Why has the U.S. economy not declined despite high interest rates?

Dhaval Joshi, chief strategist of BCA Research, gave an explanation in the latest report. The U.S. economy has experienced a highly unusual "inversion" phenomenon, and the economic constraints have changed from labor demand to supply.

While demand is in recession, labor supply continues to be insufficient, and the two are matched, so GDP temporarily escapes the disaster.

For the stock market, declining labor demand means declining profits, because labor demand only declines when profits are under pressure. But wage deflation will drive down long-term bond yields, which will create a tailwind for valuations.

The U.S. economic model is “inverted”

Dhaval Joshi pointed out that the sequelae of the epidemic are far from being eliminated, and the supply and demand relationship in the U.S. labor market has experienced a reversal that has never been seen in fifty years. The supply of labor is seriously insufficient, exceeding the decline in labor demand. This "inverted" state forces us to interpret the economic operating model from a new perspective.

Traditionally, business cycles have been driven by cyclical fluctuations in labor demand. When demand falls far behind supply, the economy will enter a recession; when demand picks up again, it will spur economic recovery. But in the current "inverted" economy, the limiting factor is no longer demand, but a shortage of supply.

After the epidemic, the long-standing labor surplus model was completely overturned. A large number of prime-age workers have left the labor force, coupled with the impact of the wave of early retirements, resulting in a sharp decline in labor supply, which for a time could not even keep up with corporate labor demand. This factor has led to an "inversion" of the economic model.

The sharp decline in prime-age labor force participation has now completely reversed, leading to a strong recovery in labor supply. But the retirement wave has not reversed, and is unlikely to. This means that the strong recovery in labor supply has now been exhausted, with labor supply still falling short of demand by millions of people and the economy remaining "inverted."

GDP has temporarily escaped recession. When will it reverse?

At present, the demand for labor in the United States has fallen into recession, and the supply of labor is driving the economic growth cycle, allowing GDP to temporarily escape the disaster.

Dhaval Joshi points out that a recession in the U.S. economy requires one of two conditions:

First, the labor supply must shrink completely. However, given the recent surge in illegal immigration, a sustained contraction in labor supply seems unlikely. This situation may change if Trump wins the election and takes office;

Secondly, labor demand must shrink significantly, reducing about 3.5 million jobs, before the economic "inversion" can be lifted. Once the inversion is lifted, contraction in labor demand will push GDP into recession again, as it did in all pre-pandemic cycles.

But while the U.S. economy has escaped a "recession," declining demand for labor combined with stagnant real income per capita can make it feel very much like a recession.

Dhaval Joshi further pointed out that for the stock market,

On the one hand, declining demand for labor means falling profits, because demand for labor only declines when profits are under pressure. But on the other hand, wage deflation will drive down long-term bond yields, which will provide some support for valuations. Taken together, this means stocks are range-bound while high-quality bonds rebound.

In addition, there is another factor to consider, Dhaval Joshi said that any excessive pricing related to artificial intelligence will bring risks to the stock market. Without this risk, the macro backdrop would mean a neutral allocation to stocks versus cash. However, this additional risk reduces its 6-12 month equity allocation to slightly underweight.