In contrast, the Nasdaq composite index shot up this week and Friday's decline was minor in comparison. As a result, the weekly gain in the Nasdaq composite was rather healthy despite Friday's bad employment news. This reminds us of the bubble period when the Nasdaq couldn't be stopped by any negative news and surpassed growth in the Dow by wide margins almost daily. Granted, much of the upward activity in the Nasdaq can be tied to friendly news in technology this week. Nonetheless, it is somewhat disturbing to see the indexes go their disparate ways once again, particularly when the Nasdaq is practically ignoring a fairly key economic variable - employment.

Bonds rally on employment news
Bond yields were on a downward trend over the week as economic figures generally came in below expectations. However, the bulk of the weekly decline took place on Friday after a very disappointing employment report that had economists rethinking their Fed policy forecasts. While no one was expecting that the Fed would immediately increase the federal funds rate target, many economists are pushing rate hikes further back into the year. Undoubtedly, bond investors believe that the Fed will have little choice but to leave rates unchanged as far as the eye can see given the lack of job growth. Granted the unemployment rate fell to 5.7 percent in December, but this was due to a drop in the labor force, not an increase in employment.

A low interest rate environment remains friendly news for consumers, especially those signing new mortgages and financing large ticket items. While credit card rates are not as low as mortgage and auto loan rates, they are often tied to the bank's prime rate and thus held in check. This is helping to keep a lid on consumer debt service payments.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

Jobless rate, payroll fluke'
The civilian unemployment rate fell back to 5.7 percent in December after dipping to 5.9 in November. The downward trend in the jobless rate is typically viewed as a good thing. However, household employment declined in December and the only reason the jobless rate decreased as well was because the labor force dropped by a much larger amount. When the labor market situation worsens, the unemployment rate can be pushed down by discouraged workers, who stop looking for work. Most economists don't really believe that discouraged workers caused the decline in the labor force in December, particularly since other measures, such as new jobless claims, were suggesting that the labor market situation was improving. It is certainly possible that the December drop in the labor force was a fluke.

But then, we should look at other employment measures, such as the employment-to-population ratio to determine how well the labor market is improving. Once again, we would be disappointed. This ratio dipped to 62.2 in December from 62.3 in November and has remained in this tight range for several months. This suggests that employment conditions have remained stagnant for much of 2003.

The establishment survey did not yield any better results vis-�-vis the labor market situation. Nonfarm payrolls edged up a measly 1,000 in December after downward revised gains of 43,000 in November and 100,000 in October. The downward trend over the fourth quarter period is indeed discouraging. Once again, factory payrolls declined 26,000 in December while construction employment rose 14,000 for the second straight month.

The service-producing sector was a drag as well with only 13,000 new jobs added. Retail trade employment dropped in both November and December and this could be due to strong seasonal factors that anticipated a surge in holiday hiring that just didn't happen. It is possible that retail trade employment will show gains in January and February since retail establishments can't fire workers they never hired. This is a typical pattern that emerges each holiday season. But even so, this is a minor issue in the report that basically reveals no hiring.

Not to be unnecessarily cheerful, it is useful to keep in mind that the establishment survey doesn't measure job creation in the small business sector. And small businesses do hire when economic conditions improve. Surveys from the National Association of Independent Businesses showed increasing optimism over the course of 2003. Moreover, new jobless claims have moderated significantly in the fourth quarter, averaging 350,000 per week in the past month compared with weekly averages of more than 400,000 just four months ago.

Structural change
Many economists have started to focus on the fact that structural change in the U.S. economy will prevent the typical monthly average of 250,000 to 300,000 workers added to payrolls during a recovery. Some are saying that we should be happy to see 125,000 to 175,000 per month in the upcoming year. Thomas Hoening, president of the Kansas City Fed, noted in a speech on Thursday that he thought nonfarm payrolls would increase between 100,000 and 300,000 in the next six months. In contrast, Fed governor Ben Bernanke said last weekend at the American Economic Association meetings in San Diego that 4 percent annual growth in GDP might not be enough to get employment on a positive growth path. Historically, a 3 percent GDP growth rate was considered sufficient.

Rapid productivity growth is the reason that we have seen a jobless recovery in the past couple of years, according to experts. There is no question that robust productivity growth is typically associated with soft employment growth and vice versa. However, judging by the chart below, it is difficult to tell whether rapid productivity growth is, after all, the sole factor behind declining employment growth in 2002 and 2003.

Wall Street economist Steven Roach has advanced the hypothesis that productivity growth is vastly overestimated because no one is measuring all the extra hours put in by service workers. Indeed, many professional workers don't have regular 9-to-5 hours anymore, but are always available via phone, fax, pager, and laptop. It is certainly true that manufacturing productivity has shot up in the past 10 years, but then again, manufacturing is an ever-declining share of total employment and production in the U.S.

We don't disagree that faster-than-average productivity growth may play a role in the current situation where employment growth is weaker-than-average for a recovery. We can't disregard the number of jobs that have been created in the past two years by U.S. multinational corporations - overseas. It is no secret that service sector jobs are also disappearing. Just this week, internet provider Earthlink announced a major layoff of support staff and indicated that these jobs would be manned by workers in other countries.

There is no question that labor market conditions are rapidly changing because the way we conduct business is rapidly changing. In times like these, it is difficult to embrace free trade. One has the inclination to pursue more protectionist policies. However, there is no getting around the fact that the U.S. has gone global in a very big way. Indeed, economic growth will have to be faster to generate employment growth, not just because of productivity gains but also because job expansion will be slipping outside of our borders.

The Bottom Line
Aside from a surge in motor vehicle sales in December, many of the week's economic indicators were a bit disappointing to equity investors since they came in below expectations. However, there is no question that economic growth is still expanding at a decent clip when the ISM non-manufacturing survey shows an index level of 58.6 for the month of December.

But since the employment report is considered the mother of all indicators, there is no question that equity investors and more optimistic economists will be discouraged. Due to the employment surprise, many economists are rethinking their forecasts for Fed policy. With the strong growth of the third quarter and an improving trend in labor market conditions (from previous employment reports and current weekly jobless claims), economists had initially expected that the Fed would start raising its federal funds rate target this year.

While the jobless rate did decline in December, the fact that it declined because labor force growth fell makes it a hard sell as a positive. The Fed is currently faced with deteriorating employment conditions measured by nonfarm payrolls - or at best, faced by stagnant employment measured by the employment-to-population ratio.

If it is true that structural change in the economy is causing sub par employment growth, there is little the Fed could do to change that. Their role is to encourage economic growth and maintain price stability. Well, economic growth was encouraging in 2003. The Fed could certainly hold off raising the funds rate target for a few more months, but can it go on forever' Structural problems can't be fixed with monetary policy alone.

It will be an interesting time for investors over the next several months to see how the debate over monetary policy develops. Structural changes in the U.S. economic fabric could cause shifts in many economic variables. But then again, the talk about structural change might have been for naught if employment starts growing at a decent pace (150,000 - 200,000) in the next few months with just a little faster economic growth.

Looking Ahead: Week of January 12 to January 16

Wednesday
The producer price index fell 0.3 percent in November, primarily due to a 1.2 percent drop in energy prices. However, prices of consumer goods excluding food and energy were unchanged during the month and capital equipment prices fell 0.1 percent. All in all, it was a month without a shred of inflationary pressures. There is no question that Fed policy makers continue to closely monitor price information.

PPI Consensus Forecast for Dec 03: 0.2 percent
Range: -0.3 to 0.4 percent

PPI excluding food & energy Consensus Forecast for Dec 03: 0.1 percent
Range: -0.1 to 0.1 percent

The international trade deficit on goods and services widened in October to $41.8 billion after reported a $41.3 billion shortfall in September. Imports rose 2 percent while exports rose 2.7 percent. However, since the level of exports is almost 50 percent lower than the level of imports, this still led to a widening of the trade deficit. A weaker foreign exchange value of the dollar should ideally increase the demand for U.S. exports and reduce the demand for imports, over time, but trade flows don't always work in an ideal fashion.

International trade balance Consensus Forecast for Nov 03: $-41.8 billion
Range: $-40.6 to $-43.5 billion

Market players will be closely monitoring the anecdotal evidence compiled by one of the 12 Federal Reserve district banks in the Beige Book. The most recent report indicated that economic activity was improving. In particular, market players will focus on holiday retail sales results and whether or not labor market conditions are truly on the mend.

Thursday
New jobless claims rose 14,000 in the week ended January 3 to 353,000 after declining for three straight weeks. This brought the 4-week average down to 350,250, a recent low. This points to an improving labor market, although one does need to view these data cautiously around holidays.

Jobless Claims Consensus Forecast for 1/10/04: 350,000 (-3,000)
Range: 350,000 to 385,000

The consumer price index fell 0.2 percent in November after remaining unchanged in October, spurred by a 3 percent drop in energy prices. Excluding food and energy, the CPI still fell 0.1 percent as housing costs, transportation costs and apparel posted declines during the month.

CPI Consensus Forecast for Dec 03: 0.2 percent
Range: -0.2 to 0.3 percent

CPI excluding food & energy Consensus Forecast for Dec 03: 0.1 percent
Range: -0.1 to 0.2 percent

Retail sales jumped 0.9 percent in November after remaining unchanged in October, spurred by a spurt in motor vehicle sales. Excluding autos, retail sales increased a more moderate 0.4 percent in November, matching the October gain. Anecdotal evidence that retailers discounted their merchandise weeks before Christmas suggests that while the volume of sales may have been strong, the dollar value of sales might not post a robust gain in December.

Retail sales Consensus Forecast for Dec 03: 0.9 percent
Range: 0.5 to 1.2 percent

Retail sales excluding autos Consensus Forecast for Dec 03: 0.4 percent
Range: 0.1 to 0.7 percent

The Empire State Manufacturing Survey moderated in December. Yet, at 37.4, the index level still showed robust manufacturing activity in the New York region. This index is relatively new but has been widely followed over the past year since it is timely and is reported in advance of the other major manufacturing surveys.

Empire State Manufacturing Survey Consensus Forecast for Jan 04: 35
Range: 32.5 to 37.2

The Philadelphia Fed's business outlook survey jumped to 30.3 in December after reaching a level of 27.9 in November. This index reflects manufacturing activity in the Philadelphia region but has done a good job of predicting the direction of industrial production growth over the years.

Philadelphia Fed's Business Outlook Survey Consensus Forecast for Jan 04: 29
Range: 25.2 to 35

In the past four years, the U.S. Treasury has recorded a budget surplus in the month of December, although this month has typically seen a deficit during most of the 1990s. Given that the administration has already predicted a fiscal year deficit of $500 billion this year, expect only smaller surpluses in months that typically see surpluses, and larger deficits in months that usually see deficits.

Treasury budget Consensus Forecast for Dec 03: $-13 billion
Range: $-13 to $-43 billion

Friday
Business inventories rose 0.4 percent in both October and November despite declines in manufacturing and wholesale trade. Inventories remain lean by historical standards; a rising trend during a recovery is typical and bodes well for production.

Business inventories Consensus Forecast for Nov 03: 0.2 percent
Range: 0.0 to 0.4 percent

The index of industrial production rose 0.9 percent in November, its fourth rise in five months. Production gains have not been uniform over this period as high tech industries have grown more rapidly than other sectors of the economy. The recovery in industrial production has been slow in coming, but it appears that an upward trend is in process.

Index of industrial production Consensus Forecast for Dec 03: 0.3 percent
Range: 0.0 to 1.0 percent

Capacity utilization rate Consensus Forecast for Dec 03: 75.9
Range: 75.6 to 76.6

The University of Michigan's consumer sentiment index ended 2003 at a level of 92.6, down from the November average, but up from a year earlier. Keep in mind that consumer sentiment surveys are not the best predictors of consumer spending: motor vehicle sales surged to a 14.9 million unit rate in December, rising to their highest level in four months.