Friday, May 8, 2015

May Macro Update: Employment + Wages = A Macro Growth Tailwind

A year ago, we started a recurring monthly review of all the main economic data (prior posts are here).

For most of that time, the consensus view has been that growth in wages and employment would soon accelerate and that this would lead to a meaningful increase in inflation above the Fed's 2% target. Our monthly review of the data has consistently shown this expectation to be premature.

The irony now is that economic data has seemingly turned negative over the past two months, to the point where many talk about a recession or QE4. We think this weakness is temporary, mostly driven by the huge drop in energy prices which has lowered inflation and depressed "nominal" price growth. "Real" growth remains positive.

More importantly, the fact that the consensus swings between extremes underscores how focused too many are on monthly data points, with the effect that underlying trend in the data is missed.

And the trend for the majority of the macro data remains positive.

This post updates the story with the data from the past month.  Highlights:
  • Employment: The average monthly gain in employment during the past year was 249,000, the highest since the 1990s. Annual growth in employment is the best in 15 years. 
  • Wages: Wages have recently started to accelerate. The 1Q15 Employment Cost Index rose 2.7%, the highest since the recession.
  • Demand: 1Q15 real GDP grew 3.0%, the second highest rate in the past 5 years. Real personal consumption (70% of GDP) grew 3.0% in 1Q15, the highest rate of growth in 5 years.  
  • Housing: Housing starts data has been disappointing in February and March but housing sales and permits have been near 7 year highs.
  • Inflation: However, the core inflation rate remains under 2%. It is near its lowest level in the past 3 years  
Our key message has so far been that (a) growth is positive but modest, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The April non-farm payroll (223,000 new employees) followed the disappointing 85,000 in March. Prior to March, NFP had been above 200,000 12 months in a row, the longest streak since 1993-95. April was therefore a bounce back to trend.

In the past 12 months, the average gain in employment was 249,000, the highest since the 1990s.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000. That has been a pattern during every bull market.  So while the March print of 85,000 was lower than expected, it fits the historical pattern. A low print was long overdue.

Volatility in NFP is not a recent phenomenon. The 1980s and 1990s bull markets were the same, only the range was higher. If anything, the swings were more extreme: NFP was negative in 1995, 1996 and 1997.

For this reason, it's better to look at the trend; in April, trend growth was 2.2% yoy. Annual growth continues to be the highest in 15 years.  Employment growth in the past five months has been better than at any time during the 2003-07 bull market.

Released together with NFP is a report on average hourly earnings. In April, this increased to 2.2% yoy, at the high end of the post-recession range. Despite improving employment, there hasn't been any notable sustained acceleration in wages.

The employment cost index shows an improving trend in compensation. For 1Q15, it was 2.7% yoythe highest since the recession; this is good news, especially as there is a trend of sequential quarterly improvements.

Despite improving employment, inflation has been decelerating in recent months and remains below the Fed's target of 2%.

With oil prices collapsing, CPI dropped to 0.0% in March. The more important core CPI (excluding more volatile food and energy) grew 1.8%, a small increase from last month. Consensus expectations are that inflation will accelerate but it hasn't happened.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core PCE were 0.3% and 1.3% yoy, respectively, in March . Neither has been above 2% since 2Q 2012. Like CPI, there has been no sustained acceleration in inflation, and the rate is well below levels in 2003-07.

For some reason, many mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index). It tracks both CPI and PCE closely.

Next, let's look at several measures of demand growth. Regardless of which data is used, real demand has been growing at about 2-3%, equal to about ~3-4% nominal.

On an annual basis, real (inflation adjusted) GDP growth through 1Q15 was 3.0%, the second highest rate of growth in the past 5 years. 1Q growth was at the high end of the post-recession range (1.5-3.0%). It's positive, but lower than what the US is used to; prior expansionary periods since 1980 experienced growth of 2.5-5% yoy. There's has not been a sustained acceleration in growth, yet.

Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP.  In 1Q15, this grew 2.5% yoy, the third highest rate of growth since 2007 (8 years). A sustained break above 2.5-3.0% would be noteworthy. Not yet.

Similarly, the "real personal consumption expenditures" component of GDP (defined), the component which accounts for about 70% of GDP, grew at 3.0% yoy in 1Q15, the highest growth rate in 5 years. This is approaching, but still below, the 3-5% that was common in prior expansionary periods after 1980.

On a monthly basis, the growth in real personal consumption expenditures was 2.7% yoy in March, near the top of the post-recession range; it was 3.4% yoy in January, the highest rate of growth since October 2006, more than 8 years ago.

Real retail sales grew 1.3% yoy in the past month. The latest print was the third lowest in the past 5 years; it follows a 3.8% yoy gain in January, the third highest in 3 years. The range has been 1.5-4% yoy for most of the past 20 years.

Not surprisingly, the culprit in the decline in retail sales was the price of gasoline. Retail sales at gasoline stations fell 22% yoy. Retail sales excluding gas stations grew 3.5% (nominal) in March.

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) fell 2.4% yoy (nominal) in March, the first negative growth rate in more than 2 years. During the heart of the prior bull market, growth was typically 7-13%. You can see that weak growth in winter has been a pattern the past three years (arrows).

This is also a nominal measure and thus negatively impacted by the fall in the inflation rate. On a real basis, growth in past month continued to trend higher (blue line is real; red line is nominal; chart from Doug Short).

In March, industrial production growth was 2.0%. The manufacturing component (excluding mining and oil/gas extraction) grew 2.7%. The typical range for annual growth in Industrial Production has been 1.5-5% through the past 15 years: the current reading is therefore near the low end of the range. During much of the 1990s, the range was higher: 3.5-7%. It's a volatile series.

Finally, let's look at two measures of housing. Housing starts data has been disappointing in February and March but housing sales and permits have been at 7 year highs. It's likely the drop in starts was related to the harsh winter and should rebound in spring. Overall levels of construction and sales are small relative to prior bull markets.

First, new houses sold was 481,000 in March; this is 19% higher than a year ago. Recall that sales in February were the highest since early-2008, 7 years ago. The overall level of sales is still meager relative to prior bull markets. 30 years ago, 600,000 would have been at the low end of the range for monthly sales.

Second, overall starts in March dropped to the same levels as in early 2013 and 2014, probably due the harsh winter in the East and Mid-West.  The overall level of construction is well off those during the prior two bull markets, but the trend is positive.

While housing starts have recently been disappointing, they are not alarming. Building permits in March were 3% higher than a year earlier. This demonstrates that the slowdown is probably weather related and will most likely rebound in spring.

Single family housing starts in March rose over the past month; in February, they were at the same level as in January and June 2014 (blue line).  Weakness was more pronounced in multi-unit housing starts which fell to the lowest level since September 2013 (red line).

In summary, the major macro data so far suggest positive, but modest, growth. This is consistent with corporate sales growth.  SPX sales growth the past year has been positive but only about 2% (nominal).

The consensus expects sales growth of about 2-4% per annum (nominal) thru 2016, excluding the volatile energy sector; the macro data presented here makes this seem reasonable.

With valuations at high levels, the current pace of sales growth is likely to be the limiting factor for equity appreciation. This is important, as the consensus expects earnings to grow 2% in 2015 and 12% in 2016.

Modest growth should not be a surprise. This is the classic pattern in the years following a financial crisis like the one experienced in 2008-09. It is also what the flattening spread in yields signaled for all of 2014. There are signs that this may now be reversing in 2015.

There has been a tendency for macro data to underperform expectations in the first half of the year. That may now be close to reaching a turning point.

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