Is Goldilocks back'
By R. Mark Rogers, Senior Economist, Econoday
October 5, 2007
This past week the big news was the September jobs report which came in with healthy payroll gains and with sharp upward revisions to July and August payrolls. Equities loved the numbers as stocks jumped across the board. The Dow and S&P 500 set new record highs during the week. Many are saying that the just-right Goldilocks economy is back. But the devil is in the details and not all was just right within the employment report. But the good news is that if it is not a Goldilocks economy, it is close to a Goldilocks economy.
Equities jumped sharply last week – especially the small caps and techs. The biggest days in the market were Monday and Friday with large gains due to greater confidence that the worst of the subprime problems is over and on Friday due to a very favorable employment report. The fourth quarter got off to a good start this past Monday as the Dow set a record close, passing the 14,000 mark again to close at 14,087.55. Investors actually welcomed reports from a number of companies on subprime losses as the reports clarified the extent of losses and gave investors confidence moving forward. Citigroup in particular warned of a 60 percent drop in third quarter earnings due to $3 billion in write-downs from losses in subprime-backed securities. But the markets liked the fact that Citigroup indicated that the mark down would be a one-time event. USB – another key financial company – announced a management restructuring that markets saw as positive. Also adding to positive psychology for the markets overall was a burst of deal making which investors saw as a sign that companies were optimistic about the economy. Small caps in particular benefited from the market’s increased confidence as the Russell 2000 shot up 2.4 percent for the day.
Markets largely drifted mid-week, waiting on Friday’s employment report. Weak auto sales and a drop in pending home sales led large caps to slump on Tuesday. Wednesday was the soft point of the week as weak earnings in the tech sector dampened the markets overall.
Stocks surged on Friday’s jobs report. Friday’s employment report came in with not just a healthy gain in September but strong upward revisions for the prior two months. The initially estimated decline in payrolls in August was revised away and recession fears essentially vanished with the release of the latest jobs report. This shift in psychology is what lifted the markets the last day of the week with small caps benefiting the most as small caps are cyclically sensitive. The S&P 500 set a record high at 1,526.75. The Nasdaq closed at a six and half year high of 2,780.32 while the Dow also advanced but fell short of the record close set earlier in the week.
Last week, most major indexes were up. Major indexes were up as follows: the Dow, up 1.2 percent; the S&P 500, up 2.0 percent; the Nasdaq, up 2.9 percent; and the Russell 2000, up 4.9 percent.
Year-to-date, the Dow is up 12.9 percent; the S&P 500, up 9.8 percent; the Nasdaq, up 15.1 percent; and the Russell 2000, up 7.3 percent.
Rates were bumped up this past week as the relatively strong September jobs report slammed Treasury prices. The week started out mixed, however. A very moderate ISM report helped to ease long rates on Monday. However, short rates spiked 10 basis points as a surge in stock prices pulled funds out of the short end of Treasuries. Tuesday saw further slippage in rates across the yield curve except on the short end as pending home sales were reported down sharply. On Wednesday, with markets sitting on pins and needles over the pending jobs report, markets actually moved on the significant rise in the employment component of the ISM non-manufacturing survey with rates firming slightly. With many traders on the sidelines waiting for Friday’s employment numbers, rates drifting down slightly on Thursday. Several facets of the September employment report sent rates up sharply across the board — a healthy 110,000 gain in employment for September, upward revisions for July and August, and a firming in wage growth. The 3-month T-bill jumped 17 basis points – more than other maturities – as the Federal Reserve Vice Chairman Donald Kohn implied in a speech that the Fed had not yet decided on whether or not another rate cut is forthcoming on October 31 at the end of the upcoming FOMC meeting.
Overall, the short end has risen a little more than the long end as markets have both come to see equities as more attractive and see a lower probability of a Fed cut on October 31. Rates on longer maturities have risen both on the view that the economy is a little stronger than previously believed and due to a boost in inflation premiums.
Treasury yields were up as follows in the week: 3-month T-bill, up 17 basis points; 2-year T-note, up 10 basis points; 3-year, up 11 basis points; the 5-year, up 9 basis points; the 10-year bond, up 6 basis points; and the 30-year bond, up 4 basis points.
Heavy outflow of funds from short rates to equities helped to flatten the yield a little this past week as short rates jumped more than long bonds.
Oil prices were little changed net this past week. There was some volatility over the period. Monday saw a drop of $1.42 as traders reevaluated the fundamentals of the markets, seeing demand a little softer than priced. Prices rebounded $1.34 per barrel on Thursday, spurred by a drop in the dollar and by an unexpected announcement of a maintenance related shutdown of a refinery in Newfoundland. Prices dipped a little on Friday in response to the strong jobs report which was seen as supporting the dollar and easing support of oil prices.
The spot price for West Texas Intermediate edged down $0.46 per barrel for the week to close at $81.20 per barrel - $2.22 per barrel below the record close of $83.42 per barrel set on Friday, September 21.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week gave us a generally favorable employment report for September and moderately positive news from the manufacturing sector. Recession talk has faded away and now the economic issues are whether the economy is staying moderate enough to suit the Fed and is inflation still easing.
The big story last week was the September employment report which was quite positive – especially after the August report was so negative with the unexpected drop in payrolls as initially announced for that month. Nonfarm payroll employment in September strengthened with a 110,000 gain, following a revised rise of 89,000 in August and a 93,000 boost in July. The initial August estimate of a 4,000 decline was revised up 93,000 and July was revised up 25,000 from the previous estimate of a 68,000 increase. For August and July combined, the net revision was up 118,000.
The September report led to a huge shift in market psychology – in equities, bonds, and even in exchange markets. It was not just the September figure but upwards revisions to the prior to months that basically removed all significant concern over any pending recession. Additionally, the markets concluded that the damage from the subprime credit crisis had been kept isolated from most of the economy. In terms of psychology, equities saw the risk of recession fading and odds rising for better revenues. The bond market sees inflation as a greater risk, and exchange markets see U.S. rates either staying put or declining less rapidly than believed just a couple of weeks ago.
Within the payroll survey, strength was primarily in the service-providing industries. Service-producing jobs were robust in both September and August with gains of 143,000 and 153,000, respectively. For the latest month, increases were strongest in education & health services, up 44,000; government, up 37,000; leisure & hospitality, up 35,000; and professional & business services, up 21,000.
Good-producing industries remain weak. Manufacturing declined 18,000 in September, following a 45,000 drop the month before. Construction fell 14,000 in September after a 22,000 fall in August. Natural resources & mining slipped 1,000 in after rising 3,000 in August.
The bottom line for current job growth is that construction and manufacturing declines are keeping overall job growth moderate. For the Fed, a forward projection of likely trends could be disconcerting. Construction jobs will stop declining sometime next year as the recession in housing ends and non-residential construction remains strong. Additionally, a weak dollar could even help bring back some manufacturing jobs. If the goods-producing job decline even becomes less of a decline that could boost overall job growth significantly, putting pressure on labor markets. These are trends that are likely to boost overall job growth – the question remaining is to whether this pushes growth beyond potential.
One of the key details that keep the September jobs report from falling into the Goldilocks category is that wage inflation firmed. Average hourly earnings increased 0.4 percent in September, following a 0.3 percent rise the month before. Year-on-year, wages were up 4.1 percent in September, a stronger pace than the 3.9 percent in August. The September pace is the strongest since a 4.2 percent pace seen in November 2006. Wage inflation clearly will be of concern for the Fed.
The other key detail that is worrisome for the Fed is a still low unemployment rate. For September, the civilian unemployment rate did edge up to 4.7 percent from 4.6 percent in August but this is still low. Recent initial unemployment claims numbers have been volatile but on average show a still tight labor market.
Overall, the September employment report indicates that the consumer sector is much healthier than was believed a month ago and that most of the economy has moved beyond worrying too much over subprime problems.
Traders in the fed funds futures market have changed their collective view on Fed easing in the near term. The implied fed fund futures rate for the end of October sees only a small chance of the Fed easing at the upcoming FOMC meeting – the markets likely get a trick and no treat Halloween afternoon. The fed funds future market now expects a 25 basis point cut at the Fed’s December FOMC meeting and the following 25 basis cut not until possibly the end of April 2008. Essentially, those in the fed funds futures market expect the Fed to cut interest rates but at a much more deliberate pace than believed on September 18 when the Fed slashed interest rates by half a percentage point.
The September employment report was quite positive in terms of allaying investor fears over any pending recession. Consumer spending will be supported by healthy income growth and this also helped reduce fears that further weakness in housing-related purchases would pull down spending too much. But from the Fed’s perspective, its view that the credit crunch was a likely temporary event with the economy needing mainly a boost in confidence appears to be correct. While there will be further effects from subprime problems, it appears that the magnitude is better understood and anticipated. Meanwhile, the Fed is weighing the strength of the economy and that of inflation fundamentals. That is, core inflation currently looks good but how are a tight labor market, a weak dollar, and high oil prices affecting the inflation outlook' These are the reasons that the Fed does not yet know how it will vote on October 31 on additional rate cuts. Importantly, outside of housing, fundamentals for the economy are good. If needed, the Fed will not have to adjust the economy too much to put it on the Goldilocks path.
This coming week one of the highlights will be the release of the minutes of the FOMC meeting on September 18, giving markets critical insight into the latest Fed thinking on inflation, economic growth, and whether more interest cuts are imminent. Also on center stage will be the producer price index giving us an update on progress on inflation and retail sales giving us insight into how well the consumer is supporting overall economic growth.
Columbus Day. Bond market closed but stocks and futures markets open.
The FOMC minutes of the September 18 Fed policy meeting will be released this afternoon. These minutes are likely to be more critical to the markets than usual since the September 18 minutes are likely to give more insight into whether the Fed was looking at one-time shock therapy of a 50 basis point interest rate cut to sooth the markets and boost the economy or whether the Fed anticipates continuing rate cuts over the next few quarters. Count on this report being a market mover.
Initial jobless claims rebounded 16,000 in the week ending September 29 to 317,000, reversing the 12,000 drop the prior week and 7,000 decline two weeks earlier. The data indicate that labor markets remain tight despite lay-offs in the financial sector. The Fed will be watching the weekly jobless claims numbers to stay on top of labor market trends.
Jobless Claims Consensus Forecast for 10/6/07: 315,000
Range: 312,000 to 315,000
The U.S. international trade gap narrowed slightly in July to $59.2 billion from $59.4 billion in June. However, we are likely to see a widening in the gap in August due to higher oil prices. While the headline number will likely be negative, markets need to pay attention to some key detail. It will be important to look at the non-petroleum deficit to see if export growth is offsetting imports. With the consumer sector slowing due to more moderate job growth and over sluggish growth in home equity, it is important that exports help keep overall economic growth healthy in coming quarters. With earlier declines in the dollar, we are indeed likely to see the uptrend in exports continue.
International trade balance Consensus Forecast for August 07: -$59.8 billion
Range: -$62.3 billion to -$58.0 billion
Import prices slipped 0.3 percent in August helped by a 1.3 percent decline in petroleum. Excluding petroleum, import prices slipped 0.1 percent in August, following a rise of 0.1 percent the month before. Nonetheless, import prices are posing one of the key concerns on the inflation front with year-on-year overall import prices up 1.9 percent. Crude oil prices are near record highs, strong world-wide economic growth is keeping commodity prices strong, and the declining dollar is boosting the dollar cost of imports for U.S. consumers. The last time the core PCE price index was in the Fed’s comfort zone, non-oil import prices actually were declining – in sharp contrast to marginally positive gains currently.
Import prices Consensus Forecast for September 07: +0.8 percent
Range: +0.4 to +1.0 percent
The producer price index fell 1.4 percent in August, following a 0.6 percent spike in July. But the drop in August was primarily due to a decline in oil prices – a factor that reversed in September. We are likely to see a swing in the other direction for the headline number for September. The core rate has been relatively well-behaved with a 0.2 percent rise in August, following a 0.1 percent rise the month before. However, higher oil and commodity prices could be starting to feed into the core rate.
PPI Consensus Forecast for September 07: +0.4 percent
Range: -1.0 to +0.8 percent
PPI ex food & energy Consensus Forecast for September 07: +0.2 percent
Range: +0.1 to +0.2 percent
Retail sales in August pointed to a slowing in consumer spending for the month with overall retail sales rising 0.3 percent, following a 0.5 percent boost in July. But there were special factors with the biggest being comparison with a strong July – at least for “core” retail sales. The August gain was led by autos. Weakness was in gasoline sales, which were pulled down by lower prices, and by building materials, which continue to suffer from the decline in the housing sector. Excluding both motor vehicles and gas stations, sales slipped 0.1 percent, following a 0.8 percent jump in July. So, on average the past two months show a moderately healthy consumer sector. The September numbers will be especially important to see if the consumer has shaken off credit crunch worries from August.
Retail sales Consensus Forecast for September 07: +0.3 percent
Range: -0.3 to +0.5 percent
Retail sales excluding motor vehicles Consensus Forecast for September 07: +0.3 percent
Range: -0.1 to +0.5 percent
The Reuter’s/University of Michigan’s Consumer sentiment index in September index was unchanged from August at 83.4. This indicator will get more attention than usual as the markets will be looking to see if the consumer has shaken off credit crunch worries. And the Fed will be watching the inflation expectations numbers to see if the direction is improving or not. Twelve-month inflation expectations dipped back 1 tenth to 3.1 percent with five-year expectations unchanged at 2.9 percent. Both of these series are known to stay well above actual inflation so Fed officials tend to watch the changes in expectations more than the actual rates.
Consumer sentiment Consensus Forecast for preliminary October 07: 84.0
Range: 83.0 to 85.0
Business inventories rose 0.5 percent in July, well below a 1.1 percent rise in business sales to push the stock-to-sales ratio down to 1.26 from 1.27. During times of slowing economic growth, it is critical that inventories not swell – otherwise, slow growth could turn into recession. That does not appear to be the case for now, but inventories numbers still bear watching. More recently, the factory component of inventories slipped 0.1 percent in August, indicating that overall inventories are likely to be soft for the month.
Business inventories Consensus Forecast for August 07: +0.2 percent
Range: +0.1 to +0.4 percent
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