As the summer draws to a close, the unemployment rate has stepped up 0.3%, to 9.7%, a level last seen coming out of the horrendous double- dip recession of 1980-2. Yes, private payrolls shed less than 200,000 jobs in August, which is a vast improvement over the nearly 750,000 jobs shed in the opening month of the year. But as summer draws to a close, look around and realize nearly one in 10 of your neighbors is chewing on their fingernails and trying to hustle up a new gig. Perhaps we should rename the recent holiday Unlabor Day, in honor of those sweating out one of the toughest job markets of the post-World War II period.
From a mainstream economic perspective, it should be renamed Leisure Day, as unemployment is interpreted as an individual choice of leisure over paid labor effort. Of course, only a tenured professor could be expected to come up with such a conclusion. As it stands, it is currently estimated there is one job opening for every six people looking for work.
Since employment is a lagging indicator of economic activity, we learned over the years to dig deeper than the headline figure to get a read on where labor market conditions may be going. One of the more useful, but often ignored, parts of the employment report tells us about the percent of private industries that are net offering jobs. Even when payrolls are shrinking in total, some industries are still net hiring – and, indeed, this is part of how markets facilitate the reallocation of productive resources during a recession, which, as the Austrian approach reminds us, is crucial to long term-growth prospects.
This measure is called a diffusion index, and we prefer to look at the average in this series over the past three months to avoid too many miscues. As it stands, the breadth of private industries net hiring, though still at a lower level than the last recession, has consistently climbed from the March lows. The pace of broadening is even a bit stronger than what we observed in the last exit from a recession, which, as you may recall, was followed by a jobless recovery. If the slower pace of layoffs is all a sugar high from extreme policy measures, or if a double dip is about to open up before investor eyes, this is one of the places it should show up first. So far, this diffusion index is more consistent with an unemployment rate that peaks near year-end around 10% and begins to show some improvement in Q1 2010. We would also note while survey results still report perceptions of a very difficult job market, these measures have stabilized in recent months.
When firms start shedding labor more aggressively than their production activity is contracting, labor productivity (output produced per hour of work) tends to reaccelerate as the pressure on the remaining work force intensifies. In fact, productivity growth has begun to rebound, and we believe it has a good shot at pushing through 4% year-over-year growth by year-end, from the current 2% pace in the nonfarm sector. At the same time, businesses struggling to stay alive have pressured labor compensation growth. Hourly compensation (wages and benefits) growth has been on a disinflation (that is, decelerating inflation) path through the entire recession. We suspect it will be flirting with deflation near year-end, which is something we have not seen since Q4 in 1949.
If we put these two developments together – labor compensation growth approaching deflation, while labor productivity growth reaccelerates – we get deflation in unit labor costs. Companies that can hold the line on pricing while unit labor costs are falling will tend to experience rising profit margins, and rising profit margins are generally a signal to expand production. Improving cost conditions are one benefit of recessions, and if final demand can stabilize or improve from sources other than the household sector – say, fiscal policy or an improvement in the trade balance or the onset of some replacement capital spending – then this can be a route back to economic recovery. We will have more to say about this in the next monthly letter, but for the moment, it does look like firms are successfully compressing cost conditions.
This matters because with the release of Q3 S&P 500 earnings in October, we suspect strong operating leverage will become apparent to equity investors. Earnings improvement through Q2 has been all cost cutting related in a flat or falling revenue environment for most companies. If Q3 begins to show top-line revenue improvement, as we suspect it will, then earnings will be fed by both revenue and profit margin gains. After the seasonal September jitters, the exposure of the operating leverage available to firms that have cut to the bone could very well capture the imagination of investors, leading to the next leg in the advance of US equity indexes since early March.
According to supply managers in the manufacturing sector, goods sector production has been on the rise since June, and new orders are through the roof. By way of reference, the new orders index was scraping a new historical low back in December, rivaled only by the 1980 lows following Fed credit controls. Never before in the six decades of Institute for Supply Management (ISM) records have new orders surged so dramatically in any eight-month span. Never before has the ISM new order and production indexes recorded these levels without marking an escape from recession. No doubt the “cash for clunkers” sugar high has something to do with this, but we doubt it explains away all of the dramatic reversal in supply manager perceptions, as the export indicator in this report has also improved remarkably since the December 2008 lows.
These ISM results are usually good for a three-four month lead time on government reports for industrial production, shipments and new orders. We can anticipate the rebound depicted above will now reverberate in the monthly reports from here to year-end, at a minimum. In particular, the ISM production index has provided a reasonably good guide to year- over-year momentum in manufacturing production.
The sharpest monthly contractions in industrial production began in September of last year as the credit markets went into cardiac arrest, and all parts of the economy went into a cash grab/cash conservation mode so that prior cash commitments could be met. This included dramatically reducing production and liquidating existing inventory stocks. In other words, the comparisons against year ago are about to get ridiculously easy, and a healthy 5% year-over-year manufacturing production growth rate is certainly within reach by year-end 2009.
As summer slips away into the flaming leaf show of fall, we conclude the labor market is still a mess, but we can find some broadening of hiring activity even though total payrolls are still contracting. That means the necessary reallocation of productive resources, which is part of the function of recessions, is under way. More importantly, unit labor costs are falling as the pace of layoffs has overshot the contraction in output, and labor productivity is improving as a consequence, which is a second growth encouraging outcome of recessions.
The question remains what lies ahead after the massive quantitative easing operations of the Federal Reserve have lapsed and the bulk of the fiscal stimulus is behind us. In the very near term, we can surely expect auto sales to wilt following the end of the cash for clunkers program, but we remain impressed by what supply managers in the most cyclical part of the economy, namely manufacturing, have to say about new orders, production and export conditions. Policymakers panicked and adopted a “whatever it takes” stance, one that has proven to be the most radical outside of major wartime conditions. Looks like something took – and not surprisingly, gold is taking out the $1,000 per ounce mark at the same time.
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