The KC Fed's Labor Market Conditions Index is a diffusion index aggregating 24 of the Federal Reserve's top watched labor market indicators. It crossed above the 0 line for the first time since the Global Financial Crisis last year and has been hovering just above that line ever since. The signal is one that has, in previous cycles, indicated an extended period of heightened economic growth that has not yet materialized, or has it?
The recently released third estimate to third quarter US GDP is a sign of improving economic momentum, whether or not it continues is still a question. In terms of the LMCI and the signal it is generating each time it has crossed above 0 before, most recently in 1994 and then again in 2004, the economy has produced sustained year-over-year growth in excess of 2% and on average, in excess of 3%. During the 1994-2000 Tech Boom rally, GDP growth hovered near 5% and during the 2004 Housing Boom rally, GDP peaked out at 5% before falling off into the Housing Bust and Credit Crisis.
Bringing it back to today, the LMC has been indicating health in the market for over a year, but without the boom in economic growth. This is most likely due to the Obama administration, the US corporate tax code and over-regulation, all of which have been blamed on the tepid nature of the post-Financial Crisis recovery.
Since the Trump election and the onset of his implementation of Trumponomics (wants to reform the tax code, wants to remove onerous regulations, wants to boost infrastructure spending and wants to stimulate the growth of jobs) the LMCI has begun to move higher once again, reconfirming the original signal. Let's have a look.
The KC Fed LMCI Hits A New High
The LMCI measures two metrics; activity of the labor market and momentum of the labor market. In the December report, the level of activity and the amount of momentum rose to new highs. The level of activity more than doubled from 0.12 to 0.25, a high dating back to early 2008, while the momentum component rose to 1.0978, a new 18-month high. These readings show a labor market that is healthy, expanding and approaching the boiling point.
Over the past six months, the activity level has risen a net 0.26 points, accounting for volatility in the market. The five components that contributed the most to the gains are: the quits rate, the number of jobs that can't be filled, the number of businesses planning to hire, the number of people working part time for economic reasons and the flow of people from unemployed to employed. Altogether, these readings show a labor market in which workers are confident of finding new and better work because it's out there, where businesses are hiring because they need to, and where a population, once out of work, is getting back into the game.
In terms of labor market momentum, the top five positive contributions come from initial jobless claims (trending at 43-year lows), the labor participation rate (creeping up), the availability of jobs (JOLTS says there are roughly 5 million job openings month to month), Challenger Job Cuts (trending lower from last year and down from earlier in the current year) and the employment component of the ISM Manufacturing report (jobs in manufacturing are growing).
A quick thought on the NFP data. Job creation has not been robust, positive and steady, yes, but not robust. My thought, job creation does not need to be robust if there are plenty of job openings already available. It's better to fill the jobs we have than to create new ones at the expense of opportunities that already exist.
In the near term, there may be some seasonal labor market weakness. The end of the year and the start of the new year are popular times for HR departments to cut back on employment to meet budgetary needs and/or simply cutting back on seasonal employment. Looking to the jobless claims numbers, both the initial and total claims figures, we can expect to see seasonal weakness top out in early January and then fall off into the spring and summer hiring season. That's when I expect to see a real pickup in GDP, possibly as high as 5%, as well as a significant pickup in hiring/employment and the LPR, and a drop in the unemployment rate. Longer term, we can expect to see 5 to 8 years of continued labor market improvement and economic growth.
Looking to next year, we can also expect to see an increased pace of FOMC interest rate hikes. The Fed's mandate of full employment has been met, and if not, is so close as to not matter anymore. The primary mandate of economic growth/inflation control is what we need to worry about now. Inflation has so far been running tame, generally beneath the target 2%, but data within the data has been showing increases in recent months that should not be overlooked.
The Inflation Picture
The Fed uses a number of gauges to measure inflation, the most recently released and perhaps, most important is the PCE prices index. The November read shows a 1.4% increase in year-over-year headline inflation, 1.6% ex-food and energy, unchanged from the previous month but holding steady at a five-month high. Over the past five months, it has risen a half percent while the core holding ex-food and energy reading has been holding steady near 1.6%.
CPI data is the same. The November reading shows a 1.7% increase in year-over-year inflation, 2.1% ex-items, and has been up on a monthly basis eight of the last nine. The all-items year-over-year rate has also been on the rise in recent months, up nearly a full percent since July and not showing any signs of abating while the ex-items rate has been holding steady above the target 2%.
A thought on rate hikes. While the pace of rate hikes is likely to pick up in the next year, the overall trajectory should remain shallow with an eye on a possible 20 to 25 incremental rate increases over the next 5 to 10 years, depending on the pace of growth and the rate of inflation.
My theory in a nutshell
The uptick in economic activity, while unleashed and empowered by President-Elect Trump, is really being driven by demographics and specifically, the shift of Baby Boomers to retired, Gen X into roles of responsibility and management left vacant by the Boomers, and the coming of age, finally, of the Millennial generation.
The leading edge of the Millennial Cohort has reached the age of 31 and, based on the breakdown of the LPR by age group, can be expected to begin entering the workforce in earnest. As a generational group, they equate to about 26% of the total population and will move from a participation rate of <70% to one that is >80%, filling in gaps left by Gen X'rs and Baby Boomers as they graduate into the next phases of their lives; Gen X'rs such as myself are being promoted into vacancies left by Boomers entering retirement. More on my theories related to this fundamental fact can be found in my article We Are In A Secular Bull Market.
The outlook is good, very good, in my opinion. Labor markets are healthy, strong and gaining strength and that will lead to more money in the economy, wage inflation, consumer spending, home sales, economic growth and what's really important, corporate profits. The forecast for next year was already good in excess of +11% EPS growth for the S&P 500, if the Trump economy booms like the LMCI is predicting, this could be quite low indeed. Just taking into account earnings trends that already exist, it is likely that the current estimate is too low, which leaves the market ripe for earnings beats and upgraded outlook. When that happens, it will be rally time indeed. The warning for investors, get ready for a continuation of the long-term secular bull market that may last for the next eight years or more.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.