Sterne Agee Chief Economist Lindsey Piegza: June Jobs Show Labor Market Structurally Weak

by: Harlan Levy

Summary

GDP Q2 up 1.7 - 2%, '14 up 1.5%.

June's jobs show labor market's structural weakness.

Fed asset-buying to end in 2014, interest rates up Q4 '16 at the earliest.

Lindsey Piegza is the chief economist for investment bank Sterne Agee. Previously she was an economist for FTN Financial.

Harlan Levy: What do June's 288,000 new jobs, the jobless rate dropping from 6.3 percent to 6.1, and the accompanying data add up to?

Lindsey Piegza: The impressive headline employment gains continue the pattern of more than 200,000 jobs for the fifth consecutive month. The composition of jobs, however, has improved little over that same time frame. Businesses still looking for flexible, low-cost labor continue to rely on temporary, part-time, and low-wage workers, resulting in the disconnect between above-consensus top-line job creation and stagnant wage growth. Without wage pressures and income growth, consumers remain constrained, growth remains limited, and the Federal Reserve remains on hold indefinitely.

While we wait for the final figures of the second quarter, the consumer appears to be on a similar trajectory as in the first quarter, meaning positive but limited spending, keeping in line with our second-quarter Gross Domestic Product forecast of near 2 percent. The market will see this report as favorable, but the headline number masks the lingering structural weakness in the U.S. labor market.

Q: With 262,000 new private sector jobs in June, can the private payrolls continue at that level?

A: I don't think they will necessarily continue an upward trend, but I do think that it will maintain the range we've seen for the past couple of months - above 200,000. So I'm not necessarily convinced there's upward momentum, but I think we have deep stability in terms of private payrolls.

Q: Pending home sales were up noticeably. Is housing ending its soft patch?

A: Here too, it's not necessarily that we're seeing an upward trajectory, but we are seeing momentum from a very low level that we saw at the start of the year as consumers significantly pulled back from nearly every type of purchase, including large purchases such as homes. Now, while we do expect activity to pick up off those extremely low levels from the start of the year, we're still seeing very lackluster demand against the backdrop of an inability for particularly the younger generation in the country to afford such a large purchase.

And we continue to see prices rise. If you're a homeowner that certainly helps with your bottom line if you see that asset appreciating, but for those trying to enter the market against the backdrop of very minimal income growth, rising prices have outpaced wage growth, and that will continue to limit the amount of demand we see going forward. Essentially we do expect activity to improve in the low levels but not gain significant momentum back to the pre-recessionary levels.

Q: What effect will that have on the economy?

A: Remember that we're not relying on housing as we once did during the run-up years. We're no longer looking to our homes to finance spending. We borrowed up to a trillion dollars against the appreciating value of our homes, so housing was a significant contributor to overall growth.

Now, even as we look to the housing market to continue to recover, it's going to contribute less than half what it once did. We're now going to look to housing as an actual livable asset rather than a supporter of spending.

Q: What does the manufacturing data tell you?

A: Most of the regional data shows steps in the right direction, suggesting that there has been momentum in manufacturing. But remember that if we see a ramp-up in production alone rather than a sustainable rise in demand to support that rise in production, then all we'll see is an inventory rise which will contribute to near-term growth but then contract from growth going forward, as we have to picture that stockpile of goods.

My concern is that we're starting to see manufacturing production outpace sustainable demand. This is very similar to what we saw in the second half of last year. Producers were ramping up production, and consumption failed to meet price expectations. Now we're still sitting on a pretty sizeable amount of goods.

Q: Is business investment and spending starting to increase in any significant way, as corporations ponder an end to the Fed's asset-buying program and an increase in interest rates?

A: No. I think businesses are still very much sidelined. It's very similar to the scenario we saw in pending home sales. We are seeing improvement from the low, low levels at the start of the year, but after one or two months of increased spending on the consumer side, we've now pulled back. The latest report on durable goods showed a 1 percent decline.

So it's very clear that the most optimistic assessment would be uneven investment strategies at best. Again, businesses are very hesitant to invest certainly in employees but also equipment, software, and structures. Despite the fact that the corporate balance sheet is incredibly strong, we're not seeing that investment cycle take hold and not seeing businesses putting those dollars to work.

Q: What do you expect the Federal Reserve to do on interest rates and when?

A: I expect the Fed to stay in this very accommodative stance for a much longer period than the market anticipates. I expect the Fed to remain on hold through 2014 and through 2015, and most likely through 2016.

A realistic expectation for the Fed to raise interest rates would be in the first part of 2017, or at the very earliest it would be the last quarter of 2016.

But you have to keep in mind that this is a very different Fed from the Bernanke Fed. Yellen is much more willing to err on the side of caution and wait for proof to come to fruition rather than basing monetary policy on expectations. As we know, the Fed is very consistent in outpacing reality in terms of its forecasts. Yellen has commented and warned against it and said we really need to know that progress, that improvement comes into reality before changing monetary policy. To me that means a longer than expected time sitting on these low, low levels.

Q: What do you think will happen to the Fed's diminishing asset-buying program?

A: Mostly members have lost faith that the asset-buying program has any positive effect left on the economy, and so I do think they will continue to wind that down, ending in 2014, ending principal reinvestment in 2015, and holding those securities outright with no plans for sales and just allowing that portfolio to wind down naturally through maturity.

Q: What do you think will happen to GDP this year?

A: What's interesting is that we have not revised our forecast. We were outliers on the Street looking for about 2 percent in the second quarter, and I wrote more than a month ago why Q2 will not be 4 percent.

Again, this goes back to the idea that expectations are outpacing reality. We continue to see the consumer pull back. We continue to see investment be lackluster. Housing is positive, but we're coming off low, low levels. All of this together spells more of the same to me. Our range is 1.7 to 2 percent for Q2 and going forward a very similar 2 percent for the second half of the year. Net, we're coming to 1.5 percent on an annual basis for the year. It's not the most optimistic forecast, but I think it's realistic, given the fact that the consumer is very much under pressure.

Q: What do you think will be the effect of the paralysis and polarization in Congress?

A: As long as we don't see Washington shut its doors, as we did last year, that causes fear and uncertainty, and that can put downward pressure on the consumer. But gridlock? That might actually be a positive thing for the economy, given that it will control any additional stimulus package that the government might want to implement. So think back to that $787 billion stimulus package, all that it did was create a bigger barrier for the economy now as we try to dig ourselves out of this hole four-plus years into the recovery.

So, given the tendency of this administration to lean on the stimulus, lean on spending, lean on the tax-the-investor class, I think gridlock in this case might rein in some of those near-term beneficial policies but long-term detrimental policies.

Q: What do you see as the effects of the situations in Iraq, Syria, Ukraine, Israel?

A: Any time there's geopolitical tension that certainly could have an effect most profoundly on confidence, but more specifically from a micro standpoint, on energy prices. If we do see sustained heightened energy prices as a result of any of these geopolitical conflicts, that certainly could put additional downward pressure on the consumer. The fastest way to derail the consumer is sustained heightened energy prices, whether it's a shortage, whether it's price disruptions because of the geopolitical strife, if any of that comes to fruition that could further act to the detriment to the economy's recovery in the near term.

Q; Do you think that will happen?

A: I think temporary fluctuation are a more realistic possibility rather than a long-term disruption in the market.

Q: Do you think Europe is going to be more of a drag than it is already?

A: I really do. A lot of economists increased their expectations of near-term growth based on the expectation that European demand was going to increase the demand for U.S.-made goods, seeing a ramp-up in U.S. exports. But looking at the profile for European GDP, we're talking minimal tenths of a percent growth, and most of that is coming from a handful of economies, Germany, the Benelux countries. This is a very small number of countries trying to support ever-growing weakness in peripheral countries.

Look at Greece, for example. If you try to bring that debt-to-GDP ratio down, there's really no austerity in the world that can do that without sending that economy deep into recession for years. So I look at Europe as a continuing, ongoing problem rather than a sign of global improvement.

Q: Will there be any growth in Europe?

A: I think minimal. Some of those economies are strong enough. Germany and the Benelux countries, as I mentioned, are strong enough at this point to offset the weakness elsewhere, but if we see Germany suffer as a result of, maybe, heightened tensions furthering between Russia and Ukraine, then that manufacturing economy could take a big hit, and then you don't have that strong link to keep Europe afloat.

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