By Evelina Tainer, Chief Economist
February 6, 2004

Recap of US Markets
With little question, the January employment report proved disappointing since nonfarm payrolls rose less than expected and the unemployment rate dipped again amid a declining labor force. But nonfarm payrolls did rise and the unemployment did fall. Clearly this was friendly news for the equity market since nonfarm payrolls posted their largest monthly gain since December 2000. Treasury prices rose - and yields fell - because the size of the payroll gain was not sufficiently large for the Fed to decide that they need to tighten anytime soon. Thus, bond investors were happy with the report as well. So, despite the fact that employment growth continues at an anemic pace, equity and bond investors were just about equally happy today, a rare event since what is good news for one is usually bad news for the other.

STOCKS
The major stock indexes peaked on January 26 and have since headed lower. The Dow and the S&P 500, which had been posting relatively modest gains, have declined the least since then. The Russell 2000 and the NASDAQ composite index, which have been growing by leaps and bounds relative to the Dow and the S&P, have dropped more dramatically in the past two weeks. Friday's employment report helped to boost prices across the board despite the fact that nonfarm payrolls grew less than expected and the downtick in the jobless rate was spurred by a decline in the labor force. After all was said and done, stock prices managed to rise on Friday over the previous week's close (except for a 0.1 percent drop in the NASDAQ). The chart below shows the year-to-date change in each of the major stock indexes. Notice that the Russell is still showing a much stronger gain than the other four.

The discrepancy is not inconsequential but for policymaking purposes today, it doesn't matter. Both surveys are still reflecting a sluggish labor market. Thus, even though the employment-to-population ratio (which is closely monitored by Greenspan & Company) rose slightly in January, it has a way to go even before recapturing levels seen a couple of years ago, during the recession. Today's employment report doesn't give the Fed any ammunition to become less accommodative in the near term.

Productivity moderates in Q4
Nonfarm productivity grew at a 2.7 percent rate in the fourth quarter, significantly less than the whopping 9.5 percent pace recorded in the third quarter. Productivity depends on output as well as employment growth. Employment grew a bit faster in the fourth quarter than in the third quarter, thus hampering the rate of productivity growth. At the same time, real GDP grew half as fast in the fourth quarter as in the third, also curtailing productivity growth. The path of quarterly productivity is dependent on two key variables that also change their quarterly growth path. Consequently, it is a good idea to look at the year-over-year change in productivity to better gauge its growth. In fact, nonfarm productivity expanded 5.3 percent in the fourth quarter after increasing 5 percent in the third quarter. There is no question that productivity remains a factor in curtailing employment growth these days. However, a sustained increased demand for goods and services would also go a long way in helping to improve employment demand.

Typically, increases in nonfarm productivity are associated with declines, or slower rates of increases, in unit labor costs. The fourth quarter of 2003 was no exception. Unit labor costs declined at a 1.3 percent rate during the period. Indeed, unit labor costs have declined more than they have increased since 2000. Given the sluggish demand for labor, wages and salaries have remained in check these past few years. Unit labor costs are likely to remain subdued over the coming year as well.

Manufacturing sector looks good
The ISM manufacturing index inched up 0.2 percentage points to 63.6 percent in January bringing this index to its highest level since 1983. It does seem ironic that a sluggish manufacturing sector (measured by slow growth in industrial production and factory orders in the past several months) would yield a 20-year high for the ISM. New orders dipped 2 points in January but still remain high at 71.1 percent. Production rose 2 points for the month to reach 71.1 percent as well. Inventories inched up but remain below the 50 percent mark. All in all, the ISM report was robust and suggests that the manufacturing sector expanded in January.

Factory orders rose 1.1 percent in December, just about reversing the previous month's 0.9 percent drop. Durable goods orders increased a meager 0.3 percent while nondurable goods orders jumped 2 percent for the month. Both defense and nondefense capital goods orders contributed to the rise but did not offset November declines. On the whole, fourth quarter results were significantly weaker than in the third quarter. Total new orders as well as nondefense orders grew in the fourth quarter, but orders for information technology goods declined after a strong showing in the previous quarter.

New orders are notoriously volatile, but one would expect a more decided upbeat path in a recovery; particularly after the sharp decline recorded in 2000 and 2001. Since the ISM new orders index continued at a high level in January, it is possible that factory orders will strengthen in upcoming months.

Motor vehicle sales sag in January
Domestic cars were sold at a 5.2 million unit rate in January, down from a 5.7 million unit rate in December. At the same time, light trucks were sold at a 7.9 million unit rate in January, down from a 9 million unit rate in December. Despite the January drop from high December levels, the figures were not all that different from the selling pace between September and November. Indeed, the monthly path of auto sales is often volatile as low sales months are usually followed by high ones after automakers decide to improve incentives. The monthly - and quarterly - paths certainly affect personal consumption expenditures as well as GDP growth, so it is not irrelevant to be concerned with changes in monthly sales. However, underlying demand for motor vehicles is better viewed over a longer period. The chart below looks at the 12-month moving average of motor vehicle sales. Notice just how consistent sales were throughout 2003. While monthly sales were certainly affected by incentives, there is no question that incentives simply changed the timing of sales, not underlying demand. The 12-month average has dipped slightly in December and January, perhaps suggesting that underlying demand will fall in coming months - unless something changes in the economy. The most likely variable to positively affect motor vehicle sales is employment growth. If it ever becomes strongly positive, we may see another uptick in sales demand.

The Bottom Line
Economic indicators were abundant this week, but many seem less relevant after the employment situation is released! At least two of the January indicators, the ISM manufacturing and non-manufacturing surveys, were robust and indicate that economic growth is off to a good start in 2004. Motor vehicle sales were not quite as robust as December, but one month does not reveal a trend, particularly in such a volatile series. Underlying demand for cars and trucks appears to be sliding, but a booster shot from the labor market could change all that.

Unfortunately, the employment report was not a bed of roses. The drop in the jobless rate coupled with a modest rise in nonfarm payrolls points to some improvement. But one could make the case that special factors diminish the significance of the higher payrolls and the lower unemployment rate.

Fed policymakers are going to need consistent employment growth before they will be able to follow a less accommodative monetary policy. Perhaps Alan Greenspan will say as much this coming week when he testifies before Congress in his semi-annual monetary policy briefing.

Looking Ahead: Week of February 9 to February 13

Thursday
New jobless claims rose 17,000 in the week ended January 31 to 356,000. Despite the rise, the 4-week average remained unchanged at 345,250. This is still a drop from the December average and will be the fourth straight month in which jobless claims averaged less than 400,000 for the month.

Jobless Claims Consensus Forecast for 2/7/04: 345,000 (-11,000)
Range: 340,000 to 345,000

Retail sales rose 0.5 percent in December after posting a stronger 1.2 percent hike in November. Motor vehicle sales posted gains in both months, although the November rise was twice as strong as the December rise. Excluding autos, retail sales inched up a modest 0.1 percent in December as heavy discounting probably curtailed the total dollar increase in retail spending during the month.

Retail sales Consensus Forecast for Jan 04: 0.0 percent
Range: -0.9 to 0.3 percent

Retail sales excluding autos Consensus Forecast for Jan 04: 0.5 percent
Range: 0.2 to 1.0 percent

Business inventories rose 0.3 percent in November after rising 0.4 percent in each of the two previous months. The inventory-to-sales ratio remains low by historical standards - even keeping in mind that technology allows businesses to maintain overall lower inventory levels. Inventories are likely to increase in the coming year as producers feel more confident about the economic expansion.

Business inventories Consensus Forecast for Dec 03: 0.2 percent
Range: 0.1 to 0.5 percent

The U.S. Treasury has reported an average budget surplus of $35.2 billion in January over the past 10 years. January typically sees a budget surplus because estimated tax payments are received by the Treasury. Given that the Administration is predicting a budget deficit of $521 billion for fiscal year 2004, don't look for such a large surplus this January.

Treasury Budget Consensus Forecast for Jan 04: $3.0 billion
Range: $-16 to $5 billion

Friday
The international trade deficit on goods and services narrowed by nearly $4 billion in November to $38.0 billion. It was the lowest trade deficit since October 2002 when dock workers were on strike. Export growth (partly due to the depreciating dollar) has accelerated in the past few months and this has helped to curtail the trade deficit.

International trade balance Consensus Forecast for Dec 03: $-39.8 billion
Range: $-37.5 to $-41.0 billion

The University of Michigan's consumer sentiment surged in January to a level of 103.8 from December's 92.6 level. This final figure for the month was slightly higher than expected and a bit higher than the 103.2 level recorded at mid-month. The spurt in the sentiment index between December and January shows a big improvement in consumer optimism.