The Fed takes centre stage again

At this point, we wish it would just get on with the show.

Robert Johnson, CFA 14 September, 2015 | 5:00PM

Markets took a rest this week from some of the volatility and declines of recent times. Only commodities, led by oil, were in the red for the week, declining about 1%. Emerging markets did the best, gaining 4% as more rumours of Chinese stimulus were circulating most of the week. Those rumours were the result of more poor Chinese economic data with export/import data leading the way yet again. Europe's markets had a good week with stock market gains of around 3%--this on better economic news.

U.S. economic news for the week was almost nonexistent with the exception of an unusually strong job openings report. The market spent most of the week fretting about  Apple's (AAPL) new products (by the end of the week, the markets decided that they like the Apple introductions) and of course, next week's Federal Reserve meeting. Uncertainty about just what the Fed might do made U.S. markets the worst performer this week outside of commodities, gaining just about 2%. Fed speculation and the JOLTS report led the interest rate on 10-year U.S. Treasuries slightly higher from 2.13% last week to 2.18% this week.

The Fed meeting on interest rate policy next week remains the market's focus. The raw economic data is not strong enough or weak enough for a firm conclusion, leaving everyone running around dissecting individual words in speeches and examining the circumstances of past rate increases. Frankly, it has been talking about doing this for so long, and the data is awfully close to falling in line with its economic targets, that we wish it would just get on with it and make its data-driven decision. It told everyone what it hoped to see. Now will it deviate from those guidelines, making discerning monetary policy nearly impossible and extremely subjective? In all honesty, we don't know. We do know the impact on the economy of a small trial rate increase is de minimis while the market impact of a change is likely to be high.

There really wasn't much to talk about relative to the U.S. economic data this week. However, some of the European data looked a little better, with German exports and production both up nicely this week. Overall GDP growth for the EU in the second quarter was boosted from 0.3% to 0.4% sequentially, not annualized. The first-quarter growth rate was raised from 0.4% to 0.5%, putting Europe on some better footing, despite all the continuing news out of China. German exports also looked quite healthy. It's still way too early to say with certainty, but so far a slowing China doesn't appear to be slowing the two major developed economic trading blocs, the U.S. and Europe.

Job openings set another record

While last week's unemployment report for August wasn't particularly weak or strong (173,000 jobs added versus an average of 211,000 per month, year to date), this week's job opening report for July was unequivocally powerful.

The 5.75 million openings for July were at their highest level since the BLS began measuring openings in 2000. The openings were up sharply from 5.32 million openings the previous month, which is one of the larger month-to-month increases they have seen in some time. It is also a full million more openings than a year ago.

Despite the sharp rise in openings, the number of people actually hired in July was down modestly from 5.2 million to 5.0 million. The hires number has been relatively flat for the past several months. Quits, often a measure of worker confidence, have also stagnated.

The sector data remains relatively positive with the July additions relatively balanced. The one exception being that a number of the smallish goods-producing sector showed little growth in openings. On a year-over-year basis the very large and well paying business and professional services sector is the fastest-growing sector for job openings. Openings for that sector were up well over 40%, or more than double the rate in the total number of openings growth.

Something doesn't seem right about the JOLTS report

The JOLTS report has long been one of our favourite labour force metrics. While month-to-month employment additions are often highly volatile, this metric has kept us positive on labour markets when others have been very negative. (Fed Chairman Janet Yellen has also mentioned this report as a favourite metric.) Still, it just doesn't feel right that openings continue to boom while hiring seems to have topped out. And until recently, openings had never been higher than hires.

We had always viewed the nice gains in openings as a positive sign, indicating that once those openings were filled they would boost the more visible employment rate. We had always thought that both employees and employers were being a bit stubborn, with employees unwilling to physically move/holding out for a better offer and employers looking for the perfect employee who was willing to except a bottom-basement wage offer. If that were truly the case, I would have expected that as more of those openings were filled, both employees and employers would have adjusted to the new realities of a changing labour market--and both would have ended some of their posturing.

That doesn't appear to be happening. Perhaps the skills mismatch between what employees have to offer and what employers want is too large and not easily fixed with just a little more money or a loosening in hiring standards. Or some have posited that openings are making a one-time jump because newly required background checks and other hiring procedures have lengthened the hiring process, causing openings to stay open longer, artificially inflating openings. In addition, with tighter markets, maybe employers are being more proactive and starting the hiring process sooner.

With openings at a new record high, the normal conclusion would be that record hiring should also be just around the corner along with higher wages. That is looking like a bit of a stretch at the moment. At least there is nothing here to suggest that the labour market is softening or falling apart. Low reported job cuts from Challenger Gray for August, continued low initial unemployment claims, and the level of higher intentions in the various purchasing manager reports all support our contention that labour markets remain relatively healthy.

NFIB report shows the conflict between the need to hire and higher compensation

Like the JOLTS report, the NFIB small-business report shows increases in openings and few applicants. Yet the same report shows that employers are less willing to increase wages than they have been in the past. Notice that the percentage of openings with few or no qualified applicants continues to surge even as wages have stagnated.

One other odd trend is that 25% of firms report having increased wages in the past three months while just 13% planned to increase wages over the next three months. Apparently owners think they will take a tough line on wages and then cave to pressures later. The intention survey has been been between 12% and 15% all year. Meanwhile, the actual percentage doling out raises has been a much stronger 20%-25%. That gap seems unusually wide at the moment compared with history. In fact, there have been periods when intentions have run above actual raise increases. Part of the answer is that businesses are really being forced by markets to keep their prices down, which in turn is causing them to try to stem the tide of rising wages. The net number of businesses that have increased prices recently appears to be zero, according to the most recent NFIB report. The percentage that has raised prices recently is now near the lowest level of the recovery at just 1%. A more optimistic 15% hope to raise prices in the future, although that figure is now at the lowest level since 2011, too.

Budget data through August consistent with CBO's 2015 US$426-billion deficit estimate

Federal budget data again remained benign in August. For the 11 months ended in August, revenue grew a very healthy 8% because of a stronger economy and strong financial markets that drove tax collections. Meanwhile, spending grew a more modest 5%, as both defense spending and interest on the government's debt have, so far, fallen in 2015.

Expenditure growth beyond the Big Three social programs has been almost nonexistent. The year-to-date deficit has shrunk from US$572 billion to just US$528 billion. Given that September always produces a budget surplus (because quarterly corporate and individual tax payments are due in September), the full-year deficit is likely to fall from US$485 billion to US$425 billion or about 2.4% of current GDP. That is well below CBO's estimate of US$489 billion just a few months ago. Deficit estimates have now proved to be too negative several years in a row.

The only real disappointment in the August report was a cryptic US$7 billion payment to insurers that underpriced their health insurance under the Affordable Care Act and suffered high loss ratios. Though these payments phase out over time, we were surprised at the size. The text seemed to imply that these payments would recur, at least in the near future. That would potentially halt some of the budget improvement we have seen lately.

While the short-term deficit news is great, long-term issues need to be addressed now

The deficit is expected to shrink again in fiscal year 2016, from US$426 billion to US$414 billion, or 2.2% of GDP. CBO now expects the deficit to remain under 3% through 2020 and then increase to 3.7% by 2025. While the short-term data (that is, through the next 10 years) has continued to improve and outperform, the longer-term outlook is still worrisome, as baby boomer retirements and health issues then begin to drive the deficit sharply higher. By 2040 the CBO still believes the budget deficit could be close to 6% of GDP, instead of today's 2.4%.

Once deficits get much over 3%, a lot of the out-year deficit growth is a function of ever higher debt. It's a vicious circle where deficits raise debt levels and interest payments, which raise the deficit more, making the debt and debt service even higher. The longer Congress waits to work on the longer-term problem, the more Draconian the solution becomes.

The Fed will have a lot of economic data to chew on before its Thursday press conference

As we noted in our opening, the Fed meeting and press conference will be all anyone really cares about next week. However, there will also be a ton of economic data, including industrial production, retail sales, consumer prices and housing starts and permits.

In some ways, the Consumer Price Index may prove to be one of the more important metrics. Theoretically, the Fed is supposed to be basing its monetary policy on a dual mandate to control price levels and ensure full employment. With recent employment reports, a low unemployment rate, and now this week's JOLTS report, it will be hard to argue that it needs to keep rates low to help the labour market. However, inflation is below the Fed's target, especially on its preferred metric, the PCE inflation rate. While the year-over-year core CPI inflation rate is 1.8% and close to the Fed's target, the PCE is still below that.

If the core CPI next week is unexpectedly low, that would give the Fed some cover to keep rates low for now. We suspect the headline inflation for August will be close to zero with another oil price decline. Excluding gasoline and food, I suspect prices to be up 0.1% or 0.2%, not enough to sway the Fed in either direction. However, car prices have been doing weird things, namely, going down, and airline price competition continues to be hot. Offsetting those downsides is health-care inflation that has been unusually low and is probably due for one of its monthly spikes. Rents, too, are likely to remain remarkably high.

This is all a very long way of saying that there are lot of moving pieces in the CPI data that could produce just about any result. A negative core CPI number is likely to take a Fed rate increase off the table. An increase of 0.3% or 0.4% could force the Fed to act.

With strong auto sales and decent weekly retail sales reports, we aren't too worried about the retail sales report. Excluding autos and gasoline, we suspect that retail sales could be up as much as 0.5% compared with a 0.4% increase in July. Our estimate averages out to a pretty impressive 6% growth rate. However, we do caution that a late as possible Labour Day could have shifted some sales from the soon-to-be reported August data into September. As always, we will keep an eye on restaurant sales to gauge short-term consumer confidence. It will also be interesting if some of the more housing-related categories, such as furniture, finally begin acting better as did home sales several months earlier. Early rumours of the new iPhone announced this week may have put a big lid on August electronic sales.

Manufacturing has been having a tough time of it because of weak commodity markets, more than anything else. July offered a bit of a respite as manufacturing only IP surged 0.8%. However, a large part of that gain was a 10% surge in auto production, which was likely due to faulty seasonal factors. The potential for a reversal of those factors in August has economists expecting the worst. Manufacturing output is widely expected to fall by 0.3% or more in August because of a true-up of the auto situation along with continued weakness in oil-related industries. Discerning industry trends will be a lot more important than the headline number.

Housing has been picking up steam recently, though starts and permits have been quite volatile. The multifamily sector has been particularly jumpy because of a thought-to-be-expiring tax credit in New York City. Last month the more lethargic single-family market had its best month of 2015. We believe August will prove to be a month of digesting the surge in starts of the prior two months. Starts had been averaging close to 1.1 million units for most of 2015 before surging over 10% to more than 1.2 million units in each of the past two months. Given a meaningful drop in permits in July, we believe that perhaps starts will take a bit of a tumble in either August--or more likely September--to get back to the trend line. However, cheaper building materials could encourage more builders to start construction sooner than later. Anything between 1.1 million and 1.2 million starts is possible with something in the middle being the most likely case for total housing starts for August.

About Author

Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.