Friday, January 10, 2014

December Jobs Report: What Recovery?

Investment thesis: The markets will continue to reflect economic stagnation until the Fed takes effective steps to meet its mandates. Bond prices should be supported, while earnings growth will moderate further. However, strong corporate buybacks support current equity valuations.

Readers may recall that last month the third quarter real growth number was raised to 4.1%, which is quite high. Market economists and pundits believed this number, and said that it signaled an accelerating recovery.  You may also recall that I said at the time that the revised third quarter number was a meaningless blip, and that the outlook for growth and employment remained bleak.

Well, the December employment data support my negative view (not that one month of data is in any way conclusive). Nonfarm payrolls rose by only 74,000 in December, the smallest increase in three years and far short of the growth that economists had predicted: the median forecast of 90 economists called for an increase of 197,000. The labor force participation rate fell to 62.8%, its lowest level since the Carter administration. The broader U-6 unemployment rate remained unchanged at 13.1%, about double what it should be at this stage of a recovery, and much higher than the peak level of prior recessions. We are looking at a weak, stagnant economy.

The lead steers in the market and the media just don’t spend enough time looking at the data. They seem to be overly headline-sensitive, and to lack a coherent model of the economy. Once the lemmings pick up the mantra of a “stronger recovery”, they won’t let the data stand in their way:
"If there ever there was a curveball, this was it," said Marcus Bullus, trading director at MB Capital in London. "These limp numbers are as puzzling as they are surprising."
Not to readers of this blog.

The pundits recommend that we ignore the December data, either because it was cold in December*, or because, as CNBC says: “Anyone reading the Labor Department report can see that the focus is on the trend, and according to the Labor Department and other general economic observations, the trend is still favorable”. Convinced? 

I hope it didn’t come as too big of a shock to the economists at DoL that it was cold in December. Are they aware that it could be cold in January and February too? They can improve their forecasts by consulting the Farmer’s Almanac.
It has been said that the best prediction of a future datapoint is that number today, and that you need a coherent rationale to predict otherwise: the future will resemble the past, ceteris paribus. When I look at the macro dashboard, what I see is stagnation at a low level, with a flat or downward trendline. Money growth is declining, as is velocity; inflation is declining; nominal and real growth are flat at low levels; the overall employment picture is recessionary; fiscal policy is contracting.
I scratch my head when I read that “the trend is still favorable”.  To what data are they referring? My data just aren’t going that way.
What does this mean for the new Fed chairman, Ms. Yellen? It means that the burden will fall heavily on her to spur the Fed to adopt more effective policies. I can’t imagine that her to-do list says “Continue current ineffective policies in order to miss both statutory mandates and further erode the Fed's credibility".
It may be a bit impolite to unearth a “discredited” and “outdated” economic theory, but the old Phillips Curve still explains a lot of the current economic phenomena: there is a trade-off between inflation and unemployment. The Fed has elected to choose “low inflation and high unemployment”. The unemployed are standing guard to ensure that we don’t experience 2% hyperinflation. The Fed needs to select “higher inflation and lower unemployment”, just as it was forced to do in 1933 and 2008-09.
Investment Conclusion
My 2014 forecasts** assumed that the newly-energized Yellen Fed would meet its mandates this year. But nothing has been done on that score yet; it’s a prediction not an observation. For now, the outlook is for continued stagnation and stable bond and stock prices (until Yellen can change policy). 

If you don’t buy my “Yellen wins” scenario, then you should expect falling bond yields and some negative earnings surprises. With NGDP growing at around 3%, the outlook for topline growth is modest, and post-recession productivity gains are almost exhausted. Supporting stock prices is strong free cashflow funding continued buybacks--instead of wealth-destroying M&A. Animal spirits in the boardroom are always bad for stockholders--even in Omaha.
That is why I am still moderately bullish.
*”The Labor Department data included signs that the hiring slowdown was at least partly due to colder-than-usual weather last month, a factor that suggests the December reading isn't necessarily the beginning of new downward trend.” (WSJ)
**  “My 2014 Predictions: Still Bullish”, Seeking Alpha, 3 Jan. 2014.

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