I wrote last month that the stock market was facing an imminent pivot point in the shape of the next FOMC meeting. Since that time, the stock market has been unseasonally weak as it struggles to deal with the Fed's planned reduction in bond purchases, a.k.a. as the "taper." The affirmation of that policy at the last meeting has heightened the market's sensitivity to disappointment, a turnaround from the "all news is good news" mentality of 2013. The second pivot point arrives with Friday's jobs report.
I probably don't have to tell you how negative Monday's surprise drop (to 51.3) in the January ISM manufacturing reading was for the market. The most recent regional survey readings had been much better, suggesting to me and others that a better national ISM reading would follow, but a divergence between the two isn't that uncommon. The Markit Economics PMI reading was better (53.7). Still, I consider all of the PMI surveys to be colored by sentiment and unreliable measures of the depth of economic strength or weakness.
Though I have long been critical of the Street's too-rosy picture of the economy, I'm not ready either to start grave-dancing on the economy. It was one month's data, and it's clear from the responder comments that weather played a significant role.
Yet it would be equally impetuous to dismiss the ISM report on weather grounds - it is usually cold in January, after all - or the follow-on reaction that brought some perspective on market direction. I wrote throughout 2013 that equities were in a sentiment-driven market, with gains out of proportion to earnings and the economy. The linchpin of the sentiment, obviously, was the belief in the Fed's policy, which mattered as much as the policy itself. Now that the linchpin is being removed, the tower of sentiment is wobbling. The promise of the Fed handing off the baton to a stronger economy is in doubt.
The stock market and the Fed might have avoided this problem had the latter stuck to its original September target for the taper. The market was well-prepared for it, and the initial step would have been followed by a third-quarter GDP print that would have inspired confidence (rightly or wrongly) that the Fed was correctly handing over the reins to a growing economy.
The three months-delayed start to the taper locates the transition into a period where the GDP print was going to decelerate anyway, and is now being dogged further by weather-related slowdowns. The perspective has shifted: Any data that calls growth into question, shrugged off last year by the promise of more QE, is now met in the context of less QE. The fear of missing the end-of-year rally has been replaced by the fear of losing last year's profits - as was made plain by the weak start to the year by equities - or fear of the Fed, exemplified by the sharp reactions to overseas developments such as the Turkish lira or recent Chinese PMI results.
Weather problems aren't unique; indeed what was rather unique to 2013 was the near-total absence of disasters, whether natural or man-made (though the drought in the West is arguably disastrous, it wasn't the kind of sudden event that makes bold headlines). It's entirely reasonable to expect a weather-related rebound as winter ebbs, but in the interim asset prices are going to be sensitive to slower economic data, regardless of whether it's cold outside. It's rumored already that traders are preparing to blame any weakness in Friday's jobs report on the weather, though if it's a clunker, chances are we'll still beat a path to the 200-day average on the S&P.
Will the jobs report be weak, and what would be the consequences? I'm in the school that says guessing the Bureau of Labor Statistics (BLS) number is a mug's game, and am not about to start now. I can offer some data, however, that says December wasn't as weak as the original release suggested. To begin with, the combination of the late Thanksgiving and unseasonably cold weather resulted in a blip in jobless claims during the measurement period, such that actual claims rose compared to the year-ago period, instead of falling as they had been doing before and afterwards (claims during the January period declined year-on-year at the trend rate of about 8%). The disparity was partly masked in the seasonally adjusted releases, apparently leading most media pundits to miss it entirely.
Second, the year-on-year increase in the actual (unadjusted) December establishment payroll count is currently estimated by the BLS to be 1.63%. That does represent a slowdown from the November rate - which I suspect was overstated - but is well within the central tendency for 2013: In fact, the initial estimate for the BLS jobs growth rate for all of 2013 was 1.64%.
Other factors could blur the January report - retail hiring, for example. Some of the November jobs increase might have been exaggerated by extra hiring (or fewer layoffs) by retailers scrambling for share and - perhaps beguiled by the stock market - hoping for a better Christmas than the one we actually had. How many of those were let go by the end of the measurement period, and how the BLS decides to treat that data, could swing the number quite a bit. A year ago I estimated that a favorable seasonal treatment of retail workers by the BLS caused a 50,000 job swing in the January report.
The annual benchmark revision that refreshes job data for the last few years is also due with Friday's report. These revisions have often resulted in a large increase overall for the prior year(s), though I ought to add that the impact of this on equities has been muted in my experience - traders seem to mostly care about the current month and the one or two before. My own analysis suggests a more limited overall revision this year, not because of any opinions I may have about the economy, but because the pattern of the data throughout 2013 seemed to indicate a BLS trying hard to avoid undercounting again. We'll see on Friday, though the final verdict may be years away.
While the market is certainly short-term oversold, another disappointing jobs report on Friday should mean a short walk to the 200-day average on the S&P (i.e., about 1700). It would also further open the door to a decline to the long-term trend line, to about 1525. If the number beats consensus instead, with a nice December revision, expect a big reversal-rally. Together with some breaks in the weather as we move into March and April, it could eventually lead to a complete retracement of the decline. As I said, it's a sentiment-driven market. If equities don't retrace the decline by April, it would be another evil omen for stock prices.
In any case, I haven't yet seen evidence that the economy is about to embark on the current consensus projection of 3% real growth. My contention is that the data suggest that third-quarter GDP represented another in a series of periodic inventory restocking episodes that we have had since the recovery began, and that first-quarter GDP will descend back towards the 2% region (if not lower) as the restock subsides.
The argument for accelerating GDP in 2014 - likely to be yet another in a series of overly optimistic projections - is based on a basket of soft assumptions and inferences: Sequester and tax effects, lumped together as fiscal drag, and increased confidence. The sequester is indeed being partly restored in the current budget, though a declaration of victory may be premature - we have the small matter of another debt-limit deal to contend with this month.
So far as the payroll tax goes, there should be a positive effect this year as the roughly 2% raises that salaried workers will generally receive flow mostly to the bottom line this year, instead of being offset by higher FICA contributions. Two forces working against that in the aggregate are one, the cessation of long-term unemployment benefits for over a million people, and two, the gap between the growth in disposable real income last year (+0.7%) and real personal consumption expenditure (+2.0%). Some of that extra income may already be spoken for. The weekly retail sales reports during January had the same sort of weakness that characterized the month's auto sales.
As for confidence, a perennial Wall Street favorite for performing magic, I'm not seeing evidence of it in increasing corporate expenditures. The annualized growth rate in business cap-ex continues to ebb, with the 2-year growth rate now down to 3.46% (annualized). 3M's (NYSE:MMM) latest buyback announcement seems more representative of where corporations want to spend their money - on buying back stock and keeping up the price. The company spent $5.2 billion buying back stock in 2013 and just announced a new $12 billion program - 14% of the outstanding shares. Contrast that with the $1.7-$1.8 billion it projects in cap-ex for 2014, or the $1.66 billion it spent in 2013, which is less than what it paid out in dividends ($1.7b). The budget for acquisitions is $5-$10 billion over the next four years.
Assuming that the trendline from the last four or five years is still the same - about 2% real GDP - that leaves us with a potential data set bringing exaggerated impacts from the weather. For the moment they're to the downside, but could very possibly swing to the upside later, making for a volatile period. The bigger swing factor to the economy will probably prove to be not the weather, however, which usually evens out over time, but the financial markets. If the current correction does turn into one of those cascading affairs, where equities lose something in the 20%-plus range, don't expect anyone to step up their spending - except, perhaps, for the central banks. Again.