At the Bank of England’s (BoE) latest meeting, a more optimistic than expected short-term outlook for Britain’s economy emerged.
One of the most notable forecasts was its call on employment.
Furlough and other emergency government measures have allowed many to keep their jobs and paycheques.
But some fear these policies are just papering over gaping holes in the labour market, and that when these schemes change or expire the number of jobless Britons will rise sharply.
The BoE’s Monetary Policy Committee (MPC) agrees with this general diagnosis, but is substantially less pessimistic about how bad things will get.
The chart below shows its employment outlook against that of the government’s fiscal watchdog, the Office for Budget Responsibility (OBR).
MPC members now expect unemployment to peak at 7.5 per cent by the end of the year, a milder bout of joblessness than after the global financial crisis.
The OBR by contrast expects unemployment to peak around or above the previous all-time high back in the early 1980s.
What employment figures can and can't tell us
The vast difference between these two outlooks is rooted in the extremely uncertain economic prospects for the coming months.
High unemployment is the hallmark of all normal recessions.
As revenues start to fall, businesses scramble to cut costs, the biggest chunk of which is almost invariably wages.
Rising unemployment naturally then leads to falling aggregate demand, as households lose the confidence and ability to spend, hitting company revenues and perpetuating the vicious cycle.
As such, keeping track of employment figures is clearly important – they can tell us if and when the current crisis shifts from a short government-induced recession into a drawn-out ‘classical’ one.
However, we should be careful not to overstate the importance of employment statistics in terms of their effect on capital markets.
Even at the best of times, employment figures tend to be a lagging indicator of economic recovery – as firms only start hiring when demand for their goods is already picking up.
Equity markets often ‘look through’ and beyond high unemployment rates to the light at the end of the tunnel.
In the US, in the midst of the last recession, the S&P 500 began its long recovery rally while unemployment was still rising – with unemployment not coming down until 2010 (see chart below).
Plugging the virus gap
Equity investors tend to factor in improved earnings for the next few years, even if the unemployment rate remains elevated.
That they will do so now is less certain.
Extraordinary central bank action – and returning risk appetite over the last couple of months – has already led markets to price in future good news.
A bout of bad news could knock equities off their path. A more dire trajectory for unemployment, as the OBR predicts for the UK, could certainly do that.
This could happen should markets perceive governments to have made a policy mistake, or if they abandon their faith in the ‘reflation trade’ (that is, the optimism that a decent recovery will happen).
Markets may instead choose to believe that global activity will remain depressed for some time.
As we can see in the resilience of household incomes and retail sales, policymakers have so far been reasonably good at plugging the virus gap.
But with the harshest phase of lockdown now hopefully behind us, both policymakers and the public are craving normality. At some point, that will mean an end to emergency support measures.
The UK’s furlough scheme ends in October.
If a resurgent virus forces workers home just as the scheme winds down, and the government is unable or unwilling to extend it, markets would have to drastically adjust their economic recovery expectations in light of rising unemployment.
Equity prices would almost certainly fall, to reflect lower household spending and a weaker earnings trajectory.
If policy mistakes or a deepening of the crisis caused markets to abandon hope of a reflating economy, things could get significantly harder for investors.
As we have written before, rising inflation expectations can push real, inflation-adjusted yields into the negative. This reflects investors’ belief that policy will be successful in generating growth and inflation and has been supportive of equities.
Loss of that faith could cause a period of stagnation, as seen in Japan's 'lost decade', where investors come to expect no positive changes in the underlying economy.
Fortunately enough for now, the opposite is happening. Real yields keep falling, and inflation expectations recover.
A question of confidence
One of the key difficulties with forecasting unemployment is gauging how much of the fall in demand is due to short-term government measures, and how much is due to longer-term concerns over health or income which undermine confidence to spend.
This can make labour market comparisons misleading.
For example, in the UK, the unemployment rate for April and May remained at just 3.9 per cent.
But since this excludes those on furlough or other virus-related measures, it's an inaccurate reflection of Britain’s labour market.
In the US, unemployment shot up to a record high of 14.7 per cent in April, recovering only to 10.2 per cent in July.
But the differing statistics across the Atlantic have little to do with differing economic prospects; rather it is because the US government’s emergency wage schemes are largely through unemployment benefits instead of job retention schemes.
This is why unemployment changes – particularly in this crisis – are not the best indicators of economic prospects.
After a shock like this, the businesses that have survived long enough to take advantage of rebounding demand will be the ones to do well – and the ones to begin hiring again.
Aiding the recovery will depend on authorities here and elsewhere keeping monetary and fiscal policy as accommodating as possible.
For its part, the BoE has suggested it may do the opposite and taper down its policies towards the end of the year.
We suspect this was intended to underline the Bank’s confidence in its own rebound forecast, but is nevertheless hugely unlikely – at least if the Bank wants to fulfil its less gloomy forecasts.
The MPC has also assured markets that tools remain at their disposal should the economy need more support.