Who’s Actually Winning This Economy?

Summary

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Mary MacNamara

Hello, everybody, and welcome to Cents of Security. We’re here with Interactive Brokers Senior Economist Jose Torres to break it all down for us. Good to see you, Jose. How are you this midsummer?

Jose Torres  

Hi, Mary. Great to see you. Always a pleasure to be on the program. How are you?

Mary MacNamara

I’m doing great. So, tell us what’s going on.

Jose Torres  

First, I’m going to need a little soft drink because it has been quite hot up in the Northeast and down here in Miami. But I’ll, now we’re ready. Now we’re ready. So today we got the jobs report. It was a big miss. It was the first decline since February, 23,000 people off of payrolls, less. Now the unemployment rate went down from 4.2% down to 4.1%.

That was due to a 250,000 people dropping out of the labor force in July. In June, you had a 750,000 number also dropping out of the labor force. So, in the last two months, one million people said, “I don’t want to work. I’m not looking for a job. I have given up. I’m discouraged. I’m retired. I want to stay home. I want to take care of family members. I want to take off for a year or two.” So, we have a, a large segment of the population that doesn’t want to participate in the labor force. The pandemic, of course, that introduced a lot of early retirements. You had stock markets do great. You had home prices do very well.

If you had two or three homes, if you had a stock portfolio, you got a lot richer right away, maybe 30 to 40% increase in your net worth over an 18-month period or so. That drove a lot of retirements back then. And then now we have the immigration restriction issue, which was a headwind during Trump 1.0 from 2017 to 2021.

But now, combined with those headwinds from COVID, they’re stronger here in Trump 2.0. In fact, Mary, the labor force participation rate, it’s at its lowest point it’s been since 1976. When you eliminate the pandemic period that, of course, the participation rate dropped quickly, but it wasn’t a longer-term view.

But really, we’re seeing that labor as a percentage of national income is becoming lighter. Assets as a percentage of income in re- in relation to gross domestic product is more elevated. So, folks are depending more on their income from assets rather than their income from labor, and that’s really causing this shift in the labor market.

And also, demographics. We’re an aging population. We don’t have the births. So we’re moving into, more of a stagnating kind of labor market. Of course, if the Democrats come back into power, you open up the borders, the conversation changes. But for right now, with the Republicans in until at least January 2029, you can expect this slow kind of grind, this stagnating labor condition that we’re in.

Mary MacNamara

Interesting. So also, with Kevin Warsh now chairing the Fed and three members pushing for a rate hike just last month, does this weak jobs report kill any chance of a possible September increase, or could it flip the conversation entirely towards cutting rates instead? What do you think?

Jose Torres  

No. Definitely not flipping it to cutting rates. We’re here now. What happened is that the rate hike for September was at fifty-fifty in our prediction markets here at Interactive Brokers. That dropped now to thirty-three percent on a hike. So now folks are looking at October or December as the first hike. The Fed is way behind the curve. What happened with Fed Chair Warsh is that he started off communicating such a hawkish view. He came in saying, “Things are going to change around here. We’re going to be looking for the two percent target. We have an unwavering commitment to pursue our inflation mandate, given that prices have run above target for five and a half years.”

The issue is, though, Mary, is that he’s had two opportunities to lift rates or to do something on the balance sheet, but what we hear is that from him to justify his slowness in moving or his pace, rather, not necessarily slow, but maybe not as fast as other people would like, or as he maybe himself had folks perceive is that you’ve had rates steady two consecutive meetings, and the balance sheet is also increasing.

So, he says, “Hey, I just started the job. I need more time. We just got here. Rome wasn’t built in a day,” those kinds of messages. But the yield curve is saying, “Hey, you ought to be a lot higher.” The two-year yield, which the two-year Treasury yield, which essentially is a barometer of what Fed funds should be on average over the next two years, considering inflation growth and those dynamics, that’s at 4.2.

The Fed is at 3.62, so really way behind, and we’re still in a loose environment that, can really unleash a lot of inflationary pressures. Of course, the political situation is top of mind. We’ve been hearing President anecdotes suggesting that President Trump has been calling Fed Chair Warsh a lot.

The last meeting he lost control of the room a little bit. The reporters started challenging him on why he isn’t doing enough, which was, Mary, a one-eighty from the first meeting, the first Warsh presser, which was, “Wow, we have this new guy here. He’s going to tighten. He’s going to raise rates. He doesn’t care about the market. He cares about inflation.” But the second meeting, Mary, the reporters were asking what are you waiting for?” So, we’ll see what happens. He has a break August. You have Jackson Hole, Wyoming. That could be a point where he can start to reset expectations.

Right now, the markets are saying he’s going to pause. Of course, with contracting labor, that widens the path to staying steady for a longer period of time because irrespective of why we’re losing jobs irrespective of the unemployment rate dropping, a critical point is that when you’re losing employment, when payrolls are declining, you are presenting a headwind to the expansion.

Because negative 20,000 could much easier become negative 50,000 than if you were up at 100,000, right? Negative 20 is closer to negative 50, closer to negative 100, right? So, you’re going in the wrong direction irrespective of why. I’m telling you that this report did- it doesn’t really matter that much from a labor perspective, but in the medium term, in the longer-term view, we’re not going to be able to handle a lot of negatives in the next 12 months or so.

Mary MacNamara

Yet stocks had one of their best weeks of the year, right? So, what does it say about the about the market when the economic news is treated as good news for stocks? Or it appears that way at least.

Jose Torres  

Yeah, the market has done great. Monday and Tuesday were terrific days, and really the reason they were so terrific, Mary, is because the president was essentially saying that there’s going to– there’s a deal with Iran around the corner. However, as the week has progressed, it’s now Friday, August 7th we’ve seen a lack of clarity on what’s actually going on in the Middle East.

There are talks about Iran and Oman agreeing to something. The US’ terms aren’t there. We don’t know what the US position is. We don’t know how the talks are going. Interest rates and oil just essentially started to reflect that risk. Rates would be a lot lower after this payroll report if it were for some clarity on the Middle East situation, because what fixed income people have to do now, they have to balance, okay, we have economic slowdown risk here because the job market is now declining in payrolls.

However, we still have this inflation issue heading into the weekend when we know that some hostilities, we’re vulnerable to see some hostilities over the weekend. So, balancing those things out, rates aren’t falling as much as they were. In fact, h-half of the gain in Treasuries or half of the fall in rates has already been recovered as the session has progressed.

What does it mean about the entire economy? The entire economy and the corporate earnings backdrop is really being driven by the AI, the capital expenditures, and the construction. Doesn’t have to do with people for the most part. It doesn’t have to do with consumer spending. It doesn’t have to do with labor markets. It has to do with AI and the race for AI. When you have a race for products, for semiconductor chips, for data center, for construction, you’re willing to pay more. When you pay more to another firm, that helps their revenues, assuming their costs are not rising as fast. That’s expanding earnings.

Everyone’s talking about how earnings are up 25% year over year. Crazy number like that, and it makes sense why stocks are doing so well. The consumer-focused companies, the McDonald’s, the fast casuals the firms that their business depends on regular people on the street, those businesses aren’t doing as well as the technological AI kind of focused companies.

Mary MacNamara

I know they can’t find enough people to build out the data centers that they want to do. They’re just like, “We need electricians, we need engineers,” and so on and you would think you would see more job growth in those areas that possibly would offset, some of the less labor participation.

All right, so let me ask you a different question here.

Jose Torres  

I just checked, by the way consumer discretionary stocks, XLY, down this year. Market up huge. Consumer discretionary down. That’s the sector that shows you, how the households are feeling.

Mary MacNamara

What about credit reports?

Jose Torres  

Oh yeah, that’s been going on for ages. There’s a lot of workarounds. When the time comes where folks can’t pay, there’s a workaround. They are “Okay, we’ll cut the balance in half. We’ll give you a, a five-year time horizon. We’ll consolidate.” There’s a lot of liquidity in the system.

Lenders don’t want to necessarily punish borrowers in this environment, so you have this situation where these things can just really go on forever at the, it seems, because lenders aren’t really punishing borrowers. They’ll work with you as a borrower to the extent that is possible.

And a lot of times it is, especially when you have a low unemployment rate. They could have wage garnishing. You can have all kinds of things happen. But absolutely, the credit sector, we’ve been seeing balances of course through the roof, delinquencies up. Autos, people going eight years on their auto loans, which is sometimes you only have a car for three or four years. For you to go out eight years on a loan, things like that are problematic

Mary MacNamara

So you answered my question is about why Americans are still calling the economy poor in polling, they’re just not seeing it in their pocketbook, and also with gas prices and the mortgage rates too, right?

They are still high.

Jose Torres  

Paychecks haven’t risen as fast as asset prices, and in America all the world really, most of society is conditioned to go to work, get a paycheck, and live off of that, right? That’s what most people are conditioned to do, but we’re moving into a system where the people that can do well are those that have assets, that see stock prices go up, that catch dividend payments, that catch rental payments.

It’s becoming more of an asset-based society. Labor isn’t being rewarded that much. On top of it, some of the highest paying sectors, big tech/information, finance, those two sectors have been areas where young people have been able to depend on employment opportunities to show up at a bank, show up at a big tech firm, and have really strong earnings.

Mary, those two sectors are the ones that are leading in the AI adoption in terms of AI technologies replacing a lot of the humans. At the margins, nothing too significant, but outside of those two sectors, we’re not seeing that the overall economy, overall employers really know what to do with AI.

There’s a lot of hesitation. There’s a lot of confusion. How do you use the technology and the humans in tandem to achieve optimal result? Most businesses don’t know how to do that, but big tech and finance, they’ve been able to do that. Finance employment is down significantly, over the years, and also big tech is as well, information.

Part of it is because they’re spending so much money on the data center build-out and the AI and the chips and all that, that their cash flows are going to zero, and the only way to keep justifying that, that investment and have a little bit of an opportunity to have positive cash flows is to reduce headcounts

Mary MacNamara

Yes, unfortunately. But healthcare seems to be consistently strong, right? And is that because of the, the boomers? Obviously, there’s a lot of I think we’re in late stage boomer phase at this point, and so that must be, helping the whole healthcare sector.

Jose Torres  

Oh yeah, definitely helping the healthcare sector. It’s going to keep growing. Yeah, the, we have this aging population. The, the need for those people is is rising. So that’s going to be a structural uptrend. And it doesn’t depend on the cyclical backdrop. It, a lot of those jobs are paid for, almost all of them really, through some kind of government stipend or government disbursement of something, whether it’s to a hospital, to an insurance program, right?

Its very government controlled, the healthcare sector. Especially in the 21st century after we’ve had some legislation that’s really changed the medical space. A lot of government involvement, so that really offers a lot of stability for those jobs. Similar to education but without the aging component of course.

And education, especially Higher Ed, has had, obviously some issues as well.

Mary MacNamara

So last question, it wasn’t on my list, but I’m going to ask it anyway. There was some information earlier in the week about us helping Japan or some guidance there on their rate. What was that all about?

Jose Torres  

Yeah. So essentially, a lot of people borrow in Japanese yen. They have a very low interest rate at 1%, the Bank of Japan, and for years it’s been considered somewhat of a stable currency for you to go there, borrow in yen, and then buy higher yielding assets like tech stocks, like another country’s bonds or something like that.

However, that calculation – becomes more complicated if you just borrowed in a currency and now that currency strengthens significantly, right? Or weakens significantly. It starts to mess up the calculation on what you’re doing in either direction. So, keeping a stable yen is pivotal for financial markets overall.

It’s also pivotal because the Japanese hold a lot of US Treasury debt, and we have such an intertwined system. Of course, they’re part of the G7. So, because of that, after 2024, specifically in August, we had a day where the S&P fell like 5 or 6% overnight. A really a crazy de-leveraging event.

That we’ve had some shock absorbers, people watching that situation more closely because, if you just borrowed yen, moved over to dollars If the yen strengthens significantly, now you have to find more dollars

To pay back that loan. But if, what if the tech stocks you just bought with those dollars also dropped, right?

So, you have this whole situation where You have less dollars and the yen is stronger, so now, you’re in a squeeze. So, things like that happen on both sides. And just once again you borrow in Japanese yen at 1.5%, call it 2%. You go buy US tech stocks that yield maybe 15 or 16%. You have to pay back the yen.

But if the yen strengthens a lot while you’re in dollars, that means you have to put up more dollars to buy the yen. But the tech stocks weaken, now you have less dollars, so now you have to find a lot more dollars to pay those loans. And of course, if that happens across hundreds and thousands and tens of thousands of cases, now you got a problem.

Mary MacNamara

You got a problem.

Jose Torres  

You got a big problem. So for that reason, Secretary Bessent is constantly talking to the Japanese because they don’t want to have that kind of case. And if they start having issues, then they’re not buying bonds or now they need to raise cash, they need to sell bonds. Of course, that would push interest rates here higher, and we don’t want that. They’re already too high

Mary MacNamara

Jose Torres, you are amazing and your perspective is just so clear. We really appreciate that. Thank you so much for joining us today. And listeners, thank you for listening to our podcast. We appreciate it

Jose Torres  

Thank you