4/25/13 – Slowdown, Employment, and Corporate Profits

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 25, 2013 12:30:00 PM

and tagged Market Updates, Employment

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Several data points have come through in the past couple of days that support some thoughts I’ve had for a while. I think it’s constructive to take a look at them to determine how we can expect the economy and financial markets to evolve in the near future.

Today’s good news was the drop in new unemployment claims to almost a five-year low. The drop was unexpectedly large, but the Labor Department confirms that there was nothing particularly unusual about the data. If this proves out, it’s a good sign, suggesting that the slowdown in the economy is not generating new layoffs.

That an economic slowdown is underway seems well supported. The recent negative surprise in durable goods orders, combined with deteriorating consumer confidence and other signs of weakness, suggests that growth going forward will be below the strong first-quarter figures.

Fundamentals also support this outlook. The sequester spending cuts are now well underway and should decrease growth by about 0.5 percent. Increases in gasoline prices in the past couple of months effectively cut consumer demand. Uncertainty about the global environment undoubtedly played a part as well, with North Korea brandishing nuclear weapons and the Cyprus banking crisis reminding us that Europe isn’t done yet.

Beneath the surface, though, we see supporting trends that are positive for the real economy but mixed for the financial markets. Demand for labor continues to grow. Even as the number of new jobs disappointed last month at 88,000, the actual hours worked increased by the equivalent of 328,000 jobs, per Ned Davis Research, as companies worked existing staff harder rather than hiring. Hours worked stats are now at levels where hiring will start to pick up again based on historical results, and the drop in new unemployment claims may suggest that companies are starting to focus less on cutting staff—a necessary first step.

Growth in real disposable personal income is also well above growth in spending, which suggests a couple of things. First, that spending could grow faster than it is now. Second, that current spending growth is sustainable. Third, that any growth in wage income would probably translate more into increased spending than increased saving. Any of these are good for economic growth.

There’s also reason to believe that wage income may well begin to increase more quickly. Historically, wage growth has started to grow faster when the average weekly hours worked figure gets to about the current level. Given current unemployment levels, that may not happen immediately, but we are certainly getting close. With new unemployment claims dropping, labor demand increasing, and the participation rate also decreasing, it is quite likely that we’ll hit a tight labor market for many workers sooner than many now think possible.

This will not be unmixed good news for the equity markets. While greater consumer demand and economic growth will certainly help companies’ revenues to grow, profit margins will come under pressure if wage growth accelerates. The results for company bottom lines will depend on which trend wins. In any event, as I have said before, it looks as if earnings growth will be below the levels of the past couple of years, which might well put valuations under pressure.

Overall, the data now suggests a slower but still healthy rate of growth, which should drive continued improvement in employment and spending. We’re not out of the woods yet, but we continue to move in the right direction.

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