Friday, December 5, 2014

December Macro Update: Employment Is A Notable Bright Spot

In May we started a recurring monthly review of all the main economic data (prior posts are here). At the time, the consensus view was that growth in wages and employment were accelerating and that this would soon lead to a meaningful increase in inflation above the Fed's 2% target. So far, this has been wrong.

This post updates the story with the latest data from the past month. Highlights:
  • A bright spot is employment: NFP has been above 200,000/month since February, an unusually long period. Moreover, the 3Q14 employment cost index was the highest since the recession. 
  • However, the inflation rate continues to decelerate. It's well below the Fed's target of 2% yoy.  
  • Several measures of consumption continue to show demand growth of 2-2.5% yoy (real).  A sustained improvement in growth remains elusive.
Our key message has so far been that (a) growth is positive but modest, in the range of ~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.

With the latest data, our overall message remains largely the same. Employment is growing at ~2%, inflation and wages are growing at ~2% and most measures of demand are growing at ~2.5% (real). None of these has seen a meaningful and sustained acceleration in the past 3 years. The economy is continuing to slowly repair after a major-financial crisis. This was the expected pattern and we expect it to continue.

We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The November non-farm payroll (321,000 new employees) was the highest since January 2012. In the past two years, NFP has only been above 300,000 once before, in April of this year. It was a strong report, especially since NFP has been above 200,000 every month for 10 months in a row.

Note, however, that the monthly prints are volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000 (circles). The November 2013 print of 274,000 was followed by 84,000 in December. Moving between extremes like these is nothing new: it has been a pattern during every bull market. The past 12-month average of 228,000 was in the middle of the last 10 year's range.

This 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.

For this reason, it's better to look at the trend; in November, trend growth was 1.99% yoy, up slightly from 1.96% in October. The trend in NFP employment has not much exceeded 2% growth yoy since 2000; the monthly prints shown above have been noise within a growth trend between 1.5% - 2.0% since the start of 2012. It wasn't much different in the 2003-07 bull market, so be careful assuming a trend with much higher growth than 2%. In order to reach the 3% growth of the 1990s, NFP will need to start printing 400,000 per month.

Released together with NFP is a report on average hourly earnings. In November, this showed growth of 2.1% yoy. By this measure, wage growth is not accelerating; 2% is the middle of its range over the past 5 years.

The employment cost index shows modest growth in compensation, with a caveat. For 3Q14, it was 2.2% yoy. In the last six quarters, yoy growth has been 1.9%, 1.9%, 2.0%, 1.7%, 1.9% and 2.2%. The latest print is the highest since the recession; this is good news, but prior pops higher have not been sustained. It's too early to say the trend has improved, but this is a possible light at the end of the tunnel.

These employment and wage reports suggest only modest pressure from labor on inflation. In the event, inflation has been decelerating in recent months and remains well below 2%.

CPI and core CPI (excluding more volatile food and energy) are growing at 1.7-1.8% yoy, respectively. Neither has been much above 2% since 2Q 2012; each time it has approached 2%, the rate has declined in the months ahead. In other words, there has been no sustained acceleration in inflation, yet. This is in contrast to 2003-07, when inflation was consistently closer to 3%. Consensus expectations are that inflation will accelerate but it hasn't happened.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; core and total PCE were 1.6% and 1.4% yoy, respectively, in October . 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 very closely.

Next, let's look at several measures of demand growth. Regardless of which data is used, real demand has been growing at about 2.0-2.6%, equal to about ~4% nominal.

On an annual basis, real (inflation adjusted) GDP growth through 3Q14 was 2.4%. 3Q growth was slightly above the middle of the post-recession range (1.3-3.3%). It's positive, but lower than what the US is used to; prior expansionary periods since 1980 experienced growth of 2.5-5% yoy.

Stripping out the changes in GDP due to inventory gives you "real final sales". This is a better measure of consumption growth than total GDP.  In 3Q14, this grew 2.5% yoy. Aside from a bump higher in 4Q13, the trend in annual growth has been 2.0-2.5% every quarter the past 2 3/4 years (since 1Q12). That was also the growth rate at the end of the prior bull market, starting in 2Q06. A sustained break above 2.5% would be noteworthy; until then, the growth rate is not accelerating.

Similarly, the "real personal consumption expenditures" component of GDP (defined), the component which accounts for about 70% of GDP, grew at 2.4% yoy in 3Q14, in the middle of its range (2-3%) since 2Q 2010, but below the 3-5% that was common in prior expansionary periods after 1980.

On a monthly basis, the growth in real personal consumption expenditures remains in a 2-3% annual growth range: in October, growth was 2.2% yoy, down from 2.7% in August. Again, the growth rate has not sustained any acceleration.

Real retail sales grew 2.5% yoy in the past month. The range has been 1.5-4% yoy for most of the past 20 years. The latest print is in the middle of this range.

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) grew at 5% yoy (nominal) in October. This follows four strong months of 8-9% yoy growth from June through September.  During the heart of the prior bull market, growth was typically 7-13%.

The typical range for annual growth in Industrial Production has been 1.5-5% through the past 15 years. It was 4.9% in July, the best since January 2011, but it has fallen the past three months to 4.0% in October. During much of the 1990s, the range was much higher: 3.5-7%. Excluding mining and oil/gas extraction, the manufacturing component of industrial production is growing at 3.7% yoy.

Finally, let's look at two measures of housing. After a weak winter, housing data has improved. Like other data, growth is positive, but tepid relative to prior bull markets.

First, new houses sold was 458,000 in October; it's virtually unchanged from January 2013. 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. The widely expected recovery from winter weakness has been modest.

Second, after a decline in winter, growth in housing starts is positive but volatile and the latest starts are below those of December 2012, almost two years ago. Growth was 8% yoy in October. The overall level of construction is well off those during the prior two bull markets, but the trend is positive.

The growth in housing starts had looked like it was being driven by multi-unit housing, but that growth appears to be tapering off; meanwhile, single family housing starts in October were the second highest since the recession.

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 3 years has been positive but has only averaged 3% (nominal) per annum.

The consensus expects sales growth to accelerate slightly to 3-4% (nominal) in 2014; the macro data presented 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 at 6% in 2014 and 10% in 2015.

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 have been signaling for all of 2014.

Overall, the macro data has been consistently meeting expectations over the past several months to an unusually high degree.

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