Volume 63, Number 3
This week’s data confirm our view that the economy remains mired in a muddle through of low nominal income growth, and hence low real growth, low inflation and low interest rates. Though the economy is not in imminent danger of a recession, the fiscal cliff that is supposed to be resolved by the upcoming election leaves little reason for risk taking before November 6th (just to pick a random date.) Before then, discomfort about possible future tax policy in the US is certain to rise, and we expect little good news out of Europe or China that will provide a lift in exports to offset the domestic malaise. Though the feature in this week’s data was the weaker than expected jobs report, we feel the decline in nonfarm productivity is a far stronger signal, suggesting an ongoing correction in employment through the summer. Meanwhile, the strength in the national manufacturing ISM despite weakness in the Chicago Purchasing Manager’s report indicates a better balance in the factory sector as the recent boom in auto production is replaced with solid, though not spectacular growth, in the broader industrial sector. Bottom line, we see directionless wandering through broad trading ranges in virtually all financial markets until the ultimate question of the election is settled, with volatility providing trading opportunities – but no discernible long term trends.
Looking in the Rear View Mirror
Employment growth, which is typically considered a coincident indicator of economic growth, is behaving far more like a lagging indicator these days. Historically, the coincident nature of this indicator is because job gains were associated with increased borrowing to finance big ticket items like houses, cars and electronics due to pent up demand. Today, for workers income growth is much more about debt repayment than leveraged spending, dampening the normal positive cyclical aspects of hiring. Meanwhile, as firms have become more confident a Lehman-like surprise is not coming from Europe, they have expanded hiring and sacrificed margins as they compete for market share in a slow growth world. Thus, the hiring cycle has more to do with past profits than the future of the cycle, and recent over hiring during the warm winter crimped profits growth resulting in a payback – particularly in goods producing areas – which will continue over the summer.
Payroll employment rose a smaller than expected 115,000 in April, but revisions added 53,000 to the totals from February and March. Despite the 168,000 new jobs, there was little income growth reflected in April’s data as both the average work week and average hourly earnings remained unchanged. Slow growth in disposable income had been the bane of this economic cycle, as higher taxes and lower transfer payments have sapped the strength from solid (though not stellar) compensation growth. Now, as firms appear to be correcting for over hiring during the warm winter weather, compensation growth is slowing as well. It is hard to see anything more than a continuing muddle through without income growth to fuel the 70% of the economy represented by consumer spending. Meanwhile, continuing declines in government hiring indicate that the drag from that sector, though a desired correction, will limit headline GDP growth in coming quarters.
The slowdown in hiring over the past two months has been heavily concentrated in the goods producing areas that benefited the most from job gains during the unseasonably warm weather. In the past two months, payroll employment has risen an average 135,000, in comparison to an elevated 252,000 during the three previous months. However of the -118,000 difference, -45,000 was in manufacturing and temporary workers (many of who work in light manufacturing) and another -34,000 was in construction. Other goods producing jobs accounted for another -17,000. The concentration of the correction in the goods sector confirms that it was payback for the strong hiring during the winter – and that there is probably more softness still to come. Meanwhile, private service sector employment ran at a 101,000 average during the past two months, about the same as the 113,000 average in the prior three months. Also, government hiring was down -14,000 over the past two months compared with –3,000 during the previous three. The relative stability in these sectors – where weather has little effect — suggests that trend job growth is about 160,000. Unfortunately, we think low productivity and profits threaten even that modest gain.
The unemployment rate fell to 8.1% in April, as labor force shrank faster than employment fell. Household employment fell -169,000 in April after a -31,000 decline in April. Yet, labor force fell even more quickly, dropping 506,000 over the two months, resulting in a 0.1% decline in the unemployment rate each month. Many have argued that this kind of decline in the unemployment rate cannot continue, but it is more realistic to understand that various individuals are making long term employment decisions as the economy’s muddling along has become the norm. Many potential workers are seeking disability or social security as permanent forms of income as unemployment benefits expire. Others are attending school to attain better skills for future employment. Bottom line, of the 3.6 million new bodies available to the workforce over the past year, only 26% (or 945,000) actually made themselves available for work. This was despite decent job growth averaging 151,000 a month in the household report, which lowered the unemployment rate from 9.0% to 8.1% during this period. In our view, the solution to the unemployment problem is more likely to come via slow labor force growth, fewer workers, shorter hours and more part time work than the consensus expects, with deflation in prices for low end workers limiting – but not offsetting – a decline in living standards.
Narrowing Margins Threaten Hiring
The bad news for employment came not on Friday, but in Thursday’s productivity report, which showed an -0.5% drop in output per man hour for the nonfarm business sector in the first quarter as robust hiring overwhelmed 2.7% private sector GDP growth. This slump came after a soft 1.2% gain in the fourth quarter, leaving a modest 0.5% gain in productivity over the past year – after a lackluster 0.9% gain in the prior year. Allowing for the boom and bust in output per man hour during the recession and recovery, productivity has risen at an average 1.8% annual rate over the past sixteen quarters, exactly the long term average in the thirty years since the 1982 recession. If firms try and return current soft productivity growth to that long term average in coming quarters, hiring would have to slow substantially. Bottom line, during the muddle through either profit margins or wages must suffer; there simply is not enough nominal growth for both to flourish. Over the past year, unit labor costs rose 2.1% while the nonfarm deflator rose 1.8%, narrowing margins slightly. This reversed a slight widening during the previous year. Over the past two years, unit labor costs and prices have risen almost in lockstep, leaving profit growth a function of GDP growth alone with no help from margins. Traditionally, margin squeezes have only come at the top of the cycle, just before the onset of recession as in 1990, 2000 and 2007. The recent slowing in hiring appears to be an attempt to rebuild margins after over hiring in the warm winter – which could help extend the cycle as in 2003 or 1996 – but the bigger question remains what will margins look, industry by industry, like after the election? If tighter fiscal policy reduces hiring, the likelihood is that this cycle – already operating near stall speed – would falter.