Cards on the table

In every poker game, there comes a moment after all the dealing has been done and bets have been made when all the remaining players have to show their cards and a winner is decided. The same is true in financial markets but with the game being built up over a period of months and sometimes years and the winners being the people who were best able to interpret the data along the way. Right now, we have a complex game unfolding between the Fed, investors, and the economic data itself. On one side, we have the Fed trying its best to jawbone markets into believing that it can manage economic policy without actually physically doing anything. On the other side, we have some economic data that if taken in the context of non-ZIRP eras would have the Fed funds rate in the 4 or 5% area. Then in the middle of things are investors trying to figure out what to make of all of it.

In terms of economic data, we have some reports that are getting to such extreme levels that they almost can’t coexist with the reported levels of some of the other data points. For example, take weekly unemployment claims data. The most recent reading in initial claims (IC) is the lowest print since March 18, 2000 and after that you have to go all the way back to November 18, 1972! In the box below I’ve compiled a comparison of some important data points that coincide with the three low IC prints.

econ grip 6.28.15

Things start to not make sense when we look at GDP and inflation. Our most recent GDP data for Q1 has come in at minus .2% from last quarter. Some people who keep up with current economic data know there is a debate going on over the legitimacy of Q1 GDP readings because of a possible statistical error. The report from the SF Fed basically says Q1 GDP could be significantly stronger than what is reported if it’s adjusted properly. This is where common sense comes into play. First off, let’s forget the winter and cold weather excuses for a low GDP. Winter has come at the same time every year for the 40 years I have been alive and it has always been cold. Next, let’s take a real world look at the things that drive GDP. The most important fundamental factor is people working. Depending on what combination of labor metrics you want to use, there are arguments to make that we are actually at full employment. If we aren’t at full employment, then we are very close. Either way, the labor market is strong and we know that wages are also rising. Furthermore, given that we are a consumption and services based economy, it’s important to note that professional & business services (PBS) jobs are leading the pack in job creation. Being that PBS is composed of lawyers, accountants, engineers, architects and advertising executives to name a few occupations, I think it is fair to say that business growth is broad-based in order to have such gains in that type of group. PBS along with education and health services were the top two job creating sectors in last month’s Nonfarm Payroll report. They also account for 40% of total earnings generated in the labor force.

See the breakdown from last month’s NFP report:

earnings 6.28.15

Since we know people are working, the question is are they spending money? The answer is yes. Before we get to retail sales, let’s first look at the elephant in the room which is housing. The most recent existing home sales (EHS) print came in at 5.35 million units which is 9.2% above last year. I use EHS because they capture 90% of total housing transactions as per NAR. Historically speaking, EHS are back to where they were prior to the artificial boom.

ehs 6.28.15

I call the boom artificial because the transactions that drove the 2004-2007 housing mania were done on mortgages that had virtually zero underwriting standards. Whereas todays mortgages are done with very tight lending standards. Speaking as someone who has gotten a mortgage post 2007, I can assure you that the process is rigorous to the point of falling just short of outright interrogation. Fed Chair Yellen also pointed out in her May 22, 2015 speech that mortgages were “still very hard to obtain for would-be homeowners without pristine credit records.” Which is not a bad thing. In my view, what we have now is a sustainable housing market which will lead to ever greater financial stability in the long run. With the strong housing market, it’s not rocket science to make the connection between home sales and all the downstream business in goods and services created from those purchases. It is that downstream business which also makes the disconnect between stated and true GDP that much more apparent. Clearly stores like Home Depot and Lowe’s have demonstrated through strong sales and earnings that a healthy housing market creates business. The homebuilders themselves like D.R. Horton (DHI), Lennar (LEN) and KB Home (KBH) have all reported stellar quarterly earnings that include large increases in their order backlogs. This is right in line with the most recent building permits report which showed a 25% gain from May 2014! We could be looking at significant gains in construction jobs which may manifest itself in next week’s jobs report. In addition to healthy transaction levels, prices are also nearing all-time highs. The most recent FHFA housing price index report shows prices sitting just 2.3% off their all-time high set back in March 2007. All in all when you have such an important section of the economy like housing doing so well, while lending standards are so strict, I find it nearly impossible to say the overall economy is not doing just as well.

With housing out of the way, let’s take a look at retail sales. Up until the May report, the headline data had been on the soft side for retail. The soft headlines had all the bears saying that most consumers were saving money or paying down debt with the break from lower gas prices. Some even went so far as to say the drop in oil/gas prices didn’t even matter. Clearly those people have either never paid for their own gas or have never known anyone from the Northeast. So instead of just going with the headlines, I dug down into the line items of the reports for the last few months and could see that restaurant & food services, building materials, home furniture and even sporting goods were all posting solid gains. So finally in May the headline number came in +1.2% with nearly all the sub categories showing strong gains and the main drag, gasoline stations, rebounding with the recent move up in oil prices. Below are the top performers for the May report:

retail 6.28.15

The above gains in retail sales are not consistent with a weak economy.

We also just had Nike (NKE) report earnings on June 25th that handily beat expectations on revenues and earnings. Nike stated that it was able to raise its average selling prices and that it also incurred higher input costs. If a global retailer / manufacturer like Nike is incurring higher input costs, I can assure you they aren’t the only ones.

The news from Nike is a good segue into looking at our inflation data. The most recent headline CPI print came in at 0.0% gain year over year. However once we look at the actual line items, we can see that things which matter in the real world are clearly going up.

cpi 6.28.15 b

Right off the bat, we can see three (shaded green) necessary areas are already well over the Feds 2% threshold. Then we have the food away from home category rising 3% as consumers enjoy increasing discretionary income. The rise in shelter is certainly not surprising given the strength in the housing market. I think we can expect that category to rise steadily into the foreseeable future given the current housing data. Even still, this CPI data is understating things when we look at real everyday prices of things that come out of our pockets.

Going back to our economic data grid at the beginning, I think it’s safe to say that GDP and CPI will be in line with previous year’s data even if the official data doesn’t say so. A basic exercise in common sense shows that what is really going in the economy is not being accurately reflected in the data. So just like in poker, we have an opportunity to look at what’s on the table and figure out who’s bluffing and who’s got the aces.

May jobs report : Not just burgers and fries..

“Would you like fries with that?” is a phrase used sometimes by people to mock a low paying services job. While using a phrase like that really says more about the person using it than it does the focus of the phrase, it does a great job capturing the ease with which people discount overall services labor. On Friday we got the May nonfarm payroll report which came in at a much stronger than expected headline number of 280,000 jobs created with labor force participation and unemployment rates essentially unchanged. And almost as quickly as the bond market sold off, out came the usual journalists and other naysayers who cling to the misguided perception that job creation is in all low paying services jobs. Take for example Jeff Cox from CNBC and this article “Fast food nation : What’s driving the jobs numbers” where he cites the 57,000 leisure and hospitality jobs as being representative of the overall report and a reason for the Fed to stick with ZIRP. What Jeff doesn’t cite are the 63,000 jobs created in Professional and business services or the 74,000 jobs created in Education and health services. That would make Leisure and hospitality jobs the third largest category for gains, not the second as Jeff’s article says. But hey, why let facts get in the way of an easy story. What I’m going to do here is breakdown Friday’s report and really look at the jobs being created and more importantly, the actual dollar value they are bringing to the table. Let’s start with the top five industries for job gains in the May report:

6.7.15 Top Job Gainers

Just looking at that, people might be concerned that a large amount of jobs being created are in the Leisure and hospitalities industry. Now, let’s look at the data taking into account labor force size and average earnings (excluding government jobs).

6.7.15 Total Earnings 3

Major points from the table:

  1. Professional and business Services (PBS) and Education and health services (EDH) represent 40% of aggregate earnings.
  2. Manufacturing (MFCT) represents just 13% of aggregate earnings which goes along with exports being roughly just 13.5% of GDP.
  3. Mining and logging which includes the Oil and gas industry counts for a minute percentage of the overall labor force. This tells me why we haven’t seen the energy sector job losses show up in claims data.

As you can see, Professional and business services (PBS) is generating the most earnings (Total Earnings = Number of Employees x Average Weekly Wages). PBS is also ranked second in job growth in May and has been a top gainer all year. What exactly is PBS you might ask? PBS is a supersector made up of 3 subsectors which are:

  1. Professional, Scientific, and Technical Services
  2. Management of Companies and Enterprises
  3. Administrative and Support and Waste Management and Remediations Service.

Basically PBS runs the gamut from lawyers, accountants, architects, engineers, CEO’s and your local custodial arts person. Many people like to discount PBS and make the argument that the loss of manufacturing jobs has been a drag on the economy, but as you can see in the below chart it has not. Clearly PBS is the workhorse of the economy.

6.7.2015 Earnings vs. GDP

This data also plays into why the Markit and ISM services reports are so important. The most recent Markit release from June 3rd came in at a healthy 56.2 with payroll numbers and business optimism both increasing. The ISM report released the same day reflected the same upward trend. Historically speaking, anything in the mid 50’s on diffusion indices is a healthy range signaling expansion. When we look at the job creation in services, the percentage of labor force earnings that services represent and the nearly all time low level of unemployment claims, we clearly have a healthy labor market.

6.7.15 Cont. claims 2

I think it’s easy for people to get hung up on the importance of manufacturing jobs because of the familiarity manufacturing has. America used to be all about steel mills, car factories and other labor intensive industries. Facts are, times have changed and lots of work boots have been exchanged for loafers and heels. Not to say American manufacturing is dead because we will always have local production of some goods, but comparative advantage allocates resources and production to the most economic places. The point of all this is to say that the labor market and the overall economy is much healthier than most people in financial media say. So the next time you hear someone bemoan the loss of manufacturing jobs and discount the growth in services, you can ask them “Would you like some research with that?”