Employment situation could set negative tone for month

Equity prices neutral to lower
Equity price movements varied this week - depending on the market. The Dow remained pretty much near last Friday's levels until Thursday when a burst of activity pushed up blue chips. Yet, the NASDAQ composite continued downward as market players realized tech stocks were still overvalued (gasp!) After the strong employment report on Friday, most market indices headed even further south. Only the Dow posted a slight gain for the week.

Summing Up: It's the summer doldrums. Investors have seen downdrafts in July and August in the past few years and are probably concerned that a shock will set off the market this year as well. Certainly, anything can happen. The likelihood of a rate hike in August is not bullish for the equity market in general. Investors won't get any good news in the near term and anticipate third quarter earnings reports.

Quarterly refunding announcement by Treasury aids prices
The Treasury market may have a schizophrenic element these days. After all, do market players react to economic news - which is generally bearish and indicative of tighter monetary policy - or do they react to the bullish news on supply? The Treasury announced the elimination of the 30-year bond issue in November. This means that 30-year bonds will only be auctioned twice a year (February and August). They are also considering reducing the quantity of the 52-week bills and the 2-year notes.

In addition, the government announced plans to buy-back Treasury securities. The idea is to buy back those issues that have higher yields. It is basically the government's attempt to refinance their loans and pay down the national debt, which stands in excess of $5 trillion.

A reduction in the supply of Treasury securities will almost certainly lead to an increase in their price. But most prices are set by the combination of supply and demand. Recently, many analysts were worried that foreign demand of U.S. Treasury securities would drop precipitously, as foreigners became more interested in their own economies in Europe and Asia. If the supply of Treasury securities becomes limited, the problem caused by the weaker foreign demand is also limited.

Some analysts are worried that the depth of the Treasury market would be reduced with a buy-back and it would hurt liquidity. That is always a possibility. In any case, the U.S. Treasury market probably has a way to go before the supply becomes "too small."

Employment situation shows strong growth; higher wages
Nonfarm payroll employment jumped 310,000 in July after smaller gains in the previous two months. While the July figure is indicative of healthy growth for the month, the 3-month moving average is about on par with last month and does set nonfarm payrolls on a slower path than earlier this year. While the reduced trend growth is likely an acceptable pace for the Fed, the July figure is still too strong. Market players immediately believed the payroll figure would lead to a hike in the fed funds rate when the FOMC meets later this month.

Often, such large gains cause economists to analyze the data with a fine-tooth comb - searching for "special factors" that may have skewed the figure one way or another. Manufacturing employment increased for the first time since August 1998, but no special factor can account for it. Perhaps the recent gains in new orders suggest better trends in factory employment (although the underlying pattern of factory orders was more anemic than the headline figures.) In the service sector, a spurt of activity occurred in retail trade - eating and drinking places added to their payrolls in a big way (+61,000). But this sector does tend to move in spurts. The longer-term trend is not suggesting the data is misleading. The bottom line on this payroll figure? It suggests economic activity is not moderating and the Fed will pounce on it as an excuse to tighten monetary policy as a pre-emptive measure against inflationary pressures.

The civilian unemployment rate was unchanged in July at 4.3 percent as both household employment and the labor force decreased modestly. It isn't unusual to see a divergence between household employment and nonfarm payrolls from month to month. On the whole, the two employment series do move in tandem. More disconcerting for financial market players and Fed policy-makers was the 0.5 percent spurt in average hourly earnings. On a year-over-year basis, earnings rose 3.8 percent in July compared with 3.7 percent in June. This shouldn't be a big deal on its own. However, if you look at the monthly changes in hourly earnings, the pattern of the past four months is not pretty. (Monthly increases from April to July: 0.2, 0.3, 0.4 and 0.5 percent.) On their own, these figures might not be the beginning of an inflationary trend, but the Fed will want to act in a pre-emptive fashion.

Productivity moderates in quarter; unit labor costs accelerate
Nonfarm productivity grew at a 1.3 percent rate in the second quarter, well below the pace in the previous three quarters. At the same time, unit labor costs increased at a 3.8 percent rate, its fastest pace since the fourth quarter of 1997. These numbers look ominous. Indeed, the Fed could very well point to these figures as a major impetus behind a rate hike at the August FOMC meeting.

In reality, the productivity figures weren't all that bad. Indeed, since productivity depends on quarterly GDP growth along with changes in employment for the period, the numbers are always volatile. It makes more sense to view them as year-over-year changes. Indeed, nonfarm productivity increased 2.9 percent from a year ago - posting its largest gain since the second quarter of 1996!

The chart below depicts the year-over-year change in nonfarm productivity along with the yearly change in unit labor costs. In a similar vein, the yearly rise in unit labor costs was more moderate than the quarterly one. The three-quarters just ended have shown the smallest three-quarter change in unit labor costs since 1996.

The bottom line on productivity and unit labor costs? The data are still showing healthy productivity trends, but the quarterly figures were sufficiently bearish that the Fed could point to them as reasons to raise rates.

Once over lightly
Earlier this week, economic indicators revealed varying signs of strength in the economy. The NAPM decreased to 53.4 in July from 57 in June, showing a less robust manufacturing sector. Factory orders for June did post a moderate gain, and shipments were strong. However, the level of unfilled orders continues to weaken. Unfilled orders are more consistent on monthly basis than new orders and a better indicator of underlying strength in current and future production. It is interesting that these two indicators for the manufacturing sector were more sluggish than today's report on factory payrolls. On the whole, the manufacturing sector remains the weak link in the U.S. economic chain.

Motor vehicle sales were on par with June levels - showing healthy spending on the part of consumers. Also, chain store sales posted healthy year-over-year gains in comparable stores. This is somewhat at odds with the weekly LJR Redbook and BTM/Schroders chain store sales indices, which actually were down for the month.

THE BOTTOM LINE
It is an understatement to say that Alan Greenspan's comments are sometimes misleading. Most of the time, the comments are simply incomprehensible. In any case, it appears that Greenspan indicated the Fed's desire to act preemptively. Fed officials have indicated their belief that economic growth is unsustainably robust and the potential for inflationary pressure increases every month that the unemployment rate remains at current levels.

The employment report reflects a robust economy - with signs that wages are beginning to accelerate again. At the same time, productivity growth moderated significantly in the second quarter (looking at the quarterly pattern, rather than the yearly pattern). This is cause for concern. Market players interpreted the economic data to imply that the Fed would soon be raising the federal funds rate once again by 25 basis points (or maybe even more) at the upcoming FOMC meeting.

Looking Ahead: Week of August 9 to 13
Few key economic indicators will be reported this week. We use the Market News Service survey of forecasts to describe the market consensus.

Thursday
Market participants are expecting new jobless claims to jump 21,000 in the week ended August 7 from last week's 279,000. A small number of economists continue to predict this highly volatile figure! Seasonal adjustment is difficult on weekly data - particularly at this time of year when factories shut down for re-tooling.

Retail sales are expected to rise 0.3 percent rate in July, a bit more than the 0.1 percent gain posted in June. Excluding autos (and trucks), sales should post a 0.5 percent gain for the month. Non-auto retail sales rose 0.4 percent in each of the previous two months.

Friday
Economists are predicting the producer price index will rise 0.3 percent in July, more than reversing the 0.1 percent drop posted in June. Excluding food and energy, the PPI is expected to inch up 0.1 percent for the month. The PPI fell 0.2 percent in June.

Market players are looking for business inventories to edge up 0.2 percent in June, about in line with the past few months. Manufacturing inventories were down in June. Wholesale trade inventories will be available on Monday.