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Turning a Sow’s Ear into a Silk Purse

It wasn’t a big surprise that Wall Street advanced the narrative that the havoc wreaked by Hurricanes Harvey and Irma is actually a positive for the economy, now aided and abetted by the strangest employment report, perhaps of our lifetimes. (Conveniently ignored is Hurricane Maria, which completely wiped out Puerto Ricco’s economy, Hurricane Nate, and the California Wine Country conflagration.)

The Recent Data
Let’s begin with the most recent underlying data:

•    Exports and capital spending are showing signs of growth; exports because of the weakening value of the dollar.  Capital spending has been in the doldrums for so long that the growth seen there may simply be coming from renewal.  But, most likely, the growth is due to stepped-up Artificial Intelligence (AI) investments.  AI investment is a huge factor in the lack of wage growth, the move towards part-time jobs, and deflation in general.  Nevertheless, despite the good news in exports and capex, the two together represent about 20% of GDP;

•    70% of GDP is represented by the consumer, and, here, the news is not so good:  While real spending is up 2.5% year over year (YoY), real incomes are only up 1.2%.  The consumer has drawn down the saving rate from 6% two years ago to just over 3.5%; this can’t last.  The excess spending over and above the growth in income has been borrowed via sub-prime auto and credit cards, and in both of these categories there are rising delinquencies.  Not alarming yet, but concerning;

•    Housing, normally a key indicator for the economy’s health, has peaked, and the latest monthly data should be raising flags:
o    Housing starts: -9.6% month over month (MoM); seasonally adjusted annual rate (SAAR);
o    New home sales: -34.3% MoM, SAAR;
o    Existing home sales: -18.1% MoM, SAAR
o    Just imagine the further impact on housing if the Fed acts on its promise to raise interest rates in December and then 2 or 3 more times in 2018!

•    Auto sales, also a key indicator of economic health, are on a downtrend.  September sales were 18.5 million units (SAAR)(vs. about 17 million in August), but that isn’t a surprise given how many cars Hurricane Harvey destroyed (October’s auto sales may also be positively impacted).  In addition, dealer incentives were once again ramped up.  Whenever we see such incentives, current sales benefit at the expense of future sales.  Another sign of oversupply in the industry is the temporary shuttering of five Ford and three GM production facilities.

The Employment Twilight Zone
The Establishment Survey (ES) is a sampling of 147,000 large and medium sized businesses (and a plug number for small business from a model that has no ability to adjust for natural disasters like hurricanes or wildfires).  The ES provides the headline number of new jobs created each month (-33,000 for September).  The Household Survey (HS) is a sampling of 60,000 households (+906,000 for September).  The survey period each month is the week that contains the 12th.

The huge disparity between these surveys is cause for concern.  The headline employment number always comes from the ES, and that was -33,000.  But the U3 and U6 unemployment rates are calculated from the HS, and since it counted 906,000 new jobs (almost all full-time, which itself is cause for pause), the U3 headline unemployment rate fell from 4.4% to 4.2%.  Had the Household survey more closely matched the ES (as it did in the aftermath of Hurricane Katrina), the unemployment rate would have climbed toward 5%.

Natural Disaster Devastation
In addition, Puerto Rico isn’t counted at all in U.S. data, yet its decimation is bound to have a negative impact on Florida and other southern states.  If you think about the natural disasters, Hurricane Harvey likely knocked off 1%-2% of U.S. economic activity (Houston alone!).  Then there is the loss of economic activity from Hurricanes Irma, Maria and Nate.  And now, wildfires are destroying the Northern California Wine Country, likely another 1%-2% of GDP.

The fact that more cars or building materials are sold after natural disasters, while it does benefit certain industries, does not imply any increase in economic activity.  Actually, the opposite is the case.  Think of it this way, the gain for the auto or construction industry comes at the expense of the insurance industry.  Insurers have to convert balance sheet assets into cash and pay out for the destruction.  On net, nothing positive here!

Pre-Disaster Trends
The natural disasters make it difficult to discern any short-term trends, so it is probably wise to wait for the October report (November 3rd) or even the November (December 1st) before jumping to any short-term conclusions.  Nevertheless, long-term data trends are worrisome.  Looking at the non-seasonally adjusted employment levels on a YoY basis, the pace of employment growth has been decelerating since early 2015.  Back then, the YoY growth in total non-farm payrolls was over 3 million and that represented a 2.3% YoY change.  In the August data, just before the hurricanes, the YoY growth had fallen to barely more than 2 million, representing less than a 1.5% YoY change.  So, even prior to Harvey and Irma, which dropped the YoY growth to 1.2% in September, employment growth was in a significant downtrend.

The Wall Street Narrative
The day of the employment report, Wall Street celebrated that fact that average hourly earnings rose 0.5% MoM, for the second time in 3 months (the trend has been 0.2% to 0.3%).  Surely, they reasoned, this has to be the beginning of the long-awaited return of some moderate inflation and good news for consumers and wage earners.  The betting line on the probability of a December rate hike moved up to 80%, as surely the Fed now has the inflation data they crave to justify a rate hike.

But wait!  We are discussing the “average” of wages paid to those working.  Most of the jobs impacted by the hurricanes were in the leisure and hospitality sectors, generally lower wage industries.  So, one would expect the “average” to have risen if lower wage jobs were undercounted.  Economist David Rosenberg estimates that the increase would have been 0.3%, more in-line with the longer-term trend.  So, no, this is not the beginning of the Fed’s long-awaited (and now hoped for) resurgence in inflation. In fact, the September core CPI (ex food and energy) was as stagnant as it has been for the last 5 years even despite the fact that the prices of cell phone service rose for the first time in 14 months (remember, Yellen said that temporary factors, like the price wars in cell service, were keeping inflation down!).  Demographics, overcapacity, high and rising debt, the shared economy, and AI will keep deflation, not inflation, at the forefront.

When Will The Party End?
Wall Street, of course, doesn’t want the party to end.  But it is inevitable that it will.  Exogenous events are often the trigger.  Here is a list of potential events that may trigger the end of the party – likely, though, that the one that does trigger it isn’t mentioned here:
•    Political events in Europe and Asia (Catalonia);
•    The Trump – N. Korea file;
•    Hurricanes and wildfires, when the devastation is translated into economic data;
•    The appointment of a new Fed chief not favored by Wall Street.

I will end with an observation from Wells Fargo’s economics group:  Whenever the Fed Funds rate rises above the low yield for the cycle of the 10 Year T-Note (1.36% for this cycle), which will happen when the Fed raises rates again (December), a recession has resulted 70% of the time (average lead time, 17 months).  Nothing is certain in this world (except death and taxes), but it is my view that a policy misstep at the December meeting is likely to have a significant impact going forward.

Robert Barone, Ph.D.

Robert Barone, Ph.D. is a Georgetown educated economist.  He is a financial advisor at Fieldstone Financial.  www.FieldstoneFinancial.com .

He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco.  Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee.  Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research  www.FieldstoneResearch.com, and is co-portfolio manager of the  Fieldstone Financial Fixed Income ETF.

Statistics and other information have been compiled from various sources.  The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.

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