It's always good to have a long weekend once in a while as it gives me time to think and reflect, rather than to react in a knee-jerk fashion to news. So what to make of the shocker of a NFP release last Friday? Upon further consideration, it sounds bad as the stock market is caught by the dilemma where bad news is bad news and good news may be bad news.
Why was employment rising so quickly?
Ben Bernanke's speech to National Association for Business Economics Annual Conference provides some clues. He said that:
[T]he better jobs numbers seem somewhat out of sync with the overall pace of economic expansion. What explains this apparent discrepancy and what implications does it have for the future course of the labor market and the economy?
The apparent discrepancy is due to Okun's Law [emphasis added]:
Okun noted that, because of ongoing increases in the size of the labor force and in the level of productivity, real GDP growth close to the rate of growth of its potential is normally required just to hold the unemployment rate steady. To reduce the unemployment rate, therefore, the economy must grow at a pace above its potential. More specifically, according to currently accepted versions of Okun's law, to achieve a 1 percentage point decline in the unemployment rate in the course of a year, real GDP must grow approximately 2 percentage points faster than the rate of growth of potential GDP over that period. So, for illustration, if the potential rate of GDP growth is 2 percent, Okun's law says that GDP must grow at about a 4 percent rate for one year to achieve a 1 percentage point reduction in the rate of unemployment.
Why are we seeing unemployment falling so quickly when GDP is growing so slowly? Chairman Bernanke explains:
[A]n examination of recent deviations from Okun's law suggests that the recent decline in the unemployment rate may reflect, at least in part, a reversal of the unusually large layoffs that occurred during late 2008 and over 2009. To the extent that this reversal has been completed, further significant improvements in the unemployment rate will likely require a more-rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.
Stalling employment gains would provide fuel for policy doves (like Bernanke) within the FOMC for further rounds of QE. As I wrote before (see How easy is this Fed?), the Fed is unlikely to have the political capital to engage in quantitative easing in the 2H as it is an election year. So will the data deteriorate fast enough to warrant QE? They are unlikely to act at the April meeting on a single month's data, especially when there is a 90% chance that the actual number lies between 20K and 220K. Doves will focus on the falling employment number, while hawks will focus on the falling UNemployment number. What if the next month's NFP came in around 150K? Will that be enough? I doubt it.
I agree with Tim Duy when he summarized his reaction to last Friday's NFP release as [emphasis added]:
A disappointing jobs report for those who expected the US economy was about to rocket forward, but one consistent with the slow and steady trend into which the US economy appears to have settled. And no reason to change the basic outlook for monetary policy - the Fed is on hold until the data breaks cleanly one direction or the other.
The markets sold off last week when the FOMC minutes revealed that, while QE3 remained on the table, further rounds of QE are unlikely unless the economic data significantly deteriorates. For now, bad news (on employment) is bad news, unless it's really, really bad.
Improving employment = Profit recession
What if last Friday's number was a statistical blip and employment continues to improve? Chairman Bernanke explains:
[A]nother interpretation of the recent improvement is that it represents a catch-up from outsized job losses during and just after the recession. In 2008 and 2009, the decline in payrolls and the associated jump in unemployment were extraordinary...In other words, employers reduced their workforces at an unusually rapid rate near the business cycle trough--perhaps because they feared an even more severe contraction to come or, with credit availability sharply curtailed, they were trying to conserve available cash.
Now that the economy has improved, businesses need to add workers to catch up. Indeed, we can see that from the graph below which shows a picture of rising labor productivity:
Click to enlarge
The price of rising employment in "defiance" of Okun's Law is a profit recession, with sales rising but profits falling as the gain begin accruing to the suppliers of labor rather to the suppliers of capital.
Ed Yardeni documented this phenomena as he showed that consensus sales estimates have been rising:
...while earnings estimates growth has been stagnant:
In a way, Yardeni is implicitly endorsing this view of employment catch-up with his analysis of the jobs picture before the NFP release.
This outlook is also consistent with Gallup's observation of falling unemployment, rising economic confidence and improving consumer spending. In addition, the Conference Board also reported that CEO hiring plans are rising.
As we move into another Earnings Season, the interaction between employment and profits bear watching. Whether the inflection point for earnings to start rolling over happens this quarter or next quarter, I have no idea. I do, however, have a pretty good idea of the trajectory of the US corporate earnings for the rest of the year.
Equity outlook: US likely to roll over, does it all depend on China?
So there you have it. If we get good news on the labor front, it means a profit recession, which is bad for the stock market. If we bad news on employment, the Fed's hands are tied for the second half of 2012 unless the economy really craters.
Looking ahead to 2013, we have the Bush era tax cuts expiring. With little agreement in Congress ahead of an election year, the US is likely to see rising fiscal drag in 2013. As we enter the second half of 2012, the markets will start to look forward and discount slower American growth, which would be negative for stock prices.
Ben Inker, the head of asset allocation at GMO, essentially voiced the similar concerns over potential margin compression as the effects of fiscal drag become more evident next year:
High profit margins are the biggest impediment to returns in the equity markets. "The big issue is profits are at an all-time high relative to GDP," Inker said. "We don't think that is sustainable. We think it's going to come down."
The question is, why has that occurred amid a relatively weak global economy? And what could cause it to change?
Inker believes the reversal of government budget deficits will kill margins. Profits have risen as corporations have successfully cut labor costs, but that was a short-term gain, Inker said. Normally, wage reductions and workforce cutbacks leave less money for consumers to spend across the whole economy. That didn't happen over the last several years because the government stepped in with offsetting stimulus measures, allowing disposable income to remain high despite the fact that labor income has been shrinking.
Hence current profits cannot last for long. Even though he expects modest growth in the global economy, lower unemployment and higher capacity utilization, Inker said that "as a necessary condition of decent growth, we need to see profit margins come down."
Today, US equities are the market leader based on a belief of an improving consumer (see This bull depends on the US consumer), Europe is starting to go sideways on concerns over Spain, Portugal, etc., and China is not showing strength.
My Asset Inflation-Deflation Trend Model moved to a neutral reading early last week (see Time to take some risk off the table), which is the likely correct tactical response for now as the markets aren't in any imminent danger of tanking dramatically. Looking forward, however, the 12-month outlook for the US are faltering. There are a number of China bulls starting to come out of the woodwork (see example here), but I can see no technical turnaround in Chinese related markets for the moment.
Under these circumstances, the bulls only hope are dependent on a revival of Chinese growth in the 2H, which is a risky bet on timing. While my inner trader isn't outright bearish, my inner investor tells me that selling in May is starting to sound good right now.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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