Second Quarter Productivity and July Small Business Index

KEY DATA:  Productivity: +2.3%; Unit Labor Costs: +1%; Real Compensation: -4.8%/ NFIB: -2.8 points; Future Conditions: -8 points

IN A NUTSHELL: “Businesses continue to operate very efficiently, which should help keep earnings solid.”

WHAT IT MEANS: The economy soared in the second quarter and that was good news for nonfarm businesses.  The sharp 7.9% rise in output more than offset the 5.5% robust gain in hours worked and as a result, productivity increased at a solid pace.  The increase in efficiency also largely offset the surge in hourly compensation, so labor costs rose at a modest pace.  While businesses did well in the spring, things were quite as good for workers.  Yes, it was nice to see that hourly wages rose strong pace, but inflation soared even faster.  That led to a sharp decline in real, or inflation-adjusted compensation. 

Small businesses should be happy about the reopening of the economy, and they were for a while.  But conditions could be changing, at least a little.  The National Federation of Small Businesses’ optimism index decline in July.  There had been a nice bump up in June, but that disappeared and the level is similar to what we have seen for four of the last five months.  For the eight consecutive month, the outlook for business conditions was negative and it dropped sharply in July.  Earnings expectations are also negative, not a good sign for hiring or expansion.  The big problem remains costs, both labor and nonlabor.  Input expenses are rising sharply and actual compensation increases are exceeding expected ones.  The lack of qualified workers is also a major issue, with a record 49% of the respondents saying they could not fill positions.       

IMPLICATIONS: There is good news and bad news in today’s reports.  The sudden reopening of the economy has not caused business labor costs to rise significantly, as production gains outstripped rising labor costs.  When you add in inflation, compensation expenses are dropping at a rapid pace.  Thus, corporate earnings should be holding up.  But that also means workers’ spending power is beginning to falter.  That is not good news, especially for small businesses who are already concerned about the future.  Still, there are no signs that the economy is downshifting.  July’s job gains were massive and with so many more people working, it can only mean that total income is rising solidly.  The conundrum the Fed faces is that the current data do not support its massive liquidity program.  But uncertainties about the future argue for it to stay the course, at least for a while.  Once again, when facing a “do too much” vs. “do too little” choice, the Fed is likely to do too much.  It is easier to slow growth than accelerate it and with rates so low, it has a lot of arrows to fire at any inflation threat. 

June Job Openings and July Employment Trends

KEY DATA:  Openings: +590,000; Hires: +697,000/ ETI: +0.84 point

IN A NUTSHELL: “With openings exceeding unemployment, strong job gains look to be with us for a long time.”

WHAT IT MEANS:  The July job numbers were outstanding, and it is clear why that was the case:  Despite all the efforts that firms are putting into finding new workers, robust economic growth is causing employers to lose ground when it comes to filling job openings.  The rate of openings, which is openings divided by total employment, was by far and away the highest on record.  Indeed, there are more job openings than unemployed workers. Labor market conditions are beginning to look like what they were in the period of 2018 to early 2020, when the unemployment rate was near or at record lows.  However, the rate is now about two percentage points higher.  The willingness of workers to quit their jobs, which includes leaving a position or moving to another employer, is also as high as we have ever seen it.  In other words, while the unemployment rate may be well above what economists consider to be full employment, for employers, that situation has already effectively been reached.

Supporting the view that the labor market is extraordinarily tight was the July rise in the Conference Board’s Employment Trends Index.  The index has retraced all that it lost when the pandemic shut things down.  As the report note, “Despite the still-high unemployment rate, many employers are still having difficulty finding qualified workers.”     IMPLICATIONS:  As I noted in my discussion of the July employment data, the huge increases in hospitality and government payrolls are not likely to be sustained or even repeated. But few economists believe that the job gains that approached one million in June and July can be repeated.But keep in mind, payroll increases between 300,000 and 500,000 are viewed as massive, so even if the gains were cut in half, the report would be great.  With job openings exceeding unemployed workers, continued robust job gains and further increases in the labor force participation rate, as people are induced to get back out into the market, are likelyBut that also means that wage pressures could continue building for an extended period.  The solid increases in both consumption and inflation are likely to be sustained as well. Businesses that have pricing power will continue to use it, while those that don’t will likely try to find ways to raise prices, nonetheless.  That might be good news for investors, as it implies profits can be sustained.  And since the Fed is in no hurry to start easing back on its supply of liquidity to the system, fears of rate hikes are premature, at least for now.

July Employment Report

KEY DATA:  Payrolls: +943,000; Private: 703,000; Revisions: +119,000; Leisure and Hospitality: +380,000; Government: 240,000/ Unemployment Rate: 5.4% (down 0.5 percentage point); Hourly Wages: +0.4%; Over-Year: +4%  

IN A NUTSHELL: “The labor market is tightening sharply as workers are returning to restaurants and schools.”

WHAT IT MEANS: July was a good month for both businesses and workers. Firms continue to expand their workforces, despite all the complaints about the lack of availability workers.  The economy added an average 940,000 new employees over the past two months, so it looks like there are plenty of qualified people searching for jobs – and finding them.  In addition, the increases of the previous two months were revised upward significantly, implying the hiring was stronger as the months went on.  The payroll increases were spread across the entire economy, with the 67.5% of industries reported gains.  That said, there was a somewhat unbalanced increase, as nearly two-thirds of the new positions were in two areas: Leisure and hospitality and government.  Most of those were in restaurants and schools.  Going forward, it is not clear how many more workers will be hired.  Indeed, leisure and hospitality total payrolls are now only about ten percent below their peak in February 2020.  Local education employment is within two percent of its peak.  So, it appears that the massive job gains are behind us.  

On the wage front, hourly wages continue to rise solidly, both over-the-month and over-the-year.  With employees working longer hours, their weekly pay is also surging.    

As for the unemployment picture, there seemed to be some “make-up” in the numbers.  With all the hiring that had been going on, it was surprising that the unemployment rate hadn’t fallen more.  Well, whatever undercount had occurred is now gone.  The unemployment rate cratered, and for all the right reasons: The labor force participation and labor force rose, employment skyrocketed, and unemployment plummeted.  The duration of unemployment is also falling, which shows that people are getting pulled off the rolls.  Some of that may be due to states ending the supplemental payments, but we don’t have specific data on that yet.    IMPLICATIONS:This was a great report, but it did contain some warnings.  Given how many of the new positions were in sectors that are nearing their pre-pandemic highs, job gains anywhere near what we have seen over the past three months are unsustainable.  Economic growth, not reopenings will have to take over.  That is actually good, as we will start getting a picture of what the fundamental economy looks like.  Right now, we are still in the recovery phase.  Businesses will have to start expanding, not returning to previous levels, for payrolls and growth to remain strong.  That change in the driving force for job gains is coming as the government is beginning to cut back on their income supports.  Even if the infrastructure and budget bills get passed, their impacts are months if not years out.  Investors should start lowering their expectations for job gains and economic growth, especially when we get to the fall and winter.  That is not to say growth will stall; there is little reason to expect that.  But six percent is unsustainable and three to four percent, which we could get over the next year, means employment increases less than one-third we have recently seen.  Those rates are still somewhat outsized, since trend growth is closer to two percent and trend job gains is probably in the two hundred thousand to two hundred fifty thousand range.  Which means the economy is looking good going forward, just not looking like it has over the past few quarters of reopenings.  And then there is wildcard, the Delta and other possible variants.  The Fed might worry that growth could remain so strong that full employment is reached sooner than the members expect.  On the other hand, the pandemic is not over.  My guess is that the Fed is willing to let the economy run hot for an extended period and not panic if inflation is elevated as well.  It is a lot easier to slow growth than to accelerate it when rates are so low, especially if the government’s massive income supports disappear.  That creates uncertainties and if the Fed is to make a mistake, it is likely to err on the side of too much growth rather than too little.

July Manufacturing Activity and June Construction Spending

KEY DATA:  ISM (Manufacturing): -1.1 points; Orders: -1.1 points; Employment: +3 points/ Construction: +0.1%; Private: +0.4%; Private Residential: +1.1%

IN A NUTSHELL: “With manufacturing strong and construction starting to rebound, any economic slowdown is likely to be fairly modest.”

WHAT IT MEANS: The economy boomed in the spring, even if many economists expected even stronger growth.  That said, most forecasts, including my own, see activity rising more moderately in the quarters to come.  The issue, is how much of a slowdown should we expect going forward?  Right now, it doesn’t look like it will significant.  The Institute for Supply Management reported that manufacturing activity grew at a “slower” pace in July than we have seen in six months.  Still, the overall index level was pretty strong.  Keep in mind, this is a diffusion index.  If businesses expand one month but only retain that pace the next, the index declines.  To highlight that point, the new orders index eased.  What happened was that a large number of companies reported that demand was stable, rather than rising.  In contrast, a smaller share reported that orders had declined.  Indeed, only 3.3% said they were lower, compared to 8.2% that said demand had declined in June.  In other words, demand solidified, at a high level, rather than accelerated in July, which is not that bad.  Similar results were seen in most of the other components, so don’t look at the decline in the headline number as saying anything.  On the clearly positive side, employment, which had eased minimally in June, picked back up in July.  Also, backlogs continue to expand at a rapid pace, indicating that production and hiring should improve going forward.

The housing numbers haven’t looked great lately.  Nevertheless, the construction sector remains solid.  Construction spending rose modestly in June, but there was a solid rise in private residential activity.  A sharp drop in road construction restrained activity.  State and local government spending patterns have been driven by federal government assistance, while revenues from taxes, such as gasoline taxes, are still falling.  That is affecting infrastructure spending.  That could change if the bipartisan bill that is making its way through Congress actually gets passed.IMPLICATIONS:It’s the first week of the month and that means Friday is the big day for the markets as the July jobs report will be released. Estimating the number is difficult as the reopening of firms and government offices raises issues about the accuracy of the seasonal adjustment factors.  It’s not the season that is leading to the surge in hiring we are seeing.  The consensus is for something in the 800,000 range, similar to the 850,000 June number, but it could be a couple of hundred thousand higher or lower.  I’ve seen estimates that range from 350,000 to 1.6 million, so don’t get too bulled up or disappointed if the number is viewed as a “surprise”.  Regardless, the economy is still moving forward solidly.  Today’s data point to that.  It is just that we have had unsustainable growth for the past year.  It is hard to think that the 12.2% growth from second quarter 2020 to second quarter 2021 will be repeated anytime soon.What investors have to start getting their minds around is what the pathway to normal growth will look like.  How many additional quarters of well above 2% trend growth can we have?  The forecasts are made uncertain by issues such as government policy, the Delta or other virus variants and consumer behavior.  Specifically, what will the infrastructure and budget bills look like?  How much of the spending will occur over the next year or into the future?  Will the cutbacks in federal assistance to workers and businesses lead to slower income growth, spending and hiring?  Will firms that stayed afloat because of government programs start going out of business and if so, how many?  Will the virus get worse, be brought under control again or just become part of life?  How quickly will consumers, who have shopped ‘til they dropped in reaction to the economy reopening, resume more normal spending patterns?  It has never been easy to forecast the economy, but at least we have had trends to fall back on.  Right now, non-traditional economic factors may be the real drivers of growth over the next year, so take any forecast, including mine, with a grain of salt.

Second Quarter GDP, June Pending Home Sales and Weekly Jobless Claims

KEY DATA:  GDP: +6.5%; Consumption: +11.8%; Consumer Inflation: +6.4%; Ex-Food and energy: +6.1%/ Pending Sales: -1.9%; Over-Year: -1.9%/ Claims: -24,000

IN A NUTSHELL: “The economy boomed in the spring, but what matters is the next few quarters and there are reasons to believe growth will moderate sharply.”

WHAT IT MEANS:  There was little doubt that economy surged in the spring and the first reading of second quarter GDP activity showed just that.  Many economists expected a lot faster increase, but gain is still great.  Consumers shopped ‘till they dropped.  Consumption exploded and the increases were almost evenly spread between durable and nondurable goods as well as services.  Business spending on equipment and intellectual property was also strong.  However, construction of business structures and housing fell, constraining growth.  As expected, the trade deficit widened, slowing growth. Also, inventories were drawn down sharply, taking over one percentage point out of growth.  Finally, the federal government cut its spending on goods and services.  It was busy supporting income through transfer payments.  As for inflation, it soared, no matter how you measure it.  Consumer goods and services prices skyrocketed, even when you excluded food and energy.  Housing prices soared, as did imports and exports.  Only the cost of business equipment declined.    

Once again, the National Association of Realtors reported that in June, pending home sales edged down.  Over the last five months, the index has gone up then down, but the average is near the level posted for 2020 – which was a pretty good year.  It is just that there was bubble for about six months that is, surprisingly, deflating not bursting.  Indeed, demand is solid, but with inventories extremely low, it is hard to sell lots of homes.

New unemployment claims gapped down last week, though the previous week’s number was revised upward.  The 400,000 level is a bit disappointing.  A few weeks ago, we were hoping it would start approaching 300,000, but it has gone in the opposite direction.  Also, there was sharp rise in the number of workers receiving benefits.  These data are extremely volatile and there is every reason to think the number of new claims and recipients will fall more consistently going forward.  It’s just that it may take longer than expected to get back to full employment.

IMPLICATIONS: We have had four consecutive quarters of strong to spectacular economic growth.  But that was driven by the reopening of the economy and massive government transfer payments.  We should see another really good gain this quarter, though it will likely be less than we have seen for three major reasons: The reopenings have largely occurred; states are already reducing their payments and in September, the federal government will follow suit; and job gains, though strong, are not likely to come close to the last twelve months given the problems firms are having finding workers.  Yes, businesses could get some help when the supplemental unemployment funding disappears, but it isn’t clear how big a factor that will be or how long it will take to significantly reduce the number of people on traditional unemployment rolls.  Income growth in the last quarter of the year will be mostly dependent on wage and job gains, not government largesse, and that doesn’t bode well for consumption.  There is little reason to expect a surge in business spending on structures.  Why the trade deficit would narrow is beyond me, as the rest of the world is not showing signs of growing a lot faster.  The only significant positive could be federal government spending.  States and local governments are losing their sugar daddy, the federal government, so don’t look for them to start buying all sorts of goods and services anytime soon.  While we might get an infrastructure bill, it will take a long time for those funds to make their way into the economy.  The Biden administration wants to spend like crazy and if it gets its way, the rise expenditures could offset somewhat the slowdown caused by the factors listed above.  That would imply a moderation in growth going forward, not a rapid deceleration.FOMC Decision: The FOMC met Tuesday and Wednesday and it kept rates constant.  No surprise there.  What was hoped for was a signal about when the asset purchases would start to slow.  The comment that “the Committee will continue to assess progress in coming meetings”, toward meeting their inflation and employment goals, with meetings being plural, implies that it will not signal when the tapering will occur until near the end of the year.  The Fed has indicated it will start tapering before it raises rates, so we need to see that happen first.  With the Fed pledging that short-term rates will remain near zero, the Fed is showing it will keep supporting the markets.  It is when tapering begins that the real challenge for investors will begin.

June Durable Goods Orders, July Consumer Confidence and May Housing Prices

KEY DATA:  Durables: +0.8%; Ex-Aircraft: -0.2%/ Confidence: +0.2 points/ Case-Shiller National Prices: +1.7%; Over-Year: +16.6%/ FHFA National Prices: +1.7%; Over-Year: +18%

IN A NUTSHELL: “Growth is slowing, and households seem to be taking stock of what may happen going forward.”

WHAT IT MEANS:  The recent economic data point to continued economic growth, but at a more moderate pace, and today’s numbers do nothing but support that view.  Durable goods orders rose solidly in June, but as usual, the headline number doesn’t tell the full story.  Excluding the strong rise in aircraft orders, my preferred data point since airplane orders don’t lead to increased production for quite a while, demand for big-ticket items fell modestly.   The details were also mixed as orders for vehicles, computers and fabricated metals dropped, offsetting increases in demand for electrical equipment, metals, machinery and communications equipment. There was a positive number in this report: Backlogs continue to build at a solid pace and that points to increases in production and hopefully hiring in the future.   

There is some uncertainty setting in when it comes to consumer confidence.  The Conference Board’s July index was up just a touch.  There was a small gain in the view of present conditions while expectations eased back a touch.  On Friday, we get the University of Michigan’s Consumer Sentiment Index, which had dropped sharply during the first half of the month.  With Covid cases picking up and inflation pressuring households, it would not be surprising to see this measure post a solid decline for the entire month.    

Speaking of inflation, as expected, home prices spiked further in May.  Both the Case-Shiller and Federal Housing Finance Agency indices posted major increases, over the month and the year.  Three of the nine regions in the FHFA index had home price gains over-the-year in excess of twenty percent, with the smallest rise being 15.4%.  Similar increases were posted for the twenty cities in the Case-Shiller measure.  These are clearly unsustainable rises that reflect the panic buying we saw over the past year.  The surging home costs are reducing affordability, which helps explain yesterday’s sharp drop in June new home demand. IMPLICATIONS:Thursday we get the first reading on second quarter GDP and there is every reason to believe it will come in faster than 6.4% surge posted in the first quarter.  But there is also every reason to think that going forward, we could see a constant moderation in growth that could get us back closer to trend 2% in over the next year or so.  Part of the problem is the supply chain, which is not showing signs of being fixed in the near future.  Housing costs are pricing households out of the market and inflation is eating into many workers purchasing power.  With the supplemental unemployment insurance payments being cut by states and ending in September, much of the government-supported personal income growth is also coming to an end.  But as is the case with most economic issues, there is the other hand.  Slower growth should bring inflation down, easing pressure on the Fed to reduce asset purchases and/or raise rates sooner than expected.  Indeed, the Fed members are making that argument, which is music to investors’ ears.  Moderate growth is something that most economists like to see. Most economists have built into their 2022 forecasts an end of the pandemic (or a limitation of its effects).  Let’s hope that is the case.  But the pandemic is not over, yet many citizens and politicians are acting as if it is.  The greater risk is on the side of slower economic growth next year, as the Delta and/or future variants could keep the pandemic going longer than expected.

June Existing Home Sales, Leading Indicators and Weekly Jobless Claims

KEY DATA:  Sales: +1.4%; Prices (Over-Year): +23.4%/ LEI: +0.7%/ Claims: +51,000

IN A NUTSHELL: “The surge in unemployment claims was a surprise, but not necessarily a signal that the economy is slowing.”

WHAT IT MEANS: The data this week are limited but that doesn’t mean they are not important.  The housing market is the center of attention and while demand is hardly surging, it is still quite strong.  The National Association of Realtors reported that demand rose modestly in June, which is actually good news.  Sales had fallen on a fairly consistent basis since they peaked last October, so maybe this is an indication that the downslide is coming to an end.  Three of the four regions posted similar gains and the fourth was flat, indicating that demand is stabilizing across the nation.  The problem in the housing market is inventory.  While there was a rise in the number of homes for sale, the number of months of inventory remained ridiculously low.  As a consequence, the median price of a home sold was up over-the-year by the second largest rate on record and the median price itself hit a new record high.  Affordability is fading and that, in conjunction with the lack of homes on the market, may be the reason demand is not rising.

week we get second quarter GDP, and it should be really strong.  But where do we go from here?  If you believe the Conference Board’s Leading Economic Index, growth should remain solid.  The index increased solidly and the gain was broad based.  Yes, it is signaling a moderation in growth, but, as the report noted, it is pointing to not only a 6.6% rise this year, but a “healthy” 3.8% gain next. 

Unemployment claims surge last week, which was quite a surprise.  Since these data are volatile, we should assume that it is pointing to a major economic slowdown.  An outsized gain one week is often met by a similar decline the next.  The number of workers receiving assistance fell sharply and that should continue.  IMPLICATIONS:Are investors irrationally exuberant?  It is hard to make that argument.Yes, bad news is met by shock and then an “aw-shucks” response.That is, the markets tank for a short period of time and then the rally takes off once again.  That has been the case for a very long time now, not just since the V-shaped sell and recovery of last spring.  When the Fed started tapering, the markets went into a tantrum, but the decline, though steep, was short-lived.  Basically, no matter how bad the news, investors don’t take it seriously for an extended period.  They have been rewarded as the initial sell off triggered actions by either the Fed and/or the government, that kept liquidity flowing to the markets and/or to businesses and households.  Whether this time is different is unclear.  While some government programs are slated to end, other may be expanded in President Biden’s first budget.  At the same time, the Fed is steadfast in favor of supporting the markets by keeping rates low for a very long time.  As long as the government and the Fed keep pumping things up, it is hard to see how the markets can stay down for an extended period.  Interestingly, that means earnings are not the true driving force for equities.  Government policy is supporting demand and liquidity and the outlook for the markets is no longer a function of what businesses do but what the government and the Fed do.  Earnings just determine the distribution of the economic gains, not the level of the gains.  So, watch public policy because when that changes, everything else could be up for grabs

June Housing Starts and Permits and July Philadelphia Fed NonManufacturing Index

KEY DATA:  Starts: +6.3%; 1-Family: +6.3%; Permits: -5.1%; 1-Family: -6.3%/ Phil. Fed (NonMan.): -6.5 points; Orders: +4.4 points

IN A NUTSHELL: “Home construction remains strong, mirroring the economy.”

WHAT IT MEANS:  This week, there are few economic reports and most center on housing.  It looks like the home building sector remains in good shape.  Yesterday we saw that the National Association of Home Builders’ index eased back slightly in July as traffic slowed.  But the outlook for sales over the next six months improved.  Today’s report on June housing starts and permits was solid, as new construction activity picked up sharply.  The gain was evenly distributed between single-family and multi-family projects.  However, permit requests declined.  That is not a great issue as permits were above starts for the previous fifteen months.  Builders have a backlog of permits to work off and they are starting to do that.  You can see that in the number of units under construction, which hit its highest level in fifteen years. 

The Philadelphia Fed’s July survey of nonmanufacturing firms fell, but as is often the case, the headline number doesn’t tell the story.  First, the level remains high.  But more importantly, demand and hiring picked up.  Also, compensation costs are accelerating, and firms are raising prices more rapidly.  The issue of labor costs was the focus of this month’s special questions.  Over forty-four percent of the respondents indicated that they were raising wages more than planned and the median wage increase is now expected to be between three and four percent.  Expected wage, health and nonhealthy benefit costs are projected to rise by four to five percent.  This must be putting pressure on earnings.IMPLICATIONS:  Today, the economic data are not the major focus of investors.  Yesterday’s sell off is, and from the look of things, it is being matched by a sharp rise.  The wild gyrations in equity prices are indications investors are skittish about where we are going – and there is good reason for that to be the case. The Delta variant has taken over and it is spreading rapidly.  At the same time, vaccinations are falling and there is now a growing and vocal anti-vaccination movement.  Last summer, there was a lull, only to be met by a massive rise in the winter.  It is unclear what will happen as we move out of the warm weather into the cold.  Shutdowns are not expected, but health concerns, especially for children, could become an issue.Adding to uncertainty is the looming reduction in stimulus funds.  Over the past year, investors have looked past most of the problems and they were rewarded.  The big difference between now and last summer is that the stimulus was adding massively to both household and business spending and the prospect was that it would continue.  That is not the case now.  That said, President Biden’s first budget is filled with new spending and that could offset the loss of the stimulus funds.  Consequently, investors have reason to be uncertain, but also hopeful.  That points to further volatility ahead, so fasten your seat belts.

June Consumer Prices, Real Earnings and Small Business Optimism

KEY DATA:  CPI: +0.9%; Over-Year: +5.4%; Ex-Food and Energy: +0.9%; Over-Year: +4.5%/ Real Hourly Earnings: -0.5%; Over-Year: -1.7%/ NFIB: +2.9 points

IN A NUTSHELL: “Inflation and optimism are sky high, but spending power is cratering.”

WHAT IT MEANS: One of the greatest concerns, at least for consumers, is that inflation is soaring.  We saw again today, just how great a problem that is, at least right now.  The Consumer Price Index surged in June.  On a year-over-year basis, the rise was the second largest in nearly thirty years, beaten out by the gasoline price surge in 2008.  Excluding food and energy, you must go back to November 1991 to see any annual price increase greater.  Clearly, there are some special factors at work.  Used vehicle costs are up by 45% since last June, as the global supply chain is not working well.  Gasoline and fuel oil have also skyrocketed by a similar amount.  But while eating out is a lot more expensive, eating in costs have been tame, though that has been changing in the last few months.  Interestingly, health care costs, both goods and services, have been a restraining inflation.  Normally, it would be leading the way up.  Also, despite the surge in home prices, shelter expenses have been increasing at a moderate pace.  We need to be cautious in jumping to any conclusions about the yearly rise in consumer prices due to the price declines created by the shutting down of the economy.  That said, Since March 2020, before the pandemic impacts were felt, the headline index is up 5% while the core (ex-food and energy) has risen 4.2%.  In other words, inflation is soaring, and it is not just a statistical anomaly.

The problem for households is that their incomes are just not increasing nearly as rapidly as their expenses.  Adjusting for inflation, hourly wages fell sharply both over the month and over the year.  People are working more now but enjoying it less.

Despite the inflationary pressures on costs, small businesses are exuberant.  The June National Federation of Independent Business’s index rose solidly and the level is nearing the peaks seen after the 2016 election and the passage of the tax cuts.  But firms are having major problems filling open positions, raising costs and forcing firms to increase prices.  The percent raising prices hit its highest level since 1981 and no one who lived through that time period wants to go through that again.     IMPLICATIONS:The heat is on, it’s on the street” and the question is, will the Federal Reserve cops (yes, that is the song from Beverly Hills Cops) keep smiling and saying that transitory factors are driving the rise and they will dissipate and everything will be beautiful sometime in the future, whenever that sometime will be? But for workers, the surge in consumer costs is eating heavily into their spending power.  That is happening as states are trimming their unemployment compensation and the supplementary payments will terminate nationally in September.  Where households will get the money to keep spending as we move through the later portions of this year and into next is anyone’s guess.  While the strong job gains mean overall income will continue to increase, high or even moderate inflation, coupled with mediocre wage increases could limit consumption for those already working, and that is the bulk of the workforce.  But investors seem to think the Fed is totally correct that inflation will fade to trend and therefore don’t seem to be adding that issue to their decision making.  Given the markets tend to be cynical about Fed forecasting, to me this attitude looks like cherry picking those things that help keep the market going and discounting anything that doesn’t support that view.  That approach could persist for quite a while as we have no idea what the time frame the Fed has in mind when it says that inflation pressures are transitory.

June Service Sector Activity and Employment Trends

KEY DATA:  ISM (NonManufacturing): -3.9 points; Orders: -1.8 points; Employment: -6 points; Backlogs: +4.7 points/ ETI: +2.14 points

IN A NUTSHELL: “The easing of activity in the nonmanufacturing segment of the economy may be due more to labor issues than demand.”

WHAT IT MEANS: From all accounts, it looks like the summer party is on.  Mobs of people are out and about and seemingly spending money like crazy.  Yet the Institute for Supply Management’s NonManufacturing index fell solidly in June.  Are our eyes deceiving us?  Probably not.  So, what is going on?  Well, in today’s report, the details were mixed.  On the concerning side, business activity was off sharply.  There was a major rise in the share of firms reporting a decline in activity.  However, on an absolute basis, the level of the overall index and business activity are both quite strong. It is just that there were record highs set during the previous three months. Another negative component was employment.  But the problem here is that firms cannot find workers, not that they don’t need workers.  Finally, there was a huge rise in backlogs, as supplier deliveries are continuing to slow at a rapid pace.  That points to an inability to meet growing demand.

Doubts about the labor market should have been removed with the strong June employment report released last Friday.  Yes, there was an aberration in the government numbers, but the private sector did add a ton of new workers.  And today, the Conference Board reported that its Employment Trends Index rose solidly in June and level is back to where it was before the pandemic hit, when businesses were trying to cope with a lack of workers.  As the report noted, “A tight labor market is likely to be the new normal until the next recession.”IMPLICATIONS:The severe labor shortages are almost certainly muddling the economic data.Add to that supply chain problems and it is clear that while some data look as if they are pointing to a slowdown, what may be the case is that bottlenecks are creating output issues.  The problem is that when demand exceeds supply, there is a tendency for prices to rise.  At least that is what economists like to claim.  And in this case, we are indeed seeing that.  Unfortunately, we really don’t know how long the bottlenecks will continue to constrain activity.  On the microchip front, it is hoped that conditions will start easing over the second half of the year, but some sectors could see problems for another year or more, at least that is what some analysts are indicating.  That is important because the lack of chips has greatly affected U.S. manufacturing, especially vehicle production. Over the past year, the prices of used vehicles have risen faster than any other component of the Consumer Price Index except energy.  On the labor front, we could see an easing of the shortages when the supplemental unemployment compensation payments disappear, but it is unclear how much that will help given the need created by the reopening of the economy.  The Conference Board’s comment about being in a tight labor market until the economy crashes again is likely to prove prescient. Pressure on wages and signing bonuses will not likely disappear soon and that brings up the question I always ask:  If the current price and wage pressures continue for an extended period, to what extent will they become embedded in expectations?  It is hard to argue that there will be no impact, but that is what the Fed seems to be counting on.Let’s hope the Fed members are correct.  Otherwise, monetary policy will have to change a lot quicker than the markets currently expect.  That said, we are likely at least a year away from that possibly happening.

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