Employment figures save the day... and the week for financial markets

Do financial market players no which way is up?
Last Friday, stocks ended on a down note. This week began with the same negative tone. The economic indicators along with Fed officials sounding hawkish contributed to the market's bearish sentiment. Wouldn't you know, it took the employment report to get the markets back on a positive track? At least, the stock market ended on a high note on Friday. It could be that the trend once again reverses after players digest the employment report. In the meantime, the belief was that the Fed wouldn't need to raise rates because employment grew more moderately in August. (Read below to get the real lowdown on the economic reports this week.)

Despite the dramatic daily changes in the Dow, the DJIA was down 0.1 percent this Friday relative to last week's close. The S&P 500 and the Russell 2000 posted moderate gains for the week. In contrast, the NASDAQ composite surged 3 percent.

Bond markets try to anticipate the Fed
Note the dramatic changes in daily activity during the summer months. This week was no different. Sentiment was generally bearish as bond prices drifted lower (and yields higher) until yesterday's close of 6.13 percent on the 30-year Treasury bond. The week's high was reversed quickly Friday morning upon the release of the employment report when the yield decreased 10 basis points. This kind of volatility could go on until the Fed's next FOMC meeting in October.

Payroll and wage growth moderates
Nonfarm payroll employment increased a moderate 124,000 in August, although upward revisions to the previous two months caused an upward tilt to the 3-month moving average of the series. The chart below shows an upward trend - not something the Fed will take lightly even though August data were softer than expected. Moreover, the average monthly gain for July and August is higher than the second quarter. This means that third quarter activity could still be higher than the previous quarter even with the soft August.

The civilian unemployment rate edged down to 4.2 percent hovering in the same narrow range of the past six months. Household employment grew modestly, but the labor force was essentially unchanged during the month. Market players focused on the weaker-than-expected rise in payrolls and earnings and this led to a rally in the bond and stock markets. Yet, the Fed is concerned about supply constraints, which are certainly evident if the labor force growth falters.

As indicated in the chart below, the good news came in the form of slower wage hikes. Average hourly earnings rose 0.2 percent in August and were up 3.5 percent from year ago levels. Note the downward trend in yearly wage growth. This might prevent Fed officials from pulling an itchy trigger finger on rate hikes.

The bottom line on the employment situation? Overall employment and wage growth were more modest than anticipated by market players. This was certainly favorable news to market participants who got spooked by productivity data and comments by Fed officials on Thursday. Yet, the data still look healthy and suggest stronger GDP growth in the third quarter than the second. While wages are not accelerating, there is sufficient evidence of strong economic activity that could worry inflation-phobes at the Fed.

Nonfarm productivity weakens; unit labor costs surge in Q2
Nonfarm productivity grew at a 0.6 percent rate in the second quarter, half the rate initially estimated a month ago for this period. This was the smallest quarterly gain in a year. Productivity in manufacturing as well as nonfinancial corporations moderated during the three-month period from the past several quarters. The Fed has consistently mentioned productivity growth as a factor that has curtailed inflationary pressures in this expansion. No wonder stock prices and bond prices tumbled on the news that productivity growth was moderating.

Yet, the headline figures don't tell the entire story. Quarterly data is clearly volatile - particularly when it depends on two factors like production and employment. The longer-term perspective can be better seen by looking at the year-over-year change in productivity. In fact, nonfarm productivity rose 2.8 percent from last year's second quarter - showing the strongest yearly gain in three years.

Unit labor costs jumped 4.5 percent in the second quarter, more than the initially reported estimate of 3.8 percent. This was the worst showing for this series in five years! It does cause fear in the hearts of inflation-phobes. Once again, it is worth taking a look at the year-over-year gain, which tends to be less volatile from one period to the next, than the quarterly change. Indeed, unit labor costs were up 1.5 percent from a year ago. The three-quarter change (from the fourth quarter of 1998 through the second quarter of 1999) is the lowest three-quarter change since 1996.

The bottom line on productivity and costs? Financial market players tend to look at headline numbers - and these were clearly worse than expected. The Fed tends to look at underlying data and will realize that the figures are probably not as bad as they appear. However, the Fed is quite concerned that the economy is growing too rapidly, that labor markets are tight, and that inflation is just around the corner. The Fed could easily use these data to justify another 25 basis point rate hike in October (the next FOMC meeting.)

Factory orders on the mend
Factory orders increased 2.1 percent in July after posting solid gains in the previous two months. A surge in defense capital goods orders contributed to the strength, but new orders excluding defense have accelerated in recent months. Furthermore, unfilled orders rose 0.4 percent in July, after declining the past three months. Unfilled orders tends to get less market attention, but the series is more reliable and consistent than new orders.

The chart above compares year-over-year changes in total new orders with orders for information technology goods. Undoubtedly, info tech equipment is a hot sector. But notice the upward trend in the past several months for total orders. This points to a pick-up in production in coming months.

The bottom line on factory orders? New and unfilled orders are both pointing upward. This suggests a pickup in production and a rebound in the manufacturing sector. Until now, the manufacturing sector has been the weak link in the U.S. economy.

Are you invested in manufacturing stocks? The pick up in new orders suggests that manufacturing activity should improve in coming months. New orders posted particularly healthy gains in iron and steel foundries; metalworking machinery; computer and office equipment; and electronic components. The stock prices of companies in these industries might show some better performance relative to other manufacturers if you consider the orders variables.

Consumers buying cars, buying houses…still happy after all these years
Domestic cars were sold at a 7.9 million unit rate in August - up 12.9 percent from July. At the same time, light truck sales increased only 1.3 percent in August to a 7.6 million unit rate. August marks the first month since December 1998 that car sales outpaced truck sales for the month! But it doesn't really matter - it all spells out plenty of durable goods spending in August.

Single family home sales edged up 0.1 percent in July to a 980,000 unit rate. This may not seem like much of an increase, but when you consider that economists were predicting a drop in sales - and June sales were revised up - it points to a booming housing market.

The Conference Board's consumer confidence index edged down to 135.8 in August from July's healthy level of 136.2. Consumers remain optimistic about economic conditions. No signs of worries here. Remember that old snappy tune, "Don't worry, be happy…" U.S. consumers took it to heart.

THE BOTTOM LINE
Financial market players went on a roller coaster this week. Economic news teased market players by coming in strong and weak. The housing market is still booming and consumers are poised to open their purse strings in their optimistic frame of mind. Even manufacturing conditions look stronger given by the factory orders report.

The employment situation was a relief in that it pointed to slower growth for the month. After the rout in the market on Thursday, just about any favorable news would have caused the market to rally in a big way, in advance of a three-day weekend. As market players digest the productivity and employment reports, they may realize that the productivity numbers weren't as bad as advertised, but the employment situation wasn't as friendly as indicated by the headline numbers.

Fed officials will meet again in early October to discuss monetary policy. Undoubtedly, they will consider every bit of information that is reported between now and then. While the productivity report favored a rate hike in October, the employment release reduces the probability. But the odds are very close to 50/50.

Looking Ahead: Week of September 7 to 10
We use the Market News Service survey of forecasts to describe the market consensus.

Wednesday
Economists are predicting consumer installment credit will increase $5.5 billion in July after a softer $2.8 billion gain in June. This series has fluctuated more wildly in recent months - perhaps due to less reliable source data.

Thursday
Market participants are expecting new jobless claims to edge up 1,000 in the week ended September 4 from last week's 289,000. The number of economists predicting this indicator has diminished rapidly these past couple of months as its volatility has increased.

Friday
The producer price index is expected to rise 0.4 percent in August, twice as much as July's 0.2 percent gain. This reflects higher energy prices. Excluding the volatile food and energy components, the PPI should edge up 0.1 percent for the month. This would also be higher than the previous few months.