Fed Chair Powell’s congressional testimony did little to allay market fears regarding the Fed’s underlying posture. Markets continue to be worried that, while the Fed is certain to cut the Fed Funds rate by 25 bps at July’s meeting, the rate reduction may turn out to be just an “insurance” cut, especially in light of the fact that the June jobs report has been portrayed as “strong.” Describing the cut as “insurance” implies that it isn’t absolutely necessary, and also implies that the Fed won’t need any additional cuts. As a result of these misgivings, interest rates have given back some of their recent fall, with the 10-year Treasury Note near 2.10% as of this writing, after having fallen to as low as 1.95% just prior to the Fed’s mid-July meeting.
Incoming data continue to show economic deceleration, sometimes at an accelerating pace, in the world’s economies. China’s GDP (5.6% sequentially and 6.2% year over year) came in on the light side, and their imports and exports both fell hard in June. And, perhaps, a canary in the coal mine, Singapore’s Q2 GDP surprisingly fell at an annual rate of -3.4% with their manufacturing sector down -3.8% from a year earlier. The reality is that Fed Chair Powell and the other voting Fed members are worried about the impact that slowdowns elsewhere may have on the U.S. and this was confirmed by the release of the June Fed minutes. In his recent testimony to Congress, Powell set the stage for the accommodation cycle to begin, i.e., a reading of his remarks would seem to confirm that July’s rate cut will be the beginning of a rate reduction and accommodation cycle (including other monetary tools, if necessary), not just a one-off insurance cut. Here is some of what Powell told Congress:
…growth in business investment seems to have slowed, and overall growth in the second quarter appears to have moderated. The slowdown in business fixed investment may reflect concerns about trade tensions and slower growth in the global economy. In addition, housing investment and manufacturing output declined in the first quarter and appear to have decreased again in the second.
…uncertainties about the outlook have increased in recent months. In particular, economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the U.S economy.
Since our May meeting…those crosscurrents have reemerged, creating greater uncertainty.
[In June] [M]any FOMC participants saw that the case for somewhat more accommodative monetary policy had strengthened. Since then, based on incoming data and other developments, it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weight on the U.S. economic outlook.
Does that sound like someone mulling an “insurance” cut? Still, Wall Street continues to worry, perhaps because in his short history as Fed Chair, Powell has, at least twice, abruptly changed directions. In a classic case of “bad news” is “good news” and vice-versa, Wall Street obsesses that the economy remains strong enough to eventually convince the Fed that one, or perhaps two cuts are all that will be necessary. This view has emerged since the “strong” June jobs report. Nevertheless, despite the prevalent Wall Street view, an analysis of that report indicates that it is anything but “strong.”
Almost all of June’s individual survey data came in weaker, especially manufacturing (Six Fed Surveys and ISM!) and construction data. So, the 224,000-headline net new job creation (the Establishment Survey (ES)) was a surprise. (That report showed +17k net new jobs for manufacturing and +21k jobs for construction.)
The ES surveys only large businesses. Because it does not survey “small business” the Bureau of Labor Statistics (BLS) has a “Birth/Death” (B/D) model that is supposed to compensate for the non-surveyed small business sector. The B/D model is not a survey, just a mathematical algorithm that adds (plugs in) about 100k/month to the BLS’s actual count. In the June survey, the B/D model accounted for 102k of the 224k total net new jobs. In the end, BLS only actually counted 122k net new jobs (of which 33k were government jobs).
The ADP Survey
The ADP Survey came out on the Wednesday (July 3rd), just prior to the Friday, July 5th employment surveys. ADP’s report is based on actual payroll counts (logical, since ADP is a payroll processing company). The ADP report showed net new private sector jobs of 102k. Adjusting the ES for the B/D model and excluding net new government jobs results in an 89k count for private sector large companies (i.e.: 224-102-33 = 89). Furthermore, ADP’s data indicated that small business actually had a net jobs loss totaling -23k in June (May was -38k). So, ADP counted 125k net new private sector large company jobs, a number higher than the actual 89k count of BLS for that same category. Given the deceleration in the economy, and ADP’s actual small company counts, BLS’s addition of 102k small company jobs makes no sense.
One other interesting item, in the B/D model, the leisure and hospitality sector was guestimated to have added 86k net new jobs in June. (That is 86k out of the 102k added by B/D.) Because it is in the B/D model, this is an estimate of small businesses in the hotel/gaming/leisure sector – think of mom/pop motels and other related small businesses (perhaps pawn shops, too). As indicated above, ADP told us that small businesses were laying off in June. And ES’s own sector breakdown only showed a net +8k jobs in big business hotel/gaming/leisure sector – think major hotel chains and the big gaming/leisure sector. It is counterintuitive to believe that mom/pop shops in that sector were adding jobs while the majors were not. Mom/pop shops in that sector always follow the majors with a lag, i.e., if business is slowing for the majors, what do you think it is doing for mom/pop shops?
So, on net, the ES jobs report was a lot weaker than the headline. Going one step further, if you remove the B/D model add-ins for year to date through June, on net, the ES would show almost no net new job creation since 12/31, i.e., none of the growth to date was actually counted – all came from the mathematical algorithm.
The Household Survey
The Household Survey (HS) is usually a much better indicator of the job market than is the ES. This survey is the one on which the unemployment rates (U3 and U6) are calculated. It showed up in June at a quite healthy +247k after having been weak for most of the year. Breaking it down, however, showed that +222k (or 90%) of that growth was government jobs, most likely census hiring. Only 31k were in the private sector, with the three prior months showing a cumulative loss of -172k private sector jobs! Here are some other disconcerting statistics:
- Multiple Job Holders: +301k (This could be associated with census hiring; but if you think about it, when people need second jobs…);
- Self-Employed: +143k (This , too, usually has an inverse correlation to economic activity);
- Teenagers: +137k and equal to 55% of the total (Summer jobs?);
- College grads (or people with some post-secondary education): -205k (eye opening!);
- Jobs in Prime Working Years (25-54 years old): +29k (-168k YTD) (more eye opening);
- Adult Males (25-54): -97k (and -338k YTD)(Yikes!).
Fed Recession Gauges
Other scary data came from the NY and St. Louis Feds, both of which have recession indexes. The NY Fed’s index now stands at a 12-year high, indicating a 32.9% chance of recession in the next 12 months. It is up 11 percentage points this year and 20.4 points from a year ago. This index peaked at 33% in 1989, in the mid-40s in ’00, and just over 40 in ’07. At the same time, the St. Louis Fed’s recession index now stands where it stood in October ’07. Food for thought!
The data alone should be enough to convince an analyst that the upcoming rate cut is the first step in a new easing cycle. As indicated earlier, the first question is whether the Fed will actually follow through. The larger question is, will the Fed’s current and future actions be enough to deliver the “soft” landing that the equity markets are counting on? Consider the following:
- In the Fed’s 106-year history, this is the lowest level the yield curve has ever been when the Fed began its easing cycle, and, on average, during easing cycles, rates are cut more than 5 percentage points. In the current cycle, 2.5 percentage points is all the Fed has (unless they push rates into negative territory. Yikes! That hasn’t worked in Europe or Japan);
- The Fed appears to have over-tightened and looks to be late in starting the easing cycle (thus the need to consider 50 bps later this month);
- To date, in the absence of Fed action, the bond market took it upon itself to lower rates, and many businesses have already reacted. The result may be that further business reaction to the Fed’s rate cuts is muted. Just look at the housing market’s muted reaction over the past few months to falling mortgage rates.
The equity market always initially rises when the Fed begins an easing cycle. But, history has shown that the initial market enthusiasm is short-lived. We can hope that the Fed engineers a soft-landing. But, hope is not a good investment strategy. What the Fed has told us means that investment portfolios should be moving to defense. The markets, themselves, have told us time and again that when easier monetary policy meets weaker economic growth, the latter matters more for future equity returns.