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The Unexpected Slowdown

Job growth slowed sharply in May, as should have been expected. Disruption of global supply chains from the earthquake in Japan, a surge in oil prices, and severe weather combined to depress economic activity with adverse consequences for the pace of new hiring. It will take a couple of months for businesses to overcome the shocks and to resume normal activity, so a rebound should be visible soon enough. But investors remain very nervous, so they will wait until evidence of improvement becomes visible. Markets are likely to remain choppy before turning decisively higher in the third quarter.
The unusual nature of the slowdown is clearly evident in the loss of auto market share by Japanese manufacturers. U.S., European and Korean car makers increased their market shares at the expense of the Japanese, who accounted for the entire decline in auto sales, even though U.S. companies lost some production because of some parts shortages. Inventories of Japanese car models plunged and this is also placing pressure on domestic model availability. Inconveniently, oil prices rose around the same time, as Libya dissolved into anarchy. Although other countries replaced missing Libyan oil production, markets became unnerved that the “Arab Spring” might impair other oil producers, so a sizeable risk premium was added to oil prices. With consumers paying more for oil, less income was available for discretionary spending. And severe weather has raised food prices, which also absorbed spending power, but mostly in developing nations where food accounts for a larger fraction of household budgets. Each of these developments was well understood by the investment community. So, the weak gain in jobs reported for May should not have been a surprise. Indeed, many analysts expected a slowdown.
So, where do we go from here? Notably, the data shows growth has slowed. There is no evidence of decline, no growth in imbalances, and underlying financial conditions continue to improve. Corporate profits are rising, bank lending has begun to increase, and household finances are improving. Much will depend on the pace at which companies overcome the disruptions to their businesses. Japanese auto companies have stated they expect to restore 90% of their February output levels by July. It will take at least another month or two to refill the supply pipeline and replenish parts supplies. So, industrial activity should experience meaningful improvement this summer, reinforced by the decline in gasoline prices, which makes more cash available to consumers.
Investor’s psyches may take a little longer to recover. Investors may respond fairly quickly to incoming data suggesting improvement. But the sharp market decline in response to the weaker data-- data we knew should be weaker-suggests that investors have not yet forgotten the meltdown of 2008. It just doesn’t take much to spook them. This increases the urgency for evidence of a rebound, lest consumers talk themselves into yet more weakness. A prompt rebound is also necessary because of the added uncertainty due to the ongoing domestic budget debate and financial turmoil in Europe. Our budget debate is over major fundamental issues, so it is important and necessary. But the prospective threat of a debt ceiling induced disruption to the payment of interest by the U.S. Treasury is unsettling. An agreement to help Greece should dispel fears an impending default there. But, Greece must deliver on its promises and the finances of Portugal and others require repair. This suggests market may remain choppy this summer as policymakers work their way through these issues.