Volume 63, Number 1
Payroll employment rose a disappointing 120,000 in March, slightly less than half of the average 243,000 gain over the previous three months. Employment fell -31,000 in the household report, yet the unemployment rate dropped to 8.2% as the labor force shrank by -164,000. We see this below average job growth as the beginning of a period of payback for the exceptionally strong employment growth in December, January and February. The 120,000 in February is only slightly below the 145,000 average over the past twelve months, which we believe is due to the continued very mild weather through early March (the survey is taken in the week containing the twelfth) particularly in the Northeast and Midwest. We expect employment gains to remain muted, but we do not expect weakness like over last summer. Last year real GDP was running at a 1.8% annual rate in the third quarter, before jumping to 3.0% in the fourth. We see the first quarter near 2.5% — effectively the average of the second half of 2011 — and expect roughly that rate for the remainder of 2012.
Employment is traditionally a coincident indicator of economic growth, and we would argue in that in this environment of deleveraging it has become a lagging indicator. Businesses are waiting to see other peoples employees spend at their stores before they hire themselves. When the economy picked up in the fourth quarter –a lot of which was inventory accumulation – the combination of stronger growth and mild weather led to robust hiring from December through February. Now as real GDP growth in the first quarter has slowed, despite better consumer spending, businesses are belatedly cutting back on hiring as well. Private sector hours worked rose at a robust 3.7% annual rate in the first quarter when compared to the fourth, suggesting significant negative productivity as we estimate private sector GDP grew about 3.0% in the quarter – and productivity correlates well with profits. Businesses are likely to trim hiring to maintain balance sheet strength much as they did during the Japan supply chain disruption last year.
The good news for the overall economy is that flat employment in the government sector is a significant improvement from an average of -25,000 for most of last year. We estimate that this leaves government sector real GDP growth near zero, compared with -3.5% on average in 2011. Bottom line, this reduces the drag from the government sector on overall real GDP to only -0.5%, down from -1.2% last year. Indeed, in our view, private sector growth has not changed much from a year ago, the real key to better – but still only at trend – GDP growth is the reduction in government drag. Indeed, it has been the sharp increase in taxes and fees, which has reduced consumers’ real disposable income, while rebuilding state and local government balance sheets and allowed them to stop reducing employment.
The key problem for the economy remains the banking sector – and everyones’ lack of desire to borrow. If surges in income growth are not leveraged through new borrowing, so that freshly hired employees are consuming more than they produce thus requiring even more fresh employment, it is hard to get the economic cycle started. Early in a cycle, new hires are typically coming off unemployment benefits – meaning their cost to the business sector is more than their increase in spending power. Typically, this reversal of the recession dampening effect of the government safety net is offset by the fact that new hires borrow to buy a new house, a new car and a new big screen TV. In this cycle, even three years after the recession, new hires are still coming off the unemployment rolls, rather than being fresh out of school or housewives attracted into paid work by rising wages. The income of fresh hires is typically pure new spending power, whether they use leverage or not. Bottom line, the slow pace of this recovery is due to the slow growth in spending power as income growth from hiring is offset by reduced government transfers and higher taxes, and compounded by a lack of borrowing. The tax bite will not get smaller soon – indeed, the election is only about how much smaller (and for whom) the effect of the massive planned tax hike will be. As for borrowing, we still see few signs that the consumers’ appetite for loans is back. Car sales were at a 14.3 million unit rate in March down from 15 million plus in January and February. Single family home sales have remained disappointing despite mild weather and sustained low interest rates. Without credit demand the economy is doomed to muddling along at trend – or below. That will leave unemployment and economic slack high, and interest rates and inflation low by historical standards.
Even if lending does pick back up, it is not clear that it will be from money expansion through the banking systems fractional reserve system. More and more banks are simply acting as fee generating loan originators for private pools of capital. They are not lending against deposits, but simply packaging and selling loans, like a mortgage brokers. Bottom line, in today’s environment there is still far too much capital chasing far too few investible ideas. There is no need to expand the money supply to create new funding. Until loan demand exceeds available capital, and interest rates move back above zero, the economy will likely remain mired in slow growth and low inflation. Moreover, it is up to the market, not the Federal Reserve to generate the first hike in rates. Any premature move by the Fed would only crimp loan demand, leaving the economy in a liquidity trap.
Back when then Governor Bernanke gave his famous helicopter speech, it was consensus that monetary policy could do it all. Chairman Volker had showed how to end a rampant inflation with his brutal squeeze on money growth. The assumption, implicit in Bernanke’s remarks, was that it was also easy to end a deflation – just print enough money to generate inflation and then apply Volkeresque strategies to fine tune. His remarks were made after a decade long failure by the Japanese to generate enough inflation to push interest rates into positive territory where the central bank would then have some ability to affect the economy. Now after two rounds of quantitative easing in the US, and more rounds in Europe and the UK, we are discovering what the Japanese learned long ago – generating inflation is not nearly as easy as it seems. Our history in the post war period has been one of scarce resources – particularly capital – and inflation was always positive. Now, we are learning – as after the Depression –how difficult it is to get consumers back to spending other people’s money. As Mark Twain noted – and Dennis Gartman often repeats – a cat that sits on a hot stove will not sit on one again, or a cold one either!
It is also important, especially for investors, to remember our favorite formula – part of it plus the rest of it equals all of it. Income, spending and inflation are all rising in the investor community as the stock market recovers. But that is not what is happening at the lower rungs of the income ladder. Note that the European economy looks much better from Germany – where unemployment is low and some are complaining of price pressures. However, just as the inability to borrow in the non-German parts of Europe are holding back growth there, a lack of borrowing by the bottom 90% of earners in America is limiting our economy’s upside. Bottom line, we are not looking at initial claims for unemployment, or payrolls or even income as lead indicators of the economy. The traditional pattern of “give them income and they will borrow” is not working. Rather we are looking for signs that banks feel comfortable enough with their balance sheets to expand loans. The recent stress tests suggest that that is true for fifteen of the top nineteen banks – but anecdotal evidence suggests the rest are still hunkered down waiting for higher home prices, and not just for one or two months. We believe that until home prices show they can outrun inflation for at least a year the US economy will be stuck in a muddle through – with the risk to the downside. That’s our story and we are sticking to it.
We apologize for the lack of pictures this week. We are writing from the road and about to head for Xian, Shaanxi, China for a week. We will report back next week on how the lead horse for the global economy is doing — is the recent slowdown a pause that refreshes or something more serious?