Third Quarter Productivity and Weekly Jobless Claims

KEY DATA: Productivity: +2%; Year-over-Year: +0.9%; Unit Labor Costs: +0.3%; Year-over-Year: +2.4%/Jobless Claims: 278,000 (down 10,000)

IN A NUTSHELL:   “As the labor market continues to firm, there are growing hints, but still just hints, that wage pressures are starting to build.”

WHAT IT MEANS:  Okay, the election is over and we will have to wait until January for the new Congress to start creating whatever chaos they want to create, so let’s get back to economic reality.  Businesses are doing what they can to keep labor costs down and in the summer, they pretty much succeeded.  Third quarter productivity gains almost completely offset labor compensation increases.  That led to a modest rise in labor costs, which is good news for prices.  These data are wildly volatile, so it is worthwhile looking at the changes over the year.  Since the third quarter of 2013, productivity rose modestly while labor costs were up fairly solidly.  And, for the first three quarters of the year, productivity increased by less than 1% while, labor compensation rose by 3.1%.  Even adjusting for inflation, compensation is up by 1.3% so far this year.  It is possible that inflation-adjusted earnings could rise at the fastest pace since 2007.  That is a clear sign that the tightening labor market is forcing firms to pony up a little more money. 

There were other data on the labor market, but they were more mixed.  Weekly jobless claims dropped solidly and the four-week average remains at historically low levels.  However, The Challenger, Gray and Christmas layoff announcement report jumped in October to its second highest level this year.  It was noted that October and November tend to be big months for layoffs as firms set business plans, so we should probably wait and see how the rest of the year plays out.  Also, we really don’t know where those cuts will come or if they will even take place.  That said, layoff notices are down by over 4% so far this year.

MARKETS AND FED POLICY IMPLICATIONS: Firms keep pushing their workers harder and harder as they hold back both their hiring and compensation.  But the dam seems to be breaking.  Productivity gains this year will probably be in the one percent range, making it four consecutive years of modest increases.  With compensation rising, there is pressure on margins and firms are worried about paying workers even more.  But it’s the tightening labor market that will likely be the driving force in 2015 and that means either firms will have to start raising prices or shrinking margins.  Most likely we will see a little of both.  But that doesn’t mean earnings have to weaken.  If economic growth is above 3%, as I believe it will be, companies will have to make it the old fashion way, through volume.  Are investors thinking about the implications or modest productivity gains and rising labor costs?  Probably not, as the headlines don’t shout rising wage pressures.  But the Fed members know the devil is in the details and they say a lot.  Regardless, tomorrow is Employment Friday and we will see what happened with October payrolls and the unemployment rate.  I expect job gains to be well north of 250,000 while the unemployment rate remains at 5.9%.

October Supply Managers’ Non-Manufacturing Survey, ADP Payrolls and Online Labor Demand

KEY DATA: ISM (Non-Manufacturing): -1.5 points; Employment: +1.1 points/ADP +230,000/Help Wanted: +11,700

IN A NUTSHELL:   “The electorate may be disappointed with the economy but the numbers are pointing to accelerating growth and a tightening labor market.”

WHAT IT MEANS:  The Democrats got shellacked yesterday and massive discontent with the economy was a key reason for the rout.  But politics is politics and it often has little to do with reality.  In this case, there are reasons voters are correct and reasons they are wrong.  First, the wrong.  Basically, economic activity continues to rise.  The Institute for Supply Management’s Non-Manufacturing Index fell in October, but it remains at a level that is consistent with solid to strong growth.  Importantly, especially with the October employment report coming out on Friday, the employment index continues to break out on the upside.  Few firms are cutting back and more are hiring, a good sign for workers.  New orders continue to grow, but a little less briskly, while production has come down from outer space to the stratosphere.  In other words, everything is moving ahead quite strongly, though maybe not at break neck speed.

Where the electorate was right, was their feeling that their own economic conditions are just not great.  As I have said, ad nauseam, it is hard to spend, or feel good about things, if your income is going nowhere.  But that could change soon.  The labor market is tightening at a rapid pace, and it looks like we get confirmation of that on Friday.  ADP’s estimate of private sector payroll gains came in higher than their number for September and that could mean we will see a very strong October job increase.  The strong rise occurred despite an almost nonexistent rise in large-business hiring.  This sector had been strong for quite some time, so I don’t know what went on.  A firming labor market was also supported by a solid rise in the Conference Board’s Help Wanted OnLine Index.  Firms are looking for lots of people and I suspect they are also hiring a lot more workers. 

MARKETS AND FED POLICY IMPLICATIONS: The sour view about the economy expressed by voters makes sense when you consider that few have seen their wages rise and many have seen their benefits cut and their copays surge.  The only thing that will change that situation is a labor market that forces firms to bid for workers.  Each month, we see more and more signs that labor shortages are starting to appear.  We are approaching full employment nationally, but in some areas, industries and occupations, that condition already exists.  It’s just that shortages need to be more widespread before wage gains will accelerate and benefit cuts will be reversed.  I suspect by the spring, the intransigence toward paying more will fade as job openings become so great that firms have no choice but to start raising offers.  We are not there yet, but the Fed members need to recognize that a rising wage environment is not that far away.  As for investors, any euphoria over the election results may have to be tempered by the simple fact that being in power means you have to actually try to govern, something that neither party has bothered with lately.

October Supply Managers’ Manufacturing Index

KEY DATA: ISM (Manufacturing): +2.4points; New Orders: +5.8 points; Employment: +0.9 point; backlogs: +6 points

IN A NUTSHELL:  “The manufacturing sector is ramping up and it looks like strong October vehicle sales will keep things going.”

WHAT IT MEANS:  After two consecutive quarters of strong economic activity, questions remain about the sustainability of growth.  If the October consumer-oriented data that we have received so far are any indication, we could be in for another solid quarter.  Last week we saw a jump in confidence, a necessary but not sufficient condition for strong growth.  The jump in the Institute for Supply Management’s manufacturing index in October adds to the belief that the economy is in really good shape.  Activity surged back up to its August level, which was the highest in 3½ years.  New orders skyrocketed and with backlogs growing solidly, it looks like increases in production will continue.  Hiring accelerated as well as firms are adding workers to meet the growing demand.  Looking forward, early, but incomplete, sales numbers point to continued solid vehicle sales in October and that should help keep the momentum in the manufacturing sector going. 

In a separate report, construction activity eased in September, which was somewhat of a surprise.  With state and local governments spending again, one of the places that they are using their newfound revenues is in infrastructure rebuilding.  That did not show up in this report and public activity fell.  Private sector construction was down slightly even as residential spending rose.

MARKETS AND FED POLICY IMPLICATIONS: We seem to be in one of those Missouri moments, where despite six months of strong growth, everyone seems to still be saying, “show me” more.  Clearly, the Fed members are still somewhat agnostic about the current state of economic affairs.  But with Europe and Japan hurting and who knows what is going on in China, you don’t have a strong manufacturing sector unless the U.S. economy is humming along.  Investors should love the manufacturing and vehicle numbers, but on a day before an election, caution remains the better part of valor.  The markets are on hold and if some of the elections go as they could, we may be waiting weeks before we know who controls the Senate.  That would require people to turn their focus to the economic fundamentals, which right now look pretty good.

September Consumer Spending, Income and Third Quarter Employment Cost Index

KEY DATA: Consumption: -0.2%; Income: +0.1%/Employment Costs (Year-over-Year): +2.2%; Wages and Salaries: +2.1%; Private Sector: +2.3%

IN A NUTSHELL:   “Household incomes are finally starting to rise but there is no rush to spend it.”

WHAT IT MEANS:  Yesterday’s strong GDP report pretty much told us what happened with consumer spending during the summer and today’s report fills in the details about the monthly pattern.  Very simply, there is no pattern.  Consumption was flat in July, soared in August and fell in September.  Part of that was a robust return to vehicle demand in August, which skewed the trend.  But there were also ups and downs in the services and the nondurables components, so it is really hard to know what people have been thinking.  The real issue, though, is can they afford to spend more.  Two bits of information point to increases in incomes, but nothing great just yet.  Personal income was up in September, but when adjusted for inflation, it was largely flat.  That is, purchasing power went nowhere.  Disturbingly, wages and salaries, the key to both spending and Fed policy, rose minimally during the month.  That is important because the wage and salary component of the Employment Cost Index, an aggregate measure of compensation, has been accelerating.  In the third quarter, private sector wages and salaries rose at the fastest pace in six years.  Hopefully, the September moderation was just an aberration.  We need greater increases in household incomes if the strong economic growth we have seen for the past two quarters can be sustained.  Inflation remains totally under control.

MARKETS AND FED POLICY IMPLICATIONS: Fed Chair Yellen is looking for any sign that the tightening labor markets are finally causing wages to rise.  That is not happening just yet, but the trend is in that direction.  Worker compensation, especially in the private sector, is accelerating.  It is not so high just yet that warning bells are being set off at the Fed, but another six months and we should be there.  But the sluggish rise in wages in September is a warning that the pattern will not be clear-cut until employers start bidding for workers.  Right now, that is happening only in a few industries, occupations and regions.  It needs to be more widespread.  The limited income gains imply that spending will continue to grow moderately at best.  We need that to change if we are to get this economy into high gear.  The key may be the holiday shopping season and if the consumer confidence numbers are any indicator, it could be really good.  Today we saw the Thompson Reuters/University of Michigan’s Consumer Sentiment Index hit its highest level in over seven years.  That came after the Conference Board’s Confidence Index also hit a seven-year high.  Consumers are feeling good and it will only take a little more money to get spending to surge.  As for the markets, it looks like investors actually think that economic fundamentals, not the Fed, will drive prices and if that is the case, people should be feeling pretty good right now.

Third Quarter GDP and Weekly Jobless Claims

KEY DATA: GDP: +3.5%; Consumption: +1.8%/Jobless Claims: 287,000 (up 3,000)

IN A NUTSHELL:   “The economy just may have shifted gears before anyone expected and the firming in the labor market provides hope the strong growth can continue.”

WHAT IT MEANS:  I have been arguing for a while now that the underlying economic fundamentals are improving rapidly and the economy should be shifting into higher gear soon.  That shift may be taking place already.  Economic activity expanded by a better than expected pace in the third quarter and the report was not filled with too many head-scratchers.  Consumer spending remains disappointing and the weak link is still services.  Of course, this is the biggest individual component of GDP, accounting for two-thirds of consumption and 45% of all economic activity.  It is hard to grow rapidly if people don’t purchase things like housing, utilities, medical care or recreation services at a decent pace.  So, where did growth come from?  Business investment was solid, growing at sustainable paces for equipment, structures and technology.  The housing market improved, though residential investment was nothing spectacular.  We shipped a ton of goods overseas while cutting back on our demand for foreign products.  Major reductions in oil imports are really a great boon to growth as we are keeping an awful lot of money in the U.S.  The government is back in the spending business with national defense leading the way.  That was probably make-up for all the cuts made earlier in the fiscal year.  But nondefense purchases rose as well and state and local governments continue to translate growing revenues into increasing spending.  Inflation remains muted and actually decelerated fairly sharply.  I suspect the Fed members were not pleased to see that.

One reason I am so optimistic about the economy is my view that the labor market has already tightened and stronger wage gains are in sight.  While jobless claims edged up last week, the level remains extremely low and it really does look like the October jobs report could be better than the September one, which we all agree was quite good.

MARKETS AND FED POLICY IMPLICATIONS: The Fed ended quantitative easing yesterday, pointing to improving economic and labor market conditions.  What could encourage the FOMC to start raising rates in the spring, as I expect, is continued strong economic growth, which leads to really tight labor markets.  With consumer confidence rising, falling gasoline prices creating fatter wallets, job gains accelerating, unemployment declining and incomes rising, the holiday shopping season is setting up nicely.  The National Retail Federation expects demand to rise by 4.1% this season, up from 3.1% last year.  I think that may be conservative.  I am in the 5% range.  That could lead to a rise in fourth quarter consumption, powering growth back to the 4% range.  A string of 3% or more growth rates, which the Fed will likely be staring at when it meets in January, coupled with an unemployment rate closing in on the 5.5% full employment rate, should be enough for most Fed members to throw in the towel.  Investors will have to start balancing the reality of rate hikes in the first half of next year with better growth.  We will find out then if it was the Fed or the economy that generated the outsized equity market gains over the past few years.

October 28-29 ‘14 FOMC Meeting

In a Nutshell: “…the Committee decided to conclude its asset purchase program this month.”

Rate Decision: Fed funds rate maintained at a range between 0% and 0.25%

Quantitative Easing Decision: Ended.

The FOMC met and issued its statement about economy and the direction of monetary policy.  Not surprisingly, the Committee decided to end, finally, quantitative easing.  The members also reiterated “that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program.”

While the ending of QE3 and the continued use of “considerable time” were expected, there were enough changes in the statement to make it clear that the Fed is transitioning to rate hikes.  First, and maybe most importantly, the members now believe “a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing” rather than “there remains significant underutilization of labor resources.”  Since it is all about the labor market, it is now clear that the Fed believes the labor market is tightening.

But it wasn’t just the comments about the labor market that make this an important statement.  The Fed also signaled it is less concerned about deflation.  The Committee noted that “the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year”.  This is in contrast to just saying it was running below its desired pace.

So, what is the take away from the Fed’s comments?  If we keep seeing the kind of economic progress that we have had for the past few months over the next few months, the Fed will have to start talking specifically about tightening.  Between now and the December 16-17 FOMC meeting, we get third quarter GDP and two more employment, consumer spending and inflation reports.  Don’t be surprised if at that meeting, there has been enough strong data that the Committee removes the “considerable time” verbiage as a signal that the time for rate hikes is coming sooner rather than later.  I am sticking with my expectation that the first increase will come in the spring, possibly as early as the March 17,18 meeting.

How should the markets take this statement?  First, there really should not have been any surprise in it.  If people didn’t know QE was over, they probably made the mistake of flying into New Jersey and wound up being quarantined.  On the labor market front, I have been arguing for months that things are better than the common wisdom and the Fed’s edging toward that view also should not have been shocking.  But uncertainty on the timing of rate hikes remains, though those who pushed things off until well into the second half of next year are probably backpedaling, again.  Thus, we are still in for lots of volatility when the economic data surprise either on the upside or downside.  Rates are going up next year, so let me remind everyone that eight meeting times 25 basis points per meeting comes to 200 basis points in a year.

October Consumer Confidence, September Durable Goods Orders and August Home Prices

KEY DATA: Confidence: up 5.5 points/Orders: -1.3%; Excluding Transportation: -0.2%/Home Prices (Monthly): -0.1%; Year-over-Year: +5.6%

IN A NUTSHELL:  “The highest confidence level in seven years shows that it’s the economy that really matters and for many, it looks like it is getting better.”

WHAT IT MEANS: Ebola may be all people are talking about but it doesn’t seem to be getting a lot of us down.  The Conference Board’s Consumer Confidence Index jumped in October to its highest level since October 2007.  While the current conditions index moved up at a modest pace, expectations surged.  Fears of a job slowdown are fading rapidly and that is triggering a belief that incomes and business activity will be on the rise. 

The manufacturing sector has become a bit of a question mark.  For the second consecutive month, demand for durable goods fell.  Excluding transportation, it was the second decline in three months.  Still, the fall off has not been that sharp, so I am not yet worried about it.  As for the details, the biggest drop was in civilian aircraft.  Orders are still up by about 40% compared to last year.  There was also a huge reduction in communications equipment orders but more moderate declines in computers and machinery.  Vehicle demand was essentially flat.  Despite the sluggishness in orders, backlogs are growing and that creates expectations that production will have to be ramped up.

The steady deceleration in home price increases continued in August.  The S&P/Case-Shiller 20-city index declined as twelve of the twenty metropolitan areas were down.  Over the year, the increase slowed to 5.6% from 6.7% in July.  Prices are back to where they were in spring, 2005.

MARKETS AND FED POLICY IMPLICATIONS: The surge in confidence was the real eye opener in today’s reports.  It’s not as if the world is spinning along merrily.  It actually seems to be spinning out of control.  But that is not affecting the outlook for the future, especially when it comes to jobs and incomes.  And that is critical, since people tend to make spending decisions based on their financial situation, not because world events or vague threats of a disease outbreak.  The sharp decline in gasoline prices, undoubtedly, is helping, but since most of the gain came from expectations, not current conditions, it is likely that gasoline is just one factor in consumer thinking.   With outlooks brightening and more money being left in the wallet after filling up the tank, there are real hopes that this holiday shopping season could be very good.  I suspect that investors will grab onto that possibility.  As for the Fed, the FOMC is meeting and will issue a statement tomorrow.  Let’s wait and see what they say but I don’t think there is a consensus yet for changing much in the statement. 

September New Home Sales

KEY DATA: Sales: +0.2%; Year-over-Year: +17.0%; Prices (Year-over-Year): -4.0%

IN A NUTSHELL:  While the existing home segment is starting to run, the new home portion continues to take only baby steps.”

WHAT IT MEANS:  The housing market is moving forward, but the gains are hardly great and there are some weak segments.  The existing home part is in pretty decent shape as sales continue to rise and are nearing what we could call decent levels.  But the new home recovery is still in its infancy.  Yes, sales did rise to their highest level in over six years, but the rate is still way less than what would be considered healthy.   Also, the August number was revised downward sharply, which was the real reason September posted a gain.  Looking across the nation, demand jumped in the Midwest, rose moderately in the South, was flat in the Northeast and cratered in the West.  As for prices, they look to be on the way down.  There was a decline as builders may be downsizing to better match the market.  The number of homes on the market went up but given the sales pace, there is no major inventory overhang.

MARKETS AND FED POLICY IMPLICATIONS: Housing is the most enigmatic sector in the economy.  It is up, then down and then up, but only in parts and only in fits and starts (pardon the pun).  While it is nice that the existing home segment is basically back, we really need more the new home portion to be hale and hearty if overall economic growth is to be strong.  That is hardly the case right now.  Sales are under one-half million units annualized and that needs to at least double.  That could take a while, which is probably a major understatement.  Thus, housing starts, at least for single-family dwellings, is likely to remain less than we would like to see for, to coin a phrase, “a considerable time”.   This is not a report that should move almost anyone.  I have no idea what motivates investors right now but Fed members will not see this report as saying the housing market is so strong that rates should be hiked.  The FOMC meets Tuesday and Wednesday and we get third quarter GDP the day after, so things should heat up.  But for now, there is no reason to believe that QE will not be ended or the Fed will remove “considerable time” from its statement.  The December meeting could be different.

September Leading Indicators and Weekly Jobless Claims

KEY DATA: LEI: +0.8%; Coincident Index: +0.4%/Jobless Claims: 283,000 (up 17,000)

IN A NUTSHELL:  “Despite some issues with housing, signs are pointing to even better growth in the months ahead for the economy and the labor markets.”

WHAT IT MEANS:  With turmoil all around, you would assume the economy is in danger of stalling.  Wrong again.  Investors have decided that maybe the world is not falling apart, even as more chaos occurs, and the equity markets have rebounded.  Consumer confidence, at least through the first half of the month, has actually improved.  And now we see that an indicator of future growth, The Conference Board’s Leading Economic Index, rose sharply for the second time in three months.  The measure had stalled in August, but it bounced back with a vengeance and the three-month average increase is pointing to even better growth ahead.  The Coincident Index, which measures current activity, has not been rising as quickly as the LEI might imply.

Jobless claims, one of the factors driving the indicators, rose last week.  But the increase was from an historically low level when labor force size is considered.  These numbers are volatile.  Smoothing them, the four-week average was down to a new record low.  Also, a new index about the labor market, ADP’s Workforce Vitality Index, posted a solid third quarter rise from the second quarter level.  Conditions in the South and West have firmed sharply over the past year.  This report, when coupled with the jobless numbers, point to an accelerating economy.  

About the only concern in the Conference Board’s report was the housing market and the data are really all over the place.  But we are seeing things improve, such as existing home sales.  Also, the Federal Housing Finance Agency released its August Housing Price Index and prices rose solidly.  The index is back to where it was in August, 2005 but is still nearly 6% below its April, 2007 peak.  The year-over-year increase, however, is decelerating, though it was better in August than July.

MARKETS AND FED POLICY IMPLICATIONS: Today was a good day for the economic numbers.  They should brighten an already rebounding investor mood as they point to stronger growth in the future.  Issues such as Ebola and ISIS terrorism may cause concern, but they shouldn’t have a great impact on fundamental economic activity.  And if the labor markets are tightening, as most data seem to imply, then the Fed has to take notice.  We will see if the lights are on in the Eccles Building next week as the FOMC is meeting.  Quantitative Easing should be ended but concerns about less than desired inflation and labor market slack may still be at the center of the discussion.  Since some at the Fed want to see the whites of inflation’s eyes before shooting, there is no reason for them to indicate they are going to pull the trigger soon.  But if the October and November employment reports are as good as I suspect, conditions may be a lot different when the Fed members meet again in the middle of December.  That is when I expect them to start signaling that rates will be going higher and not after a considerable time.

September Consumer Prices and Real Earnings

KEY DATA: CPI: +0.1%; Excluding Food and Energy: +0.1%; Real Hourly Earnings: -0.2%; Year-over-Year: +0.3%

IN A NUTSHELL:   “Despite minimal inflation, worker compensation continues to go nowhere.”

WHAT IT MEANS:  The missing link remains a missing link.  The lack of any gain in household spending power has restrained growth during the recovery and there are still no signs of this changing, even as inflation remains in check.  Consumer prices inched up in September, which was a bit of a surprise given the sharp decline in gasoline costs.  Since energy costs are viewed more as an issue of consumer spending than underlying inflation, I think the index that excludes energy is a better measure to watch.  Here, prices moved up at a more moderate pace but still nothing threatening.  Food costs continue to rise more rapidly than general inflation, a trend that is likely to continue for a long time as growing incomes around the world pressure prices.  Medical costs are beginning to rise sharply once again and that includes commodities and hospital services.  There were also solid increases in rent and vehicle maintenance and insurance costs, as well as utility piped gas, which was odd.  Otherwise, prices remained well restrained.  Over the year, just about any measure you can use rose by less than the Fed’s 2% target.

Despite the minimal increase in prices, earnings, adjusted for inflation, fell.  An increase in hours worked offset the decline in wages and led to a gain in weekly earnings.  But the reality is that over the past year, both hourly and weekly earnings, adjusted for inflation, rose by only about 0.5%.  It is hard to have strong growth when spending power is largely flat.

MARKETS AND FED POLICY IMPLICATIONS: Inflation is not a major issue for the Fed as long as wage gains remain muted.  That has been Chair Yellen’s talking point since she has taken over and there is little reason to think that will not be the message in next week’s FOMC statement.  But there was a sign that labor shortages are on the horizon.  The September state unemployment numbers were released yesterday and fifteen states now have a rate below 5%.  With full employment around 5.5%, there are a growing number of markets where labor shortages have to be appearing and wage pressures building.  In addition, another eight states have rates between 5% and 5.9% and they are nearing the point of no return.  Since wages are not falling in above-average unemployment areas, the inevitable increases in the labor shortage locations will drive the numbers up.  Compensation gains are a lagging indicator and they are trailing even more now as firms cling to the belief that they don’t have to raise wages any more than minimally.  Good luck with that over the next year.  As for investors, it is off to the races again as either irrational exuberance has returned or there is a growing belief that strong growth is on the horizon.  I think GDP will rise well in excess of 3% next year and could exceed the 3.3% posted in 2005, making it the strongest gain in a decade, but that is not the consensus in the investing community.

Linking the Economic Environment to Your Business Strategy