The headline numbers, for jobs and GDP, and most of the sentiment indexes, would lead one to conclude that the economy was robust and accelerating. Even the Fed agrees, as they upgraded their view of the economy to one now in “solid” growth mode.
The reality is that much of the data was distorted by the hurricane rebuild effort, and Q4 data will also be plagued by distortions due to the loss of 6,500 expensive homes in northern California’s wine country. A truer picture of the macro-economy emerges when those distortions are put into perspective.
The headline seasonally adjusted jobs number (establishment Survey) showed a net addition of 261,000 jobs in October. This follows an 18,000 print for September, revised up from -33,000. As expected, a significant portion of the gains were a rebound from the impact of September’s hurricanes. For example, 106,000 jobs were from the leisure and hospitality industry (hotels, motels, restaurants), an industry that suffered the most from the hurricanes.
Of the 261,000 jobs, about 55,000 were magically added by the Bureau of Labor Statistics’ (BLS) “Net Birth/Death Model” (the B/D Model). This is a mathematical algorithm that “estimates” net job growth from small business since the BLS doesn’t survey this sector. Between October ’16 and October ’17, BLS data show an addition of 2.037 million jobs; about 170,000 per month. Of the total, however, 45% (914,000) came from the B/D Model or more than 76,000 of the 170,000 per month. That means that BLS actually counted 1.123 million new jobs, or 93,600 per month – a far cry from the 170,000 average. I am not disputing the fact that small business adds jobs. What is questionable here, however, is the fact that the B/D Model algorithm is incapable of taking exogenous events, like hurricanes, into account. So, the current data is suspect and probably doesn’t mirror reality.
In the companion Household Survey, which is quite volatile on a month to month basis, employment fell in October by 484,000. The unemployment rate, which is calculated from this survey, fell from 4.2% to 4.1%. How is that possible when employment fell in the survey? The answer is that 765,000 people dropped out of the labor force, i.e., stopped looking for work. In technical parlance, the labor force participation rate fell. So, it appears that the labor market actually softened, while the official 4.1% unemployment rate indicates the opposite.
Wage Growth Non-Existent
A softer labor market seems to be confirmed by the fact that wage growth did not “accelerate” as the narrative would have you believe. In fact, “average” hourly earnings fell slightly (-.04%) in October. This shouldn’t be a surprise as “average” wages spurted in September when the lower wage jobs were decimated by the hurricanes (remember, this is an “average”). The fact that 106,000 of the net new 261,000 jobs were lower wage jobs would tend to pull the average down.
On a year over year basis, average hourly earnings have grown 2.4%. When Janet Yellen first became Fed Chair, she said that inflation would become an issue when wage growth rose significantly above 3%; actually closer to 4%. We haven’t seen this kind of wage growth since before the recession, now more than 8 years ago. Yet the Fed is hot to tighten!
Incomes Drive Spending
The workweek, too, was stagnant in October (i.e., average hours worked). As a result, in October, work based income did not grow! This is really important, because it is ultimately income that drives spending. The October “spending” data rose 1% on a nominal basis (0.6% in real, non-inflationary terms), the best performance since August, ’09. Much of this was due to the rebuild and replace caused by the hurricanes, and generally financed by a drawdown in insurance company reserves, not from increased incomes; and we are going to see much more of such distortions over the next quarter or two due to the northern California fires. Excluding autos and household furnishings, consumer spending grew at a ho-hum 0.2% pace.
The Headlines Say Growth…
The point here is that, in times of significant exogenous events, a better measure of economic well-being is income growth. (In fact, it is always a better metric, but spending is used because it is easier to measure.) In Q3 and the first month of Q4, real incomes appear to be flat, a sign that the economy may not be as “robust” as the headlines say.
The initial estimate (guess) of GDP growth for Q3 at 3% is a prime example. Without the positive change in net exports induced by a weaker dollar (now being reversed with the near certainty of Fed rate hikes) and inventory accumulation (which will slow manufacturing output in the current quarter), underlying GDP growth was likely less than 2%. In addition, the Commerce Department indicated that September’s hurricane devastation was not included. In Q4, we will have the distortions in spending in the GDP growth data due both to the hurricanes and to the California fires.
The sentiment surveys, too, including consumer sentiment and the ISM Manufacturing and Non-Manufacturing indexes seem to send an all clear signals; in fact, just looking at them, one would guess that the economy is expanding closer to 4% or 5%. But as pointed out by Wall Street Economist David Rosenberg, consumer confidence peaks very late in the business cycle, and a recession typically follows within a year. “This is a great contrary indicator because at the peak it signifies a consumer who is so satiated… that there is no more pent-up demand to satisfy.”
Missing in the consumer confidence surveys are buying intentions, and they are all moving lower including home buying intentions, intentions to purchase major appliances, and auto buying intentions.
While the pundits and talking heads on bubblevision see an accelerating economy based on the headlines, the reality is that the economic engine actually decelerated in Q3, and it appears to have carried over to Q4.
At its November meetings, the Fed upgraded the economy’s performance to “solid.” A December rate hike is all but certain. The short end of the yield curve has already priced this in. Yet, the 10-year yield while briefly moving above 2.4% in mid-October, has fallen back to the 2.3%-2.4% range, not even coming close to the 2.64% peak in the post-election reflation euphoria of a year ago.
This is puzzling. If the economy is on solid ground, growing at 3%, and accelerating, and the Fed continues in tightening mode, why do long-term yields refuse to rise? The bond vigilantes are concerned about two items: the lack of inflation, and the huge debt burdens faced by nations, corporations, and households. I have written extensively about the deflationary world in which we live, and have also outlined in prior writings that the debt burden today is much higher than it was at its pre-recession peak. (As a percentage of GDP: U.S.: 251% today vs. 228% pre-recession; China: 258% vs. 145%; Japan: 372% vs. 308%.)
Ten years ago, the economy faltered because it could not handle the debt burden of a 5% interest rate environment mandated by Fed policy. Likewise, today, there is a yield curve, likely much lower than that of 2007, that will choke any economic expansion. With the economy already in slow growth mode, every one-percentage point rise in interest rates will choke off between 2% and 3% of GDP growth by throwing the available cash into debt service costs. Given an economy with a 2% growth potential, the Fed is likely only two or three rate hikes away from that growth stifling yield curve.
There are four major central banks in the modern world: The Fed, the European Central Bank (ECB), the Bank of England (BOE), and the Bank of Japan (BOJ). For the past year, only the Fed has been in tightening mode, and only mildly so. The liquidity provided by the ultra-easy monetary policies of the world’s central banks has been a prime reason for the equity market’s rise to unprecedented heights, as dividend yields have been more attractive than paltry bond returns.
But now, of the four, only the BOJ remains extremely accommodative (resulting in Japan’s stock market’s rise to levels not seen since 1996). The Fed, besides the rate hikes, has now embarked on balance sheet reduction (Quantitative Tightening). This started in October at a low level, but is scheduled to accelerate as long as the Fed views the economy’s growth as “solid.” Over the past few weeks, the ECB has announced that it is “tapering” is Quantitative Easing, and the BOE, early in November, announced that its next move would be a rate increase.
I suspect that, as a result of these tightening moves, the complacency about overvaluation that we have observed in the equity markets, as measured by the record low levels in the VIX (a measure of market volatility), will begin to erode.
Robert Barone, Ph.D.