The US economy needs to generate unemployment of at least 1.5%, if not 2.0%, to generate a wage growth outcome of 3.5% to 4.0%, which would get the Fed moving down towards its target inflation zone. This matters because US Core CPI is being driven by shelter and services inflation. If goods inflation today were contributing zero to core CPI, then core CPI would still be 5% by virtue of Shelter and Services Inflation. In this respect, wage growth matters and getting to a satisfactory level will require higher unemployment. 

To hear Paul's thoughts, watch the interview below. A summary follows.

The graph below shows the direct relationship between wage growth and Shelter and Services Core CPI contribution. Wage growth is feeding Shelter and Services Inflation, and it is becoming a significant risk of spiralling. 

To solve this, we are left with the need to increase unemployment in order to suppress and break this spiral of wage growth and services inflation. 

In the next chart, we can see the current read for wage growth and inflation in the big green dot. It shows, in the grey line, the post-GFC relationship between unemployment and wage growth appears to have broken down, with lower unemployment generating significantly higher wage growth. 

Our view is that the combination of the post-Trump immigration decline and a poor policy response to COVID has resulted in both a structurally smaller and less flexible labour force. Unemployment has to increase some 1.5% to 2% to get to a more satisfactory level of wage growth, and in turn, shelter and services inflation. This is the pivot point. The Fed may reduce the scale of rate increases, but they will otherwise persist until such time as unemployment starts to purposefully materialise. 

In saying that, the anecdotal evidence at large US corporates is that significant layoffs are occurring. The markets are fixated on inflation, but not the one that matters, Shelter and Services inflation. They need to watch unemployment to understand the Fed’s policy pivot.

Without exception, to generate a 1% or more increase in unemployment, a recession will result. US recession in 2023, we think should be the central case for investors.

So, what does this mean for investors?

• The Fed and other western central banks do succeed in significantly moderating inflation

• Bond and Treasury yields will moderate, which will provide good positions for investors

• Greater capital investment and intensity to support industrial demand

• To position into high-quality industrials, which are well priced for 2H 2023 and into 2024.