February 22, 2010
Notes on a Difficult Employment Outlook
Following the January employment report, I noted that "If we get perhaps a month with about 400,000 or fewer weekly new claims for unemployment, that is about the point where we would expect positive prints for monthly job growth, on average. Even then, however, the difficulty will be speed of recovery. I am hopeful for a stabilization of the job market, but that I suspect that last month's dip in the unemployment rate was an anomaly. Given what remains a difficult credit outlook, I suspect that we have observed a lull rather than a reversal, and that we'll most likely see an 11-12% unemployment peak before a sustained downturn is observed."
Presently, the 4-week moving average of initial claims for unemployment is running at 468,500. This level is normally consistent with monthly payroll job losses on the order of 80,000. Against that, however, we are likely to get significant short-term job growth from census hiring, which can be expected to exert a positive impact on non-farm payrolls through mid-year. I continue to view the 4-week average of initial claims as one of the more informative series to monitor regarding the employment situation.
I was recently asked whether I thought there was anything significantly misleading about the seasonal adjustments being used by the Bureau of Labor Statistics in reporting employment figures. Despite my more general skepticism about the recent January figures, which appear to be outliers for other reasons, after carefully working through the data, my simple answer is that I don't find anything suspicious in the seasonal adjustment methodology.
Using BLS data for seasonally adjusted (SA) and non-seasonally adjusted (NSA) data, I estimated the implied adjustment factors used by the BLS - one factor for each month of the year - by taking the ratio of the two figures they report (SA/NSA), and then updating each factor annually since 1950 using exponential weighting. The result is the blue line in the chart below (presented as a percentage adjustment). Next, I estimated a smoothed employment trend (essentially the past year's average raw payroll figures, adjusting the trailing average to account for the approximate 2.2% long-term growth rate of employment), and calculated the factors by which raw monthly employment figures (NSA) would have to be adjusted in order to match that smoothed trend. The resulting factors are presented below in red. These are, for all practical purposes, virtually identical to the implied BLS factors.
So essentially, every month the BLS adds or subtracts a certain amount (from +1.5% to -1.0%) from the raw, non-seasonally adjusted employment figures, in order to provide a final, adjusted employment number that reasonably reflects what they estimate the true "smoothed" employment trend to be. I don't have any real problem with this, as long as everybody understands that this is what they're doing. That said, the current level of payroll employment (NSA) is 127.6 million jobs, so in any given month the seasonal adjustment to the reported payroll employment figure amounts to something between +1.9 million and -1.3 million jobs. If you have any belief at all that the monthly payroll number released on the first Friday of each month is precise, now would be a good time to abandon that illusion.
On the other hand, several aspects of the employment picture concern me quite a bit. First and foremost, the unemployment rate is reported as the ratio of individuals who are unemployed and actively seeking work (thereby still being counted as being in the labor force) divided by the labor force itself. The difficulty is that we have seen an unprecedented exodus of discouraged workers from the U.S. labor force over the past two years, which has the result of sharply understating the extent of the unemployment problem. Had labor force participation remained at the same level as it was in 2000, the unemployment rate today would be nearly 3 percentage points higher than is currently reported. Instead, mostly over the past 18 months, the U.S. labor participation rate has retreated to a level we haven't seen in a quarter century. Moreover, the share of employed individuals who are employed full time has also dropped by 3 percentage points, resulting in a significant contraction of employment activity. Even this would not be a difficulty had we not also vastly expanded the debt burden on the average family since then. Unfortunately, the high debt burdens and weak employment conditions cannot coexist without producing credit strains. Simply put, current employment levels are incongruous with servicing existing levels of household debt.
The chart below illustrates the gap that has emerged between population trends and employment. In order to continue servicing existing mortgage and consumer debt burdens, it is likely that we would require not only job growth to narrow the gap with labor force growth, but enough labor force growth to restore the same slope as population growth.
A few technical details. The official unemployment rate includes only individuals who have been unemployed for 15 weeks or longer, and are actively looking for work (the broader U-6 measure, which includes discouraged workers, is much higher, currently at 16.5%). The official unemployment rate is based on figures obtained from a "household" survey, while the non-farm payroll report is based on an "establishment survey." These surveys are have provided very divergent signals in recent months, so the level of noise in the data is far higher than the seemingly precise job creation figures might lead investors to believe. For example, in the January labor figures, a net loss of 20,000 jobs was reported for non-farm payrolls, while at the same time the number of unemployed workers (used to calculate the unemployment rate) dropped by 378,000. Meanwhile, the total number of payroll jobs was revised sharply downward, so that January non-farm payrolls were reported to be about 1.4 million lower than total that was originally reported in December. So we had huge downward revisions in jobs, yet fewer workers were reported to be unemployed. These inconsistencies threaten to be a source of further revisions in the months ahead.
Aside from the shorter-term suspicion that unemployment has not peaked, I want to be clear that my main concern about the employment situation is with servicing debt, not providing for the basic needs of the population. I'm certainly not talking about Malthusian macroeconomic shortages or an inability for our nation to support itself. It is the gap between cash flows and household debt service that strikes me as problematic.
On the broader issue of supporting a growing population, it has historically been true (and is likely to continue to be true even in the event of further credit strains) that the needs of the U.S. population can be supported through productivity growth and to some extent by importing the output produced by cheaper foreign labor. In the long run, productive investment is the cornerstone of economic stability. Over the past decade we have greatly threatened that that stability through the ridiculous misallocation of resources in speculative bubbles and unproductive "investments," but I am convinced that we will re-learn, painfully or otherwise, to better allocate our resources. My impression continues to be that the current deleveraging cycle will likely be a multi-year process that is presently far from complete.
Foreign trade can also be the source of mutual economic benefit, but only if it ultimately improves the allocation of resources. On our current path, we have instead relied on cheap imports from China and other countries while at the same time destroying our own capital through poorly allocated speculative investments, followed by bailouts to the lenders who provided that capital. The only plausible outcome of that dynamic is that foreigners will gradually acquire claims on our nation (Treasury debt or private securities), and with them, the ability to acquire our productive assets. No doubt many analysts on the financial channels will gurgle with excitement every time a foreign acquirer bids for ownership of a U.S. company, but this is how we will pay for our the difference between our consumption and our income. Again though, I am convinced that we will ultimately re-learn to better allocate our resources.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. Internals have improved moderately during the rebound of the past two weeks, though price-volume behavior remains poor. Interest rates have become notably hostile, and presently would weigh on the prospective return/risk ratio of stocks even if internals were to improve here. That suggests that the rebound we're seeing from the correction low of a couple of weeks ago may turn out to be a whipsaw. Still, if we do observe further improvement in internals, I expect we'll establish a small position in proportion to the return/risk ratio that is evident at the time - possibly in the 10-20% area in terms of overall market exposure. For now, the Strategic Growth Fund remains fully hedged, and the combination of rich valuations, yield pressures and potential credit strains are the primary concerns.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and unfavorable yield pressures. Bond yields have pushed higher in recent weeks, and we would be inclined to slightly increase our portfolio duration if yields push moderately higher. For now the Strategic Total Return Fund has a duration of about 4 years, meaning a 100 basis point move in interest rates would be expected to affect the value of the Fund by about 4% on the basis of bond price fluctuations.
My impression is that the increase in the Discount Rate last week was largely posturing by a Fed that is eager to look prudent in the face of criticism, particularly since Thomas Hoenig, one of the FOMC's own governors, dissented on the most recent move to leave monetary policy unchanged. The good thing about the Discount Rate hike, from my perspective, is that it gives the Fed a costless way to respond to any fresh credit difficulty, at which point (as it did in 2007), it will now have the option of cutting the rate by 50 basis points some morning when the market appears prone to panic. Not that such a move is likely to have more than a psychological effect, but it does provide one more tool to use when responding to any fresh credit issues.
NEW from Bill Hester: Bond Yields, Earnings Yields, and Inflation
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