, not doing ruinous damage to the EU economy. As such, it is a political balancing act. Note that the actions under consideration are about oil and not natural gas. The dependence on Russian gas is too great and alternative sources are not necessarily readily available.    

• Meanwhile, observers have wondered what Russia’s next move will be. The sanctions imposed by the West have damaged the Russian economy. Meanwhile, the European Union is engaged in discussions about potential next steps in its effort to undermine Russia’s economy. They are looking at new measures meant to reduce Russia’s revenue from the sale of oil and gas. Thus, it is not entirely surprising that, very recently, state-owned Gazprom (Russia’s largest supplier of natural gas) announced that it is suspending supplies of natural gas to Poland and Bulgaria. Immediately, European gas prices increased by roughly 20% on a single day while the euro fell sharply against the US dollar, hitting a five-year low. 
  

Gazprom’s action came after Russia had demanded that European countries pay for their gas in rubles. Most have refused to do so, saying that this would violate existing contracts. The suspension of supplies to Poland and Bulgaria was due to their refusal to pay in rubles, according to a statement from Gazprom. Yet many observers see it as an effort to divide the European Union and to put pressure on it not to implement further sanctions. EU Commission president Ursula von der Leyen said that it is a form of blackmail and that Russia is no longer a reliable partner. Recall that, for the last two decades, Putin often spoke about how Russia was a reliable partner. 

Poland’s prime minister said: “Russia has moved the borders of gas imperialism a step further. This is a direct attack on Poland. But we have been preparing for this moment for years. From the autumn, Poland will not need Russian gas at all. We will cope with this blackmail, with this gun to our head, in such a way that Poles will not feel it.”

There were reports that Germany will attempt to provide gas to Poland and Bulgaria. Germany’s economy minister said that the Gazprom action will accelerate the European effort to diversify sources of gas. He said that “the EU’s goal is to become independent of Russian energy imports as quickly as possible.” 

Finally, Gazprom warned that, if gas flowing in pipelines through Poland is diverted, then the volume of gas in the pipeline will be cut commensurately. It is likely that today’s action will cause an intensification of efforts to obtain alternative sources of gas. Several European countries, including Poland and Germany, are investing in the ability to receive liquid natural gas from other countries such as the United States. In the long term, this trend will likely damage Russia’s ability to generate revenue from the sale of gas. 

The ECB navigates stagflation

• The word stagflation is being used by some to describe the Eurozone economy. That word implies weakening growth combined with accelerating inflation, something experienced in the 1970s. In the first quarter of 2022, real GDP in the Eurozone was up only 0.2% from the previous quarter (although it was up a robust 5% from a year earlier, reflecting the base effect of a weak first quarter in 2021). 

Inflation in the Eurozone continued to accelerate in April. Prices were up 7.5% from a year earlier and up 0.6% from the previous month. When volatile food and energy prices are excluded, core prices were up 3.5% from a year earlier and up 1.1% from the previous month. The latter figure reflected the fact that, in Europe, energy prices actually fell from March to April. 

This data points to the reason why the European Central Bank (ECB) is reluctant to dramatically shift gears and start raising interest rates. First, growth is already receding and is threatened by the possibility of restrictions on energy imports from Russia. Second, although inflation is historically high, it is mostly due to what has happened with oil and gas prices. When these are excluded, core inflation remains far below the more onerous level seen in the United States. As such, underlying inflation is less of a threat and receding growth is more of a threat than in the United States.   

Despite rapidly accelerating inflation in the Eurozone, and despite a sharp decline in the value of the euro (which could be inflationary), the ECB has been reluctant to shift gears and tighten monetary policy, even while the US Federal Reserve does so. The argument is made that Europe is far more vulnerable to recessionary pressures than the United States, that most of the European inflation is related to increases in energy prices, and that a tightening of monetary policy might not have much impact on inflation but might increase the likelihood of recession. Indeed, core inflation (inflation excluding the impact of food and energy) remains quite low in the Eurozone. 

Despite the ECB argument, private investors are becoming skeptical. In fact, investors are now pricing in an interest rate increase as early as July. Currently, the ECB’s benchmark interest rate is –0.5%. Investors now expect the rate to move into positive territory later this year and above 1% sometime next year. Christine Lagarde, ECB president, has said that any action on interest rates is unlikely this year. 

Are investors correct and is Lagarde likely to change direction? The answer is more nuanced. Many economists know that monetary policy is most effective when it is least expected. That is, if the ECB raises rates sooner than investors expect, it will change their behavior more radically. If, however, investors get ahead of the central bank, then ECB action will simply demonstrate that investors had it right all along. Still, Lagarde has made a fairly strong argument for forbearance. She recently said that “If I raise interest rates today, it is not going to bring the price of energy down.” 

Deceptive US GDP data

• With many people increasingly expressing concern about the risk of recession in the United States, pessimists likely felt validated by the news that US real GDP fell in the first quarter. After increasing at an annualized rate of 6.9% in the fourth quarter of 2021, real GDP fell at an annualized rate of 1.4%, the first decline since the second quarter of 2020. Yet the reality is that the decline in first quarter GDP was entirely due to a sudden decline in inventories as well as a sudden decline in exports. Absent these factors, underlying demand was stronger than in the previous quarter. Regarding inventories, there was a massive accumulation of inventories in the fourth quarter. Consequently, businesses ran down inventories in the first quarter as they satisfied robust demand. Inventory investment is a key and volatile component of GDP. Thus, when inventories rise sharply in one quarter, thereby boosting GDP growth, they tend to fall in the next quarter, thereby suppressing GDP growth. The important thing is to look at underlying demand, which remains strong.

Let’s look at the details. First, consumer spending growth accelerated in the first quarter, rising at a rate or 2.7% after rising 2.5% in the previous quarter. This included a significant acceleration in spending on durable goods and services. Yet spending on nondurable goods declined, principally due to a drop in spending on gasoline and food—both driven by much higher prices of energy and food. The surge in durable goods was principally due to much more robust spending on motor vehicles. 

Nonresidential fixed investment also accelerated, rising at a very robust rate of 9.2% in the first quarter versus 2.9% in the previous quarter. Investment in structures, which fell sharply in the fourth quarter, stabilized in the first quarter. Meanwhile, investment in equipment accelerated sharply in the first quarter while investment in intellectual property continued to grow at a robust pace. Residential investment continued to grow at a modest pace. 

Finally, exports of goods and services, having grown at a rate of 22.4% in the fourth quarter of 2021, fell at a rate of 5.9% in the first quarter. If the impact of inventories and trade are excluded, we arrive at final sales to domestic purchasers. This is a measure of domestic demand and is a good reflection of the strength of the domestic economy. In the fourth quarter of 2021, this measure increased at a rate of 1.7%. In the first quarter it accelerated to 2.6%. In other words, underlying demand in the US economy improved. And this is despite the fact that real disposable personal income has declined in six of the last seven quarters, largely due to a reduction in government stimulus.  

Does this mean we should not worry about recession? Hardly. It simply means that the first quarter data offered no evidence that recession is imminent. Other data points to continued economic strength. The unemployment rate is the lowest in nearly 50 years. Plus, the number of initial claims for unemployment insurance last week was close to the lowest in 50 years. Still, there are substantial risks to the economy going forward. These include elevated commodity prices (which undermine consumer spending power), high inflation, tightening of monetary policy, contraction of fiscal policy as government stimulus fades away, and the negative impact that an uncertain political environment has on business investment decisions. The biggest risk comes from a tighter monetary policy that is currently under way. However, it is worth noting that, in recent history, recessions tended to begin about three years after monetary tightening commenced. 

Is a shift in US trade policy imminent?

• If you asked almost any economist to find a quick way to reduce inflation, they would likely suggest cutting tariffs. That would reduce the prices of imported goods, create more competition for domestically produced goods, and thereby suppress inflationary pressures. Yet in the United States, that is not a popular sentiment, nor has it even been discussed—until now. US Treasury secretary vetted the idea, saying that cutting tariffs is “worth considering.” In addition, Deputy National Security Advisor Daleep Singh said that the existing tariffs on China “serve no strategic purpose,” especially those on consumer goods. It thus appears that the Biden Administration is attempting to start a conversation, perhaps to test the treacherous political waters.

Meanwhile, the administration’s lead trade negotiator, Katherine Tai, was relatively quiet on the topic, not answering a question at a recent press conference. In addition, in Congressional testimony recently, she said that to cut tariffs unilaterally would imply a loss of leverage with US trading partners. She said, “No negotiator walks away from leverage, right?” 

Also, it is reported that the administration debated a plan proposed by the National Security Council to cut tariffs on consumer goods. However, the administration has, instead, adhered to Tai’s plan to focus on negotiating a follow-up to the so-called Phase One trade agreement between the United States and China that was negotiated by the Trump Administration. That agreement called on China to significantly boost imports of key products in exchange for US forbearance on new tariffs. The agreement was signed just as the pandemic began. Consequently, it has been impossible for China to meet the targets in the agreement. This fact gives the United States leverage with China.

In any event, Yellen’s comments have created a stir in Washington on the part of lobbyists and members of Congress. Perhaps that was the intention. The administration has already boosted the availability of exemptions for existing tariffs, effectively reducing the rate at which duties are imposed. Perhaps the administration will cut some tariffs before Congress has a chance to influence the process. If tariffs on consumer goods are cut, it would take time before the disinflationary effect is felt.

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