Why we think the resilience of the U.S. economy is proving to be a real conundrum for investors.

“It was the best of times, it was the worst of times,” says Dickens’ novel of the French Revolution, A Tale of Two Cities.

It often feels that way when policymakers take the punchbowl away and a long period of financial market excess starts to unwind.

It has felt especially acute this year, however. On the one hand, we’ve had ongoing support from the pandemic-era fiscal stimulus and the strong economic recovery from the pandemic lockdowns. On the other, we’ve had to cope with the inflationary shock of the war in Ukraine and a particularly aggressive tightening of monetary policy.

The resulting crosscurrents of economic data and investor sentiment have created significant volatility, resulting in violent downdrafts followed by powerful bear-market rallies. We expect this to persist well into 2023.

Manufacturing Versus Services

Right now, it feels a bit like the “worst of times” for goods manufacturers.

The JPMorgan Global Manufacturing Purchasing Managers’ Index (PMI) peaked at a record level well in excess of 55 in May 2021. (Readings above 50 indicate expansionary conditions, below 50, contractionary.) Since then, it has fallen rapidly, slipping below 50 in September of this year. The S&P Global/BME Germany Manufacturing PMI is deep in contraction territory, at 46.2. The Institute for Supply Management (ISM) U.S. Manufacturing PMI slipped below 50 in November, for the first time since the height of the pandemic.

While it’s not exactly the best of times for services industries, they are holding up relatively well.

The ISM measure for U.S. services has kept above 54 since the pandemic, and after hitting a two-year low of 54.4 in October, saw a sharp, consensus-busting rebound to 56.5 in November.

Some of this likely reflects a seasonal uptick in activity, but there has been clear outperformance relative to the year-long decline in manufacturers’ surveys. This reflects a broad consumption transition from goods to services. While locked down during the pandemic, consumers accelerated goods consumption, pulling forward significant demand. As the world opened up, consumption transitioned rapidly, releasing pent-up demand for services such as travel, vacations and dining out.


This goods/services dynamic is notable, given the nature of the U.S. labor force in 2022.

According to the Bureau of Labor Statistics, 110 million Americans worked in the private services industries in November 2022, versus 21 million in goods production (such as manufacturing, construction and mining). Fifty years ago, those numbers were 40 million in private services versus 24 million in goods. The U.S. has fewer goods-producing workers today than on the eve of any of the past seven recessions, going back to December 1969.

During each of the seven of the most recent recessions, goods production lost a far bigger proportion of its jobs than private services. On average, more than 8% of goods jobs were lost. In contrast, outside of the Global Financial Crisis, private service industries lost fewer than 1% of their jobs during these recessions. In some recessions they even added jobs.

Therefore, should the manufacturing sector slow to recessionary levels while services continue to expand or at least remain stable, the U.S. workforce would be much less exposed today than in years past.

All of this helps to explain how the U.S. continues to add more than 250,000 jobs a month to its nonfarm payrolls, and maintain an unemployment rate close to a 50-year low at 3.7%. It helps us understand why third-quarter GDP growth came in at a surprisingly high 2.9% annualized, and why the Federal Reserve Bank of Atlanta’s GDPNow model suggests that fourth-quarter growth could come in at 3.4%. It makes sense of the surging U.S. retail sales revealed in October’s data.

We are concerned, however, that just as “pull-forward” demand during COVID has negatively affected current goods manufacturing, the ”pull-forward” demand occurring now in services will have a negative effect on future demand.

Will the Current Rally Hold Up?

The recent equity market rally appears to have more to do with anticipation of less aggressive U.S. Federal Reserve policy than with resilient economic data.

Tomorrow, we will find out where U.S. headline inflation was in November. It has declined for four consecutive months since the peak in June. The Fed’s favored measure of inflation, Personal Consumption Expenditure (PCE), also declined substantially in October.

However, the more resilient the economy, the consumer and the labor force prove, the stickier inflation is likely to be, and the higher the Fed’s terminal rate is likely to have to go. Rates markets were pricing for a terminal rate of 4.83% before the latest, strong U.S. jobs data was published, but since then have risen back above 5%—as well as pricing for a higher rate for longer through 2023.

That shift in sentiment has provided strong headwinds to the recent rally in equity markets.

A Rock and a Hard Place

It’s possible that the rally could catch hold again and that equities could finish 2022 strongly—especially if tomorrow’s U.S. inflation data comes in softer than expected.

As we’ve been arguing for a while now, however, at some point investors are likely to focus less on the pace of rate hikes and more on potential weakness in the economy and corporate earnings.

What they might see is that the resilient U.S. consumer in a safe-looking services job is quickly becoming an endangered species. Inflation has forced many Americans to burn through the high savings built up during the pandemic: The U.S. personal savings rate is now as low as it has been in 17 years, and close to a multidecade low. Alongside the “pull-forward” effect, this could soon start to dampen services demand.

That puts the economy and policymakers between a rock and a hard place, in our view: Either tight financial conditions and inflation cause a slowdown, or an even more aggressive Fed induces the slowdown to ensure we don’t suffer runaway inflation.

In short, we believe that current resilience is a conundrum for investors. It could pour cold water on hopes for a more dovish Fed policy pivot, but it could also cause complacency about the underlying economy and corporate earnings.

Faced with these “best of times and worst of times,” we continue to err on the side of caution. We anticipate continued volatility driven by uncertainty in the economic data, and ultimately see some further downside for risk assets.

In Case You Missed It

  • ISM Services Index: +2.1 to 56.5 in November
  • Eurozone 3Q 2022 GDP (Final): +2.3% year-over-year
  • Japan 3Q 2022 GDP (Final): -0.8% annualized rate
  • U.S. Producer Price Index: +0.3% month-over-month, +7.4% year-over-year (core PPI +0.4% month-over-month, +6.2% year-over-year)

What to Watch For

  • Tuesday, December 13:
    • U.S. Consumer Price Index
  • Wednesday, December 14:
    • December FOMC Meeting
  • Thursday, December 15:
    • U.S. Retail Sales
    • Japan Manufacturing Purchasing Managers’ Index (Preliminary)
    • European Central Bank Policy Meeting
  • Friday, December 16:
    • Eurozone Manufacturing Purchasing Managers’ Index (Preliminary)x
    • U.S. Manufacturing Purchasing Managers’ Index (Preliminary)

    Investment Strategy Group