Strong Employment But Still Lots of Slack
Sentinel Investments
By Christian Thwaites
October 8, 2012
The ECB's dearth of tools came through loud and clear last week. Rates remained unchanged not because the economies have a ghost of a chance of recovery but because inflation, at 2.7%, scored well above the 2% target. There's a certain amount of in-built inflation in European economies not present in the US, for example, indexing across many industries and pensions, VAT and euro denominated commodity costs. The combination of higher oil costs and a weaker euro put some of the YOY increases in energy costs as high as 40%. Not all fall through to final consumer prices but it does make the inflation target a very difficult animal to pin down.
So with declining economic outlook and inflation unbound (at least by their own standards), Mario Draghi laid out a stout defense of recent programs. Recall that OMT a few weeks ago was to help countries that i) delivered reform programs ii) formally requested help and in return iii) the ECB would buy short-term bonds to relieve funding pressures. Since then the OMT program has bought precisely...nothing. So the obvious questions were when, where and how much? There was clarification in the press conference. Here it is. Apologies in advance but, really, there's not much license in this:
The ECB is ready to undertake OMT when everything is in place and when it's warranted by monetary policy and as long as there's conditionality. We will exit from OMT when the objectives are achieved or when there's a failure. We certainly won't continue if a program is under review but will resume if there's compliance.
That's a rather opaque set of guidelines in our book. But let's try. Now, given that the ECB runs monetary policy, the start gun would seem to be in the ECB's hands. But it appears not. And if they start a bond buying program they will stop if a reform program is in review. Does that mean they would sell the bonds they bought? And if the transmission mechanisms are broken in Europe, as the Bank regularly states, what would be the point of any rate changes?
This is not to pile on opprobrium. But there's a toxic combination of M3 growth barely above inflation, contracting credit and nearly all economic indicators unambiguously downbeat. Recommendations for unified bank supervision and fiscal compacts are all well and good. But direct action is a still a distant prospect for Europe. There's also probably more to come. So far, Germany has been the driver for change and been able to point to its own deft economic performance, export success, labor reform, low unemployment and growth. All that is set to change. Third quarter GDP may well prove to be negative which will limit Germany's ability to pressure the European bodies and its willingness to back stop ESM and OMT type programs.
Brief Shining Light
The employment numbers surprised. There was a thread in the last few weeks that looks clearer now. The NFIB reported optimistically on employment a few weeks ago, which also showed up in better ADP numbers, and we saw some bounce in the ISM numbers. The ISM series has two components, manufacturing and services. The manufacturing report is older and enjoys a solid record for tracking growth. It gets a lot of attention because manufacturing is such a high value added part of the economy, around 7% of employment and 11% of GDP. Both indexes gained in September. A useful way to think about them is to GDP-weight them at around 89% for services and 11% for manufacturing. This gave us a score of 54.7 in September and 53.2 in August, which led us right into the NFPs for September which showed a 114,000 gain.
There were a number of positive developments. We have discussed for some time government's net drag on the economy for a number of quarters. Here we show the consistent 0.5% negative contribution to GDP growth of only around 1.5%. It's the longest period of negative growth from the government sector in over 40 years.
Source: Federal Reserve Bank of St. Louis, Economic Research
So you would expect that to show up in the number of government employees and, helpfully, it does with the number dropping consistently since 2009 with only a brief respite in the census hires.
Source: Federal Reserve Bank of St. Louis, Economic Research
A final part of the puzzle is the participation rate which is shown here inverted in blue against the headline unemployment rate. Usually, and not surprisingly, as participation declines, unemployment climbs and vice versa. What we see now is a secular fall in participation rate (it peaked in 1999) stabilizing at round 64% but now with a declining unemployment rate which on Friday came in at 7.8%. This is the lowest it has been since the dark days of January 2009 when the crisis hit full square across the economy.
Source: Federal Reserve Bank of St. Louis, Economic Research
And there was more good news especially on the revisions front. The first NFP prints in the last three months came in at 373,000 but have been revised to 437,000. That's on top of the annual revision for the year ended last March which increased the payroll numbers by 386,000. So put all this together and since January 2011, we have seen the number of people employed grow by 3.6m, of which 2.9m were in the private sector. The starting numbers for that period, and remember it's the initial numbers that get the attention, were 2.56m new jobs. So that's over 1m more once the final count is in.
This all must be gratifying for the Fed which placed much greater emphasis on unemployment in its last meeting. The new 7.8% rate is better than its 2012 projections and about in line with the 2013 forecast. Of course, we're not quite out of the woods mainly because personal income is still under extreme pressure, falling 0.3% in real terms and only up 2.7% in the last three years. Here it is on a per capita basis, stuck at around $32,500.
Source: Federal Reserve Bank of St. Louis, Economic Research
And even that number is inflated because of this, which shows income from interest and dividends, both of which have risen faster than the rate of overall compensation.
Source: Federal Reserve Bank of St. Louis, Economic Research
Bonds:
Most of last week GT10s stayed around 1.62%. There was little to move it other than ongoing fiscal cliff noise, election outcomes and a set of "just the facts" FOMC minutes. And China was out all week. Then on Friday we saw a pop after the NFPs with rates climbing some 10bps and about a point in price. It probably won't last. This is a data dependant market and so gives us a chance to extend duration. We continue to like the corporate space despite September being a heavy issue month.
Equities:
There's plenty to like in equities despite the straight 15% run since June. We're about to enter earnings season and the data to watch will be top line, Europe warnings and cash usage. The SPX[1] is on track for around $104 in earnings with $31 in dividends. That's one of the lowest payout ratios in years. Expect dividends to grow faster than earnings.
Bottom Line:
Markets are quiet. There seems to be a back stop of sorts what with the ECB programs and Fed easing. We continue to favor the large cap names. Call us skeptics but any beta trade looks short lived.
Sources: Bureau of Economic Analysis; US Department of Commerce; Bureau of Labor Statistics; David Ader, CRT Capital Group; Federal Reserve Board; Institute for Supply Management; European Central Bank; Federal Reserve Bank of St. Louis; High Frequency Economics; Bloomberg; Capital Economics; J.P. Morgan Market Intelligence; Sentinel Asset Management, Inc.
[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.
(c) Sentinel Investments
