The much stronger than expected 195,000 gain in payroll jobs – with an additional 70,000 in upward revisions to April and May – leave the markets and the Federal Reserve with a conundrum. The Fed has indicated that it wants to see 200,000 jobs a month for six months as a precursor to ending quantitative easing. That metric has now been met for the past nine months – with job growth averaging almost exactly 200,000 a month in the fourth quarter of 2012, and for both the first and second quarters this year. However, the Fed has also indicated that the unemployment rate should decline to 7.0% before it ends QE, and they expect that mid-2014. Finally, the Fed has indicated that ending QE is dependent on the economy reaching self-sustaining growth – which they project at over 3% for the second half of 2013 and accelerating in 2014 and beyond. In this month’s household report, the unemployment rate remained stuck near 7.6% for a fourth month as the labor force grew in line with job growth. Meanwhile, consensus forecasts for real GDP growth in the second quarter have been revised down to 1.5% at an annual rate, primarily based on stronger than expected imports. The soft second quarter comes after a meager 0.4% growth rate in the fourth quarter of 2012 – probably reduced by 1% due to Hurricane Sandy – and a 1.8% growth rate in the first quarter – despite a lift from rebuilding after Sandy. Bottom line, we have seen nine months of 200,000 plus jobs, but with less than 1.5% real GDP growth. Oh, and inflation has ebbed the entire time. What will the Fed do now?
The fixed income markets clearly are taking Chairman Bernanke at his word about job growth and over the past two months have spiked ten year treasury rates by over 100 basis points, now at 2.71%, in anticipation that QE will be curtailed starting in September. Meanwhile, the equity market rebounded 16 points on the S&P to 1631. The interpretation seems to be that the job growth signals a strengthening economy that will allow the previously Fed-fueled equity market to continue higher despite higher interest rates from the end of QE. We don’t see that in the data at all. Rather, we see job growth as a notoriously lagging indicator – especially in this economic environment. Strong job growth in the fourth quarter of last year was due to rebounding third quarter real GDP – up at a 3.1% annual rate. Sustained strength in the first quarter was largely due to the disgorgement of insurance payments for Sandy, which lifted construction employment and replacement sales. First quarter consumption was also sustained by the special dividends and bonuses paid in the fourth quarter ahead of the tax change. These payments overwhelmed the initial impact of end of the FICA tax holiday. But what about a third quarter of strength? Two factors appear to be at work here – neither of which suggests an imminent strengthening of growth.
First, much of the job gains and revisions in recent months were from jobs in leisure & entertainment and retail where firms are spreading work by hiring employees with less than 30 hours in preparation for Obamacare in 2014. Chris Low of FTN Financial reminds us this program has a six-month look-back, making June the critical deadline. The White House is so aware of this trend that they pushed off the start of Obamacare for one year – making the announcement on July 3rd while the President was out of the country to minimize press coverage. There is no way one can interpret an additional year of uncertainty about a major business costs as bullish for job growth. Some firms will now assume Obamacare can be repealed after the mid-term election – where historical precedent says the Democrats will lose seats and maybe even control of the Senate. Others simply will delay work spreading for a while. Medical firms, which have traditionally been an engine of job growth, now face renewed uncertainty about future revenues. Uncertainty is not good for economic growth – and this move added a significant amount considering medical cost account for over 10% of GDP. While the Fed may be clumsily trying to increase transparency in an effort to anchor expectations, the President has just re-injected Washington’s very partisan politics back into the mix leaving a wide range of policies hanging on the next elections — in November 2014! CEOs are likely to play wait and see until the outcome is clearer — many months from now.
Second, as Philippa Dunne of the Liscio Report points out, a substantial part of the job growth in June came in part time jobs for workers under 25 years old – especially for women. In part, this is due to the leisure and retail bias. However, we feel it also reflects the first decent summer hiring in four years. Seasonal factors look back five years, with emphasis on the past three, in projecting the “normal seasonal” hiring in a given month. Summer hiring in 2008, 2010, 2011 and 2012 was fairly miserable – especially for college and high school students. Finally, this year it is approaching normal. Indeed, this year there is even a re-evaluation of the legality of unpaid internships – about the only career path work young people could get for the past five years. This return to normalcy looks like a job surge after several soft years. We saw a similar pattern last Christmas, with “robust” retail hires in October and November. We will have to wait until October to see if this pattern unwinds – but expect even more part time jobs in July. However, we do not see this as a precursor to more robust hiring of full time permanent workers. On that score, aggregate hours worked in the private sector rose at an anemic 1.4% annual rate in the second quarter when compared with the first quarter average – well below the 2.8% and 2.2% growth rates in the previous two quarters. The 1.9% gain over the past year is well below the 2.7% and 2.4% pace of the previous two years. Bottom line, job growth is nice – but hours tells us more about income and corporate profits.
For CEOs, the world does not look nearly as rosy as for investors. Labor markets are tightening. Yes, unemployment in the US is still high, but skilled workers are already scarce and wages are rising again, while inflation is falling. Meanwhile, interest costs are rising – especially in the five to seven year range, where the Fed was active and businesses typically borrow from banks. Finally, global growth is slowing as the emerging markets, which have been the world’s engine of growth, are facing a stiff credit squeeze thanks to the end of quantitative easing. Higher costs and less demand do not generate an increase in risk taking or investment. True, some subsectors will perform well in these late stages of the economic cycle – but narrowing profit margins due to rising costs as inputs become scarce, at the same time inflation is slack due to earlier overexpansion, strongly suggest this cycle is winding down, not about to break out. We reiterate that the slowdown may be less pronounced in the US as money flows home to safety as it did following the Asian crisis. For the emerging markets – and the world economy – it seems a shakeout is coming.
China’s Middle Income Trap
We have been China bulls ever since we first visited in 2005. We saw unprecedented growth — in size — as they rapidly expanded along the earlier path of Japan, South Korea, and Taiwan. We anticipated their survival of the Lehman collapse, as they were still the world’s low cost producer and low cost was in great demand during the downturn. We had hoped that continental diversification would help them avoid the middle income trap that stalled their Asian predecessors – but it is increasingly clear that China will suffer from a period of sub-par growth until they deal with excesses of pollution, debt, and market concentration built up during the boom phase, and adopt freer more flexible markets to compete with, rather than simply catch up, to the rest of the world. It is clear that the new leadership will allow, and support, an economic reset, doing so now because it is easy to blame the problems on mistakes by past leaders and foreign economic weakness.
The plan appears to be to return to the reform ideals and freer markets championed by Premier Zhu Rongji. Many believe the success of China in the early part of the millennium was based on these reforms, but that benefit was squandered under Hu and Wen as state owned enterprises saw the lion share of growth. In particular, the rise of Bo Xilai illustrated to the Party that there was as much risk from a cult of personality due to the concentration of power as from a loss of control due to freer markets. The Chinese are still incrementalists, but a wave of new development zones and pilot projects reveals that they are willing to take risks. Freer credit markets, which direct funding to areas other than SOEs or property, seem at the top of the list. The recent SHIBOR spike was directed at reining in the wealth management products offered by banks which threaten a Minsky moment. Far too much of this high interest rate lending appears to be going to already overly indebted institutions and provinces so they can pay interest due on earlier investments with weak cash flow. Opening up the bond markets to provincial governments will provide an alternative, and more market oriented, access to depositors’ savings. Many feel that freeing capital to invest outside China may reduce the value of the Renminbi, increasing competitiveness with other Asian exporters while also reducing losses on foreign exchange reserves.
Robert Burns wrote, “The best laid schemes of mice and men often go astray”. Clausewitz warned,
“No campaign plan survives first contact with the enemy.” There are many entrenched dissenters to the Party’s new direction. In a society where face is a premier consideration, introducing the market concept of failure will be a painful process – as indicated by the quick backtracking on SHIBOR hikes. In this vein, due to the 2011 high speed rail debacle and the removal of its minister, the railway industry appears to be the most likely SOE to be broken up as it costs no one face. Similarly, investment in environmental control seems a particularly targeted area as it falls under no existing state enterprise purview and opportunities for entrepreneurial activity are both needed and wanted. Eliminating the Hukou system and allowing more rural residents access to health care and education is seen as a way to reduce savings and boost consumption – especially in the urban areas where many of these “illegal” rural workers now live. Sustaining low end consumption is critical, as Morgan Stanley’s Helen Qiao tells us that China’s middle class is increasingly sated – but the things they want most: like health care, clean air and water, food safety, and less traffic congestion cannot be bought in the marketplace. The middle class represents the vast majority of China’s undersized consumer sector. To successfully rebalance growth away from infrastructure investment and toward consumption will require efficient financial markets which match new entrepreneurs with initially small ideas that blossom with access to capital – or fail.
We have frequently compared this stage of China’s development with the Progressive Era in the US. After the laissez faire Robber Barons’ deflationary boom from 1865 to the Panic of 1893, a populist period of regulation, reduced market power, broader voting power, and increased unionization was ushered in. It was not easy or stable. The economy was in recession 50% of the time between the panics of 1893 and 1907. The period was enshrined by the passage of four amendments to the Constitution (one since repealed) and the creation of the Federal Reserve. Japan has for twenty years tried to avoid the hard process of opening its domestic economy to competition, surviving marginally by the extraordinarily high productivity of its exporters. Korea suffered a deep shakeout when it reformed its Chaebols. Bottom line, success in China is not guaranteed; indeed we are not sure one could even argue it was probable, as opposed to possible. What we do know is that when an $8 trillion dollar economy (over 10% of world GDP), that previously grew at 9%+ slows to 5% or 6%, it will leave a mark. China may never admit to growth under 7.5%. Watching indicators like ISMs, rail traffic, and electricity suggest it is already weaker than that. Persistent wholesale price deflation is another hint. What is critical now is whether the new leaders are able to establish their footing and get the country marching in one direction. We are no longer a China bull, but we still feel China will be the major barometer of world growth – or recession. After all, it remains the world’s factory floor, and that is where recessions and expansions are felt the most – wherever the initial mistakes or successes in political and business decisions are made.