A complacent consensus interpreted the 175,000 gain in payroll employment in May as a continuation of the recent long muddle through – but they have their eye on the wrong ball. They are focused on when job growth will accelerate to meet the Federal Reserve’s recently expressed hurdle of four consecutive months with over 200,000 new jobs, which could lead to the tapering of QE. We do not believe we will meet that metric anytime soon. Recent experience shows that strong job growth comes in the winter months when there are fewer layoffs than expected, while weak job growth comes in the spring and summer when there are fewer hires than expected. Firms have slowed layoffs, as is clear from the moderate descent in initial and continuing claims for unemployment. However, businesses have been reducing their demand for additional labor for the past two years in response to slower growth in profits. True, job growth has been steady with the twelve month moving average stuck in a narrow channel between 187,000 and 164,000 over the past fourteen months. However, the reality is that the annual gain in aggregate hours worked has slowed steadily from a peak of 3.5% back in February 2012 to just 2.1% over the past twelve months.
History shows that once growth in hours worked is in a downtrend, it take a jolt of stimulus to ignite acceleration. Growth in hours worked plateaued for roughly three years before falling below 2% in 1989, 1995, and 2007 – and 2013? It rebounded from a slowdown in 1997 because money flooded back to the US during the Asian Crisis. Another modest rebound also came in 1999 as the fear of Y2K spurred economic activity and the Fed pumped up the money supply. Unfortunately, we see no new savior stimulus on the horizon from an expansion of QE, tax cuts, or government spending increases. With profits foundering, we expect no autonomous surge in private investment. A shock from abroad may send money rushing for a US safe haven as during the Asian Crisis. A problem in core Europe – especially France – or a faltering in China are at the top of our list. Either or both would likely spark a deflationary shock in the US through a stronger dollar and falling commodity prices – especially for oil. Bottom line, we remain convinced and concerned that the US and world economy are closer to the end of this economic cycle than to the start of a stronger expansion.
Employment is a coincident indicator and the unemployment rate a lagging indicator, making them exceptionally poor metrics for determining monetary policy. There are three phases of the normal expansion of labor demand: 1) first, hours per worker recover for those employees considered so valuable that they were not laid off in the downturn; 2) after normal hours have been restored – and indeed, the core workforce is often overburdened – new hiring flourishes, focused first on temporary workers; 3) as the labor force starts to tighten competition for the most productive workers begins to drive up wages, especially relative to firms’ ability to raise prices (inflation). We are now in the third phase of labor expansion. Growth in hours per worker peaked back in October 2010 – the first month that annual job growth turned positive. Over the cycle, faster job growth has
been offset by slowing growth in hours per worker generating overall slower growth in aggregate hours worked for the past fifteen months. Now, wages are starting to rise — as inflation falls –causing both blades of the scissors to cut into profits growth. As noted last week, profits growth slowed to zero over the past two quarters – and there is nothing in the second quarter consensus call for less than 1.5% real GDP growth and roughly 1% inflation that would indicate profits will accelerate. Even modest increases in both hours worked and wage rates have pushed growth in labor costs above growth in nominal GDP – beginning compression in profit margins and the end of the economic cycle. Corporate balance sheets are still strong, so the competition for market share should keep the economy expanding as profits shrink for several more quarters. However, the US will become increasingly vulnerable to an external shock as corporate balance sheets erode – whether due to rising labor costs, dividend payouts or stock buybacks as firms seek to keep stakeholders happy.
The Drury Rule
I have long maintained that if an economist is going to call for a boom or a bust, they should be able to point to three cities or three industries that are either pedal to the metal or in free fall as the drivers of that forecast. During this muddle through, we easily identified state & local and, eventually, federal government as the drag on the system. Meanwhile, oil & gas (actually gas, then oil) and housing & autos provided the lift. The drag from reduced direct government spending was deep, falling at a 4% annual rate and acting on 20% of the economy. However, expansive federal transfer payments – which rose by 4% of GDP early in the crisis – helped cushion the blow for consumers. The trio of surges in oil, gas, and autos would normally have satisfied our boom requirement – but, unfortunately, the interest sensitive sectors are so atrophied compared to even their normal troughs that they provided far less oomph than in a normal expansion.
Now, as we look forward, we are losing even these extremes as the economy settles into a dissatisfying slow growth, low divergence, status quo. The effects of reduced government spending should be worst due to sequestration in the third quarter, with a rebound in the fourth quarter, and less drag in 2014 as improved state and local budgets offset ongoing federal deficit reduction. Meanwhile, the previously robust growth from energy, housing and autos will fade. Positive effects from shale oil & gas will slow primarily because trees don’t grow to the sky. With the Bakken and Eagle Ford already in production it will likely be a while before Marcellus shale or Utica join the club. Housing and autos have already wound down from their peak growth rates, and over the past six months unit sales of existing home sales and autos appear to have plateaued. If interest rates see a sustained increase, they both may become drags going into 2014. However, for now we are agnostic about domestic growth prospects, and are sticking with a forecast of a 2% muddle through for real growth with low inflation. The consequent modest growth in nominal GDP will make it hard for the private sector to pay down debt and regain confidence in fresh green field investment.
No Pain, No Gain
What would brighten our economic outlook? For us the key would be political progress on the many structural imbalances that are holding back investment around the world. Virtually every country knows they need reform post-Lehman, but few have the political will to sacrifice jobs now for stronger growth later. Governments have never been good at initiating Schumpeterian creative destruction, and with cautious financial markets the private sector is hampered as well. Japanese Prime Minister Shinzo Abe just announced his “third arrow” of reforms – but with an upper house election coming in July they were predictably tepid. Perhaps we will get a stronger thrust after the elections. Europe is also hobbled by Merkel’s bid for re-election in September, which suggests there will be no big push for fiscal reform before she is safe for five more years. China’s newly elected
leaders are also talking a strong schedule for reform – while their economy is showing increasing signs of economic weakness. China has more policy levers to pull than any other country on the planet, with deep reserves, a strong currency, very positive real interest rates, and a nearly balanced budget. However, it has less experience in using these levers – especially for fostering a consumer led recovery — and we may have to wait until the traditional November economic report for the new Administration’s marching orders. In the US, corporate leaders are still waiting for clarity on Obamacare, Gramm-Dodd and a wave of other regulations. The good news is that political gridlock probably means no new initiatives until 2015. For the emerging markets, weakness in the developed world is crimping export led growth, while a liquidity crunch is hampering domestic initiatives.
Apparently, money still makes the world go around.
Bottom line, we do not see strong political leadership that will spark a revival from the current global economic malaise. Recent export-led improvement in Japan is coming at the expense of South Korea, Taiwan, and to a lesser extent China and Northern Europe. Europe is expected to recover next year, primarily because it is in recession now. It is possible a period of rolling
recessions and recoveries among regions will allow sustained global growth. However, we still see the economic path of least resistance as a slide into renewed recession somewhere in the next eighteen months – probably a much milder 1990 or 2000 style downturn, not a Lehman-like crash – and with few policy levers left to pull the main corrective process will be from prices falling until markets clear. This is painful old school pre-central bank deflation, like what is going on in the periphery of Europe today and what happened in state & local governments in the US over the past five years. With monetary or currency levers already at their extremes heading into the recession, fiscal leaders will have to do the hard work they seem unwilling to tackle so long as growth is even muddling along. With a plethora of best practices adopted during that downturn, the following expansion should be more similar to a post-war norm – but first we have to get there.