Second Quarter Productivity and Costs

KEY DATA: Productivity: +2.5%; Output: +5.2%; Real Hourly Compensation: +0.1%; Unit Labor Costs: 0.6%

IN A NUTSHELL: “Productivity rebounded, keeping business costs low as wage gains remain largely under control.”

WHAT IT MEANS: Rising wages don’t have to be a major problem for firms as long as workers offset those increases with improved output.  Unit labor costs, which reflect the balance between wages and production, edged upward in the spring.  Strong spring economic growth, a reflection of the rebound from the winter weather-restrained production in the first quarter, offset an increase in wages.  Indeed, there was a huge rise in labor costs in the first quarter, which points out that the quarter-to-quarter numbers really don’t mean a whole lot.  Smoothing out the data by looking at the year-over-year numbers gives a better indication of what is happening with productivity and costs.  If you want to know about the potential for consumer spending to rise faster, just look at compensation adjusted for inflation.  Real hourly compensation was at the same level in 2013 as it was in 2007.  But that may finally be changing, at least a little.  While workers inflation-adjusted income fell by 0.3% in 2013, it is rising at about a 1.5% during the first half of the year.  If wage gains accelerate, as I expect, we might actually hit 2%.  Will that cause business labor costs to rise?  Probably, but not necessarily a whole lot.  Productivity will likely rise about 1.5% to 2% this year so labor costs should be mostly offset by additional worker output.  But we may see unit labor costs look a lot less positive for businesses than they have been the case for a decade.

MARKETS AND FED POLICY IMPLICATIONS: Labor costs are and will be the focus of attention for a very long time.  Yesterday’s unemployment claims report points to strong job gains and a decline in the unemployment rate.  Full employment is on the horizon, whether the business community wants to accept that or not.  Today’s report doesn’t say that labor costs are a problem yet, but it hints at some improvement in pay.  That is good.  Real worker compensation has essentially gone nowhere for six years, so how can anyone think that people will be able to shop ‘till they’re tired let alone ‘till they drop unless wages rise solidly?  The Fed members, at least the inflation hawks, will likely look at the report as supporting their view that it is time to change direction.  But investors will probably take solace from the headline number, which implies that labor costs are again well contained.  These numbers are hugely volatile and believing the quarterly numbers mean anything is a short-cut to muddled thinking.  Regardless, with geopolitical issues heating up, who knows what will drive the markets these days.

June Trade Deficit

KEY DATA: Deficit: $41.5 billion ($3.1 billion narrower); Exports: up $0.3 billion; Imports: down $2.9 billion

IN A NUTSHELL:  “The narrowing of the trade deficits indicates growth was stronger than expected though the softening in our demand for imported products raises some questions.”

WHAT IT MEANS: The second quarter is past but we are still getting a picture of what happened.  The latest number is the June trade deficit, which was a lot less than expected.  On the one hand, that is good news.  It looks like the negative impact that trade had in the initial GDP estimates will be revised downward, meaning that growth was likely higher than thought.  However, the details are a bit strange, especially on the import side.  The decline in purchases from the rest of the world was largely across the board.  Demand for foreign capital and consumer goods, vehicles and industrial supplies were all off.  Moderating petroleum demand, which is a trend that should continue as we replace foreign products with shale energy, played a role but is only a partial explanation.  With the economy growing, consumer and business spending rising and vehicle sales robust, there is every reason to believe that imports will rebound going forward.  On the export side, we sold a lot more aircraft, chemicals and medical products but not much else.  Looking across the world, the Chinese economic issues have them ramping up their export machine while their purchases of U.S. products remains limited.  Our trade deficits with most of the rest of the world either narrowed or turned to a surplus.

MARKETS AND FED POLICY IMPLICATIONS: The sharp narrowing in the trade deficit is something I will take every month, but I would prefer it happening by exports growing a lot faster than imports.  That would be reflecting strong economic growth around the world.  It is doubtful that buying less from foreigners is a trend as the U.S. economy seems to be picking up steam.  So look for the deficit to widen going forward and that could mean the foreign sector will restrain growth.  I still expect third quarter to show a growth rate of at least 3% as consumers and businesses keep buying and investing.  With the supply managers telling us the service sector is getting on a roll, that missing link may no longer be absent without leave.  If services spending, which is 45% of the entire economy, is indeed expanding more rapidly, then we should get growth between 3.5% and 4% during the second half of this year and in 2015.  But the Fed seems to be in “show me” mode so a forecast of stronger growth is just that, a forecast.  Until it occurs and the labor market tightens to the point where wage inflation actually shows up, this Fed seems willing to keep rates low.  As for investors, we have Russia, earnings and mergers and acquisitions roiling the markets so who knows what they are thinking.

Supply Managers’ Non-Manufacturing Index

KEY DATA: ISM: +2.7 points; Orders: up 3.7 points: Employment: +1.6 points

IN A NUTSHELL:  “The services sector is bouncing back rapidly and since that is the largest part of the economy, it looks as if strong growth is just about here.”

WHAT IT MEANS: To get to rapid growth, you need just about every component of the economy hitting on all cylinders.  True, you can have one or two smaller sectors soft and still get a quarter or two or robust gains.  But for strong activity to be sustained, you cannot have the big dog sitting on the porch.  That has been the case with the U.S. economy as minimal income gains have limited services growth.  That is changing.  The Institute for Supply Management’s Non-Manufacturing index jumped in July, rising to the highest level since December 2005.  Yes, 2005!  Supporting that gain was the Markit Purchasing Managers’ services sector index, which did ease a touch but was still near the record level that had been reached in June.  In other words, non-manufacturing firms seem to have turned the corner.  The rise in business activity was driven by surging new orders as thirteen of the sixteen industries reported gains.  Exports didn’t accelerate but import orders did.  With factory orders up by a robust 1.1% in June, it is clear that someone is buying lots of goods and now we see services as well.  The strengthening demand is translating into new hiring.  Inventories are growing, but minimally and that may lead to even more activity going forward, especially since backlogs continue to expand.

MARKETS AND FED POLICY IMPLICATIONS:  The economy has seemed poised to break out before and we have been disappointed so I will believe it when I see it, but the data are really pointing to strong growth.  The employment report was not as great as hoped for but the data don’t go in a straight line.  Don’t be surprised if the August gain is above consensus.  But even with the less than hoped for rise in payrolls and the modest increase in the unemployment rate, the labor market situation remains positive as unemployment claims are at levels not seen in forty years.  Since both manufacturing and non-manufacturing accelerating, it is likely that the labor market will tighten further.  But wages will likely remain restrained as businesses still don’t think they actually have to raise compensation.  It may take a jump in employee turnover before the reality strikes home and we may not see that until much later this year.  Regardless of the timing, it is coming and the Fed is going to have to deal with it.  Chair Yellen seems to believe that she can wait until she sees the whites of wage inflation’s eyes until pulling the trigger so don’t expect a whole lot of talk about rate hikes for a while.  But that discussion, as well as information about how and when the Fed intends to shrink its balance sheet, needs happen in the public view soon.  The Fed has done great work in getting the economy to this point and now we have to know how it intends to unwind the crisis-based policy it has been operating under for the past seven years.  As for the markets, who knows what investors are worried about right now?  While this report should be positive, that doesn’t mean the markets will look at it that way or even consider it an important aspect of today’s trading

Second Quarter Employment Cost Index and Weekly Jobless Claims

KEY DATA: ECI (Private, Year-over-Year)): +2.0%; Wages: +1.8%; Benefits: +2.5%/Claims: 302,000 (up 23,000)

IN A NUTSHELL: “Wage and benefits pressures are barely starting to accelerate even as the labor market continues to strengthen.”

WHAT IT MEANS: If the labor market matters to Fed members and the concern centers around employment costs, then the quarterly Employment Cost Index should be an important number.  Whether it is or not for others, for me it is another critical part of the picture and right now businesses are still controlling workers costs but maybe not as well as they had been.   Private sector compensation costs rose at a solid pace in the second quarter though that came after an aberrant nonexistent increase in the first quarter.   Both wages and benefits jumped.  Looking over the year, though, the increases in total compensation, wages and benefits were all at the top of the range we have seen for the last couple of years but not above it.  Public sector costs are rising at the same pace even though wages and salaries are barely budging.  Looking across occupations, service workers are doing the worst, which is not surprise.   Whatever gains in compensation we have seen have been centered in the professional and construction worker ranks.

Jobless claims jumped, but that was expected.  Last week’s report was assumed to be a bit too low due to the random nature of vehicle sector summer shutdowns.  The four-week moving average, though, was the lowest in over eight years and that is without adjusting for labor force size.  If the claims numbers relate in any way to job gains, and I believe they do, then the July employment report which comes out tomorrow should be good.  Given the robust June gain, I expect July’s to be lower but we could easily average between 260,000 and 275,000 for the two months.  That would be impressive.  The unemployment rate could also decline.  I would not be shocked if it breaks 6%, though that is not in the forecast for this month.

MARKETS AND FED POLICY IMPLICATIONS: So far, so good, at least when it comes to controlling employment costs.  Yes, the second quarter number was hotter than expected but the first quarter rise was strangely minimal.  Average them out and there was not any major change in the rate of worker cost increases.  Benefit expenses have accelerated a touch and wages seem to be moving upward, but the pressures do not look great.  But the Fed has to look at least six to twelve months down the road and if the unemployment rate keeps declining, unless the law of supply and demand has been repealed for the labor market, compensation pressures simply have to increase.  The issues are when and how fast.  Most members of the Fed appear to believe it will be a lot later and not very rapidly but I am not that sure.  Tomorrow’s jobs report will give us another piece of the puzzle and hourly wages should be watched carefully.  Workers need more income to spend more and power growth to a higher level.  That does not seem to be happening just yet but I think we will be seeing signs very soon.

July 29, 30 ’14 FOMC Meeting

In a Nutshell: “…a range of labor market indicators suggests that there remains significant underutilization of labor resources.”

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

Quantitative Easing Decision: Bond purchases reduced by $10 billion to $25 billion

The latest FOMC two-day meeting was not expected to create any major change in the messages that the Fed members have been trying to send, and it didn’t.  But there were still some interesting takeaways from the statement.

If it is all about the labor market and wage pressures, then the Committee did elevate its thinking about the potential for rising compensation to the top of the discussion.  That said, the members then decided to downgrade the threat by indicating there was “significant underutilization of labor resources”.  There is still belief that the labor market will improve, but right now they seem to be saying potential wage pressures are not a threat.  The statement seemed to be a little more cautious about inflation, which has accelerated recently.  The comment was that “Inflation has moved somewhat closer to the Committee’s longer-run objective” rather than just being below target. I am not exactly sure how much worry that shows given the lack of concern about wages, but at least there was recognition that the rate is moving upward.

Otherwise, everything was expected.  The Committee knew that growth had rebounded in the spring and said so.  With growth back on track, it was easy to continue the reduction in asset purchases by another $10 billion.  It is likely that quantitative easing will be a thing of the past as of the October meeting.  But other than indicating that all funds would be reinvested, there was no indication of what will happen to the Fed’s balance sheet after asset purchases end.  As for the funds rate, it was repeated that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends”.  Since considerable time is about six months – per Janet Yellen – and the program should end in October, that gets us to April.  I think the March meeting is still a good possibility.

Okay, what does this all mean?  There seems to be a growing discontinuity between the firming labor market data, excluding wages, the upward trend in consumer costs and the Fed’s lack of concern about future inflation.  Indeed, it is unclear why the Fed believes that wages will not start rising faster by year’s end.  Keep in mind, the Fed has been so easy for so long that it will take at least two years or longer to unwind everything.  If they are using wages, which is a lagging indicator of a lagging indicator, to signal inflation pressures, then they are taking a fascinating gamble.  While I am not an inflation hawk by any means, it is time for the Fed to explain how it will know when labor market conditions are becoming tight.  My view is simple: If you wait until you see that wage pressures are building, it will be very late in the process to begin dealing with the rising cost pressures.  That is true for both businesses and the Fed.

Second Quarter GDP and July ADP Jobs Forecast

KEY DATA: GDP: +4.0%; Consumption: +2.5%; Consumer Prices: +2.3%/ADP: 218,000

IN A NUTSHELL:  “The strong second quarter growth supports continued solid payroll gains and a further tightening of the labor market.”

WHAT IT MEANS: The Fed is meeting and the members now know that the winter of our discontented economy is past.  Economic growth had declined sharply in the first quarter, though the latest estimate of 2.1% was not as ugly as the previous 2.9% guess.  Still, that size fall in activity raised questions about the true strength of the economy, an issue that is no longer a concern.   Growth rebounded sharply in the spring, led by strong vehicle sales, solid export activity, strong business investment and inventory building and renewed government spending at the state and local government sectors.  In other words, only the federal government remains a weight around the economy’s neck.  On the inflation front, consumer costs accelerated, rising at the fastest pace in three years.  The pace was not great but at 2.3%, it is above the Fed’s target of 2%.  Excluding food and energy it was right at the number.

Friday we get the July jobs report and ADP expects it to come in a little lower than the June gain.  The economy probably still averaged at least 250,000 new jobs over the past two months and that is strong.  The moderation in hiring, if you can call it that, was largely in the small business component.  Payrolls rose by about 40,000 less in this component than in June.  That doesn’t worry me since Paychex/HIS reported yesterday that small businesses were adding jobs faster, so that slowing may unwind in August.  Still, the increases appear to be across all industry segments.  Consensus is for about 230,000 new positions which should support a drop in the unemployment rate to 6.0%.  I think job gains could be a touch better, closer to 250,000.


MARKETS AND FED POLICY IMPLICATIONS:  This report was much higher than most expected (I was at 4.1%).  It should also put to rest the questions about the rebound from the winter.  The economy came back and even though there may have been a little extra inventory building that could moderate third quarter growth, solid activity was so widespread that you cannot call this number an aberration.  We are likely to see growth in the 3.5% to 4% range during the second half of the year.  With job gains strong and the labor marketing tightening, income should begin rising faster, powering better consumer spending.  Chair Yellen is focusing on wages, but that is a lagging indicator which may lag even more because of business intransigence on raising compensation.  That is, when broad wage increases start showing up, it will be late in the process to begin dealing with the rising cost pressures.  That is a warning to both the Fed and business executives.  Either have plans in place soon to deal with the inevitable workings of supply and demand in the labor market or play catch up.  That is why I think the first rate hike comes in the first quarter of next year.  It is also time the bond markets begin focusing on the increasing likelihood that growth will be closer to my forecast, which is well above consensus, and as a consequence prices will accelerate faster than expected.  We are not talking high inflation, but inflation that exceeds Fed targets.

May Case-Shiller Home Prices and July Paychex Small Business Hiring

KEY DATA: Case Shiller (Monthly): -0.3%; Annual: +9.3%/Paychex: up 0.3%

IN A NUTSHELL:  “Small businesses are hiring but the improving labor market conditions are not translating into booming home sales or prices.”

WHAT IT MEANS:  Another day, another sign that economic conditions are improving but not across the board.  Today’s fun numbers spoke about housing prices and small business hiring.  In May, home prices took a step backward, according to the S&P/Case-Shiller home price measure.  The seasonally adjusted 20-city index fell between April and May with fourteen of the twenty cities posting declines.  In April, only four cities saw home prices fade.  Looking over the year, prices are still up strongly, but the rate of gain is decelerating sharply.  It had peaked in November 2013 at 13.7%, so the increase is off one-third.  That said, the increases are still impressive with only New York, Charlotte and Cleveland having home costs increase by less than five percent.

While housing seems to be in a lull, hiring is not.  The Paychex/IHS Small Business Hiring Index rebounded from a spring thaw and is closing back in on the record high it posted in April.  Except for the West South Central, which includes Texas, all regions were up nicely over the year.  The Mountain and Midwestern regions led the way with somewhat more modest gains being recorded along the East Coast.

MARKETS AND FED POLICY IMPLICATIONS: It just seems that when it comes to breaking out of its slow growth pattern, if it isn’t one thing that restrains activity it is another.  When manufacturing came around, housing and the labor market lagged.  Then housing started to rebound, but jobs and incomes were not growing rapidly.  Now that firms are hiring, the housing market is starting to stumble.  Will we ever get things going all at once?  Maybe, but not right away.  Still, the key remains wages and with small business hiring picking up, that bodes well for income growth.  As for the housing situation, I differ from many of my colleagues.  While others bemoan the rising prices as a problem for first-time buyers, I cheer rising prices because they are lifting people out of the negative equity/minimal equity trap.  Without enough equity to buy another home, families are basically “home bound”.  The normal churn in the market, where current owners move around, is limited.  The more prices rise, the more households can move.  I think adding to equity is a more important factor in getting the housing market back to normal than keeping prices low so new buyers can enter.  But that is just me.  Anyway, it is still earnings season and with geopolitical concerns lurking, these reports are not likely to move the markets much.  And let’s not forget that the Fed has started its two-day meeting.  Not much news is expected tomorrow, when the FOMC meeting ends, but it still hangs over the markets.

June Durable Goods Orders

KEY DATA: Durables: +0.7%; Excluding Transportation: +0.8%; Non-Defense, Non-Aircraft Capital Spending: +1.4%

IN A NUTSHELL:  “Corporations are investing in big-ticket items, a clear indication that business conditions are improving.”

WHAT IT MEANS: Durable goods orders, the poster-child for volatile data, showed once again that if you don’t like the numbers one month, wait thirty days and they will change.  Demand for big-ticket purchases plummeted in May, setting off concerns that the economy was not picking up steam.  Well, not to worry.  Orders rebounded in June and the increases were in a variety of industries.  Yes, aircraft, both Boeing and Pentagon, was up.  But it wasn’t just sales of airliners and fighters that moved the needle.  Demand for machinery, electronic products and primary metals rose.  While vehicle orders fell, demand is so strong that it is likely that sector will be posting gains going forward.  As for corporate capital spending, the key measure – non-defense, non-aircraft orders – jumped.  They had been soft and this may be a sign of improving confidence.  Looking toward the future, backlogs built in almost every major sector.  That implies production should accelerate in the months to come.      

MARKETS AND FED POLICY IMPLICATIONS: Just as I cautioned that we shouldn’t read too much in a decline in durable goods orders, so should be we careful not to jump to conclusions when demand rises.  The data are just way too volatile to assume one or even two months of numbers mean a whole lot.  With that said, the rise in orders in June means that durable goods demand has increased for four of the past five months.  That is really the story.  If big-ticket purchases are growing on a fairly consistent basis, then economic activity should be improving.  With the labor market tightening and loan demand picking up, about the only place where there seems to be problems is housing, and that is more in new homes than existing homes.  The existing market seems to have righted itself after the winter slump.  Neither is strong, but it is hard to get a mortgage with income growth weak and with many homes still either under water or with limited equity, owners just don’t have the down payments.  Next week the Fed is meeting on Tuesday and Wednesday, before the employment report is released.  They will have second quarter GDP but regardless of the rebound from the first quarter decline, it is still all about labor compensation.  The July payroll and unemployment numbers should be good, though with businesses adamant about not raising wages, don’t expect hourly earnings to pop.  It will take real labor shortages before firms get the picture that to fill open slots, they will have to pay more.  But as I keep saying, the longer the pressure builds, the bigger the explosion.  When wages start to rise, they could really pop. The Fed has some time to watch and wait, but their flexibility may come to an end sooner than expected.  As for investors, they should like this report.  But it is earnings season and with orders bouncing around so much, don’t expect this report to drive the markets.

June New Home Sales and Weekly Jobless Claims

KEY DATA: Sales: down 8.1%; Jobless Claims: 284,000 (down 19,000)

IN A NUTSHELL:  “The labor market may be getting better but wage gains are not and until that happens, families will not be buying new homes at any great pace.”

WHAT IT MEANS: When it comes to economic numbers, today’s data were the best of times and the worst of times.  First the good news.  Jobless claims dropped to their lowest level in over eight years.  And when you adjust for the size of the labor force, you have to go back to 1999.  Clearly, the labor market is tightening, but we have to be a little cautious about the July claims numbers.  The vehicle makers don’t close plants in the same pattern that they used to when July was standard changeover to new model time.  Thus, the seasonal adjustments may be a little out of whack and it wouldn’t be surprising if the number gaps upward next week.  It will still be low, but not as eye-catching as today’s number.

While the job market may be getting better, the housing market is not, at least when it comes to new home sales.  Builders saw demand plummet in June and the decline was across the entire nation.  The largest fall off was in the East, where sales plummeted 20% while the West saw demand decline by just under 2%.  The supply of homes for sale is continuing to rise and that growing inventory could lead to improving sales as buyers have more options to choose from.

MARKETS AND FED POLICY IMPLICATIONS:  While the declining housing sales are troubling, they really didn’t make a lot of sense.  It is hard to believe that builder confidence is jumping, as we saw with the jump in the Home Builders’ index, while sales are falling.  So I am a little suspect about these data.  Meanwhile, the jobs numbers are just getting better and better and for me it is all about the labor market.  Not to sound too much like the broken record that I am, the missing link in this recovery continues to be solidly growing worker income.  We saw this week that in June, earnings were flat again and adjusting for inflation, they declined.  It is hard to make a commitment to buy a house when you don’t have increasing funds.  But that is likely to change.  The low levels of claims points to another solid jobs report and we could see the unemployment rate decline to 6% or even lower when the July data are released next Friday.  Now there are many who simply do not believe that worker compensation will accelerate any time soon.  But unless the law of supply and demand has been repealed for the labor market, the tightening of conditions will force firms to start bidding for workers.  There may be resistance to doing that and the appearance of wage pressures may take longer to show up as a result, but it is coming and probably sooner than most think.  When household incomes start rising, they will be better able to qualify for mortgages while the resulting increase in confidence will likely also encourage more home purchases.  The Fed will likely wait to until wages are actually rising before any decision to increase rates is made.  The old saying that “if you wait to see the whites of inflation’s eyes before tightening you have waited too long” seems to have been discarded by the Yellen Fed.  As for investors and business owners, they dismiss the warning signs about growing wage pressures at their own peril.

June Housing Starts and Weekly Jobless Claims

KEY DATA: Starts: -9.3%; 1-Family: -9%; Permits: -4.2%/Claims: 302,000 (down 3,000)

IN A NUTSHELL:  “We thought that home construction would surge this spring but instead it has fizzled, despite improving labor market conditions.”

WHAT IT MEANS: I know this will probably date me but does anyone remember the Vanguard rockets that were supposed to launch our satellites into space?  No?  Not surprising, since most of them went up and the fell back right to earth.  Well, the home construction sector, which was supposed to rocket us into stronger growth looks more like a Vanguard than the Atlas V that successfully sent our men to the moon.  Yes, I miss the space program. Housing starts posted a second consecutive big decline in June.  After rebounding sharply in April from the winter weather, builders seem to be getting more cautious.  This is a real surprise.  First of all, permits, while down in June as well, have been running about five percent above starts for the last two months.  Builders are not paying for permits unless they expect to build those units.  The number of homes authorized but not started also jumped.  And finally, builder confidence soared in June, according to the National Association of Home Builders.  So what is going on?  I am not certain but the nearly thirty percent decline in starts in the South has to be suspect.  I could understand it if there was just a huge decline in the volatile multi-family sector, but the single-family component also dropped sharply.  In the rest of the country, activity was up.  So let’s wait a while before we jump to any conclusions about the state of the housing market.

The good news today was the drop in jobless claims.  We are looking at levels not seen since 2007 and when you adjust for the size of the labor force, we are approaching record lows.  The monthly surge in the number of jobs being created and the continuous drop in the unemployment rate is no fluke.  The July jobs report is setting up to be another really good one.

MARKETS AND FED POLICY IMPLICATIONS: Home construction is a critical component of any strong economy and right now, activity seems to be faltering.  But I just don’t believe that the headline number is telling the whole story.  The huge fall off in the South makes no sense, especially given that starts rose everywhere else and other indicators point to rising activity.  So my suggestion is that we feel disappointed by the report but don’t get too worked up about it.  What I think investors should focus on is the jobless claims data.  The labor market is tightening.  Firms are not cutting workers and people are finding jobs.  Don’t be surprised if the unemployment rate dips below 6% by the fall and with full employment at around 5.5%, it is hard to believe that labor shortages will not start appearing across industries, occupations and regions.  The real question is: When will businesses feel compelled to raise wages to attract workers?  I have said this before and I will keep saying it, that time is coming, likely before the end of the year, and once the wage dam breaks, retention issues will arise and compensation costs will become the main topic of discussion at the Fed.  But Fed Chair Yellen is content to wait until she actually sees that happen so rate hikes are still well into the future.

Linking the Economic Environment to Your Business Strategy