Markets tend to overreact and the last few weeks in France were no exception. Equities fell around 9% on the expectation of a change in government. On close look, the Hollande manifesto is modest...a change in retirement age here, a year difference to a balanced budget, a non-descript growth pledge, tax banks more, reduce immigration. There won't be much difference to the end game in Europe but there will finally be a more robust opposition to the German line. Markets also have notoriously short memories: socialist (i.e. left of center) governments are good for markets. Stocks rose vigorously in the years after leftist governments took control of France in 1981, Sweden in 1998, the UK in 1997, the US in 1992. The list goes on but the story is that ideologies give way to pragmatism with popular support. And it's the last item that matters most.

We also have a possible change in Greece, where things could get more hairy. Greece has a strange mix of first-past-the-post and proportional representation. Seven of the ten parties flat out reject the EU/IMF and two, with a combined 17% of the vote, would leave the euro all together.

This is all part of a bigger picture. Electorates everywhere are scalping one by one the governments who got them into, and failed to extract them from, the financial mess. We should not be particularly concerned as we need more answers than "austerity is the best policy."

ECB left rates unchanged. No surprise there. What was surprising is that Draghi thinks "recovery is proceeding" when the PMI composite (manufacturing and services) recorded its lowest level since mid-2009 and output growth hit a six-month low in Germany and France. The April numbers are thus likely to extend the downturn into the third successive quarter. There are two odd things coming from the ECB:

1. Repos: The ECB version of QE is all about repos. In the US it's all about government securities in a framework of asset purchase programs. Both place money into the interbank market and increase reserves. But in Europe the result is asymmetric. Southern country banks are holding government securities and contracting loans and northern country banks the opposite. And a large proportion of total liquidity remains in overnight deposits. Europe has no banking union so the result of ECB policy is hugely dilutive. And the repo means that if asset quality declines, the banks must re-up ECB collateral. It's all a very sticky transmission mechanism.
2. Bank recapitalizations: are needed in Europe and the message from the ECB is i) tighten credit standards and ii) recapitalize through retained earnings. Fair enough. But that means financing of demand growth takes third place.

On the bigger picture, adjustment by surplus and deficit countries must occur. Yes, labor reforms are necessary, but in the short-term, it would be good to see a rise in the relative price level in the core countries which would then deliver more dynamic demand. In this context, it's good to see that IG-Metall, Germany's influential cross-industry union, is likely to get a 6.5% wage rise.

The Nature of Jobs: A very modest jobs report of 115,000 but the revisions were solid, at 66,000 for the last two months. It's best to look at these numbers over a few months rather than just the headline. The last four months have seen job gains of 803,000 compared to 702,000 in the prior four months and total private payrolls have increased by 2.03m in the last year. So this latest number is probably some weather payback and not enough to change any outlook on QE.

Over the longer term, we must still worry about what jobs are on offer. In the recession, two thirds of job losses were in five industries, three of which were high wage sectors (construction, manufacturing, and business and professional services) and two in low wage sectors (retail and leisure). But in the recovery, two thirds of the job gains have come from three low wage sectors: retail, education and health services, and leisure. This is part of a longer trend. Here's manufacturing jobs as part of all workers. It has been in decline for years but arrested recently, which is part of the manufacturing recovery story. Still, this is a net exchange of higher for lower paid jobs.

 

Source: Federal Reserve Bank of St. Louis, Economic Research

And here's its corollary, leisure and hospitality workers as a total of all employees. It's clear, then, that the recession hit high-wage earners hard and the recovery is mostly in low-wage alternatives.

 

Source: Federal Reserve Bank of St. Louis, Economic Research

So why the drift? Many reasons including the great off-shoring, education, skill mismatch, etc. But one reason is this, which shows private non-residential investments over GNP.

 

Source: Federal Reserve Bank of St. Louis, Economic Research

It has bounced from the bottom but still way below the 1970s when businesses were truly scared. You can also see the flattening in the early 2000s. That's when investment moved into residences rather than plant and equipment. At that time, government incentives to pull investment into housing completely overwhelmed business investment. It should get better but it partly explains the slow and erratic jobs recovery.

Yes, Still No Inflation: The inflation gang usually respond to the "no inflation" facts with the "Aha, but expectations are high and they count more" theory. Well they're not. A study from the Atlanta Fed last week showed 74% of businesses expect unit costs to rise only 2% in the next year. For the next 10 years, 82% expect labor, input, productivity, margin adjustments or sales to have no material effect on unit labor costs. So if they don't see any price inflation then they must expect only low demand. And here it is:

 

Source: Federal Reserve Bank of St. Louis, Economic Research

The DPI per capita declined by 0.1% in March and hasn't moved for years. That puts a cap on wage and price inflation.

Bottom Line: The market did not like the employment number because it rules out QE3. But that was ruled out at the recent FOMC meeting. We're seeing very little directional trade. Yes, there's support at the 1350 levels for the S&P but we don't see much push beyond 1400. The themes we like are i) companies with cash flows, dividend growth and high margins and ii) trading GTs, often on intraday levels. Fund managers (not us) get bored with investment themes quickly. But the best ones can run for years.

Sources: "Pourquoi un chapeau ferait-il peur?", Le Petit Prince, Antoine de Saint-Exupery, European Central Bank, Bloomberg, VOXEU, Peterson Institute for International Economics, Federal Reserve Bank of Atlanta, HSBC, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, Sentinel Asset Management, Inc.