“He that doth what he should not, shall feel what he would not.” – Benjamin Franklin (ed.), Poor Richard’s Almanack
Ladies and gentlemen, we have seen this movie before, though it is doubtless new to some of you: A weak jobs report occurs late in the economic cycle. Cut to a temporary bout of selling, followed by a rally on the theory that the Fed will take market-friendly steps. It’s not bad news, it’s good, says the narrator.
Except that the movie never ends that way. Shifts in monetary policy can have quite a short-term impact on stock prices, but interest rates alone cannot stop the end of the business cycle. Monetary policy is a cushion, not a magic charm, and the business cycle will end anyway. In the short-term, however, Wall Street prefers to trade on the magic-charm principle, which only exacerbates the steepness of the final decline in prices when it becomes apparent that the Eccles building in Washington – home of the Federal Reserve – is in fact not Hogwarts, and there are no wand-wielding wizards within. Gee, who could have known?
As shown in the Economic Beat below, the jobs report joins a number of other reports that have been showing weakness; as a lagging indicator, employment will be the last component of the cycle to contract. Business spending is declining and retail spending has been at stall-speed for months. At some point employment will contract and the reality of recession will come home to roost on Wall Street.
The big drop isn’t likely to happen right away, though. It could if some surprise adversity comes along. At this stage in the cycle, it might be useful to think of the economy as a very drunk person walking down the street – you know it’s only a matter of time before they fall over, but guessing the step at which the final stumble occurs is mere speculation.
That’s where we are right now in the cycle, simply awaiting the right pebble that trips us up. Many financial journalists labor on in the mistaken belief that only a sustained surge in interest rates can be decisive, but they are like the ancients who firmly believed that the sun traveled across the sky without ever suspecting that it was the earth’s rotation that changed its apparent positioning. The sun doesn’t “go down” because the charioteer is tired, nor does the cycle end when the Fed raises rates. The Fed has initiated exactly one post-war recession, when it pushed short rates to nearly 20% and choked off the money supply at the beginning of the 1980s in a bid to stop pernicious double-digit inflation.
In this cycle, the Fed will be lucky to have rates as high as fifty basis points before it has to start lowering rates again. That probably won’t stop the usual malcontents from blaming the central bank, the government, illegal immigrants or perhaps Lord Voldemort (the villainous arch-wizard of Harry Potter fame). Or they may blame the sun’s charioteer. Regardless of who they blame, the cycle is going to rotate from expansion to contraction and it will not be good for stock prices.
Just don’t look for stock prices to telegraph the end. Returning to our walking drunk metaphor, any number of things might trigger the final stumble. It could be a Brexit (British exit from the EU) or Grexit or Chinese event. It could be some “sudden” default somewhere that panics the credit markets, it could be the U.S. election, or turbulence in the commodity markets, or even the stock market itself. There are always storm clouds somewhere in the world, but the ability of our economy to withstand the resultant air-pockets is growing more limited all the time.
So long as any of the foregoing stay off the front pages, the stock market is perfectly capable of climbing to a new high, if only to squeeze the shorts again and for lack of any clear alternative. The markets have rather persistently made fresh all-time highs shortly before collapsing disastrously for the last forty years, so doing it again would be nothing unusual and indeed is nearly the odds-on outcome, though there is very little gain to be had in betting on it. Every fresh disaster averted in the coming months might cause the broad market to rally just a little bit more, however foolish it may appear afterwards.
I can make the case for some scenarios being more likely than others, and some strategists like to do just that, taking credit for higher-odds prediction should it come to pass and blaming random chance if it doesn’t. All I will predict here is that the cycle will end soon, in months not years, and that this is the ideal period to be exiting, not entering. The economy and earnings have been flashing yellow lights for months, but the stock market is unlikely to tell you about it until everyone else already knows.
The Economic Beat
The jobs report was the report of the week, more so than it’s been in some time. The small change in payrolls (+38,000, seasonally adjusted, or SA) was a large surprise in the face of consensus for around 160,000. The ADP report two days earlier had come out with a number of 173,000 (173K) and an upward revision to April, to 166K from an original 156K, within the recent Labor Department (BLS) range of 150K-200K.
The BLS number blew all that of away and then some, piling weakness on weakness with large revisions to March (186K from 208K, SA) and April (123K from the original 160K). A well-known bromide that many veteran traders follow is to trust the direction of the revision more than the actual estimate itself, making the report a bigger miss.
Before we get further into the numbers, recall some of the points that this column has been making in recent months. One is that recent claims data has been suggesting that the growth in employment is nearly over. Another is how changes in hiring can be difficult for the BLS to pin down in a new calendar year until the spring, giving the appearance of sudden, dramatic shifts when the reality is one of more complete data. Hiring can and does shift quickly, but at times the apparent monthly speed is amplified by a process of catching up with more complete data and evolving adjustment factors. As an aside, ADP doesn’t try to outdo the BLS number, it tries to anticipate it – when the BLS makes changes, ADP will adjust its model to follow suit.
Predictably enough, Wall Street strategists were leaning towards calling May an outlier and an exception, but the downward revisions suggest a steady decline. The revisions to the raw data for March and April were benign, with the seasonally adjusted data highlighting the weakness that may not have been as great in the raw data as it seemed, but unless the BLS got everything wrong and is going to revise everything over again, the strategists are simply blowing smoke. Even so, while it’s possible for the jobs number to keep declining at this rate, the reality is likely to be different – historically, the jobs numbers become irregular in a cycle’s waning months. I would not be surprised to see a bounce-back over the summer that included an upward revision to May, nor would I be surprised to see the numbers labor in the 100K range before suddenly plunging again.
Despite the benign changes in the raw data, the revisions look to me as in they are in the right direction. The reason I say this is that the net change in the raw data over the first five months is the weakest it’s been on a percentage basis since 2009, the depths of the recession. It’s even weaker than 2007, though not by much, which should put paid to any “outlier” excuse. That should lend further support to my ongoing assertion that the expansion is coming to a close – indeed, some parts of it have already begun their decline.
An example is in business capital expenditures, which are in recession territory. Though the latest factory orders data for April were positive (1.9%), the bump was due to civilian aircraft orders (years away from fulfillment, and subject to cancellation if the economy turns down). Business capital expenditures continue to decline (-6% year-on-year in April) and have been in contraction for many months. All of the regional manufacturing surveys were negative the last few weeks, though the national ISM purchasing survey released Tuesday was mildly positive at 51.3, not much behind its non-manufacturing cousin, still positive but a rather disappointing 52.9, down from 55.7. Neither result qualified as robust, but activity isn’t falling off a cliff, either. It would be better to say that growth is softening. Both reports had less than a handful of sectors reporting contraction, and the non-manufacturing report had prices – the best leading indicator in services – firming. I would look for more of the same sort of reports in the immediate future.
The week began with a report on April income and spending, and while there was a bit of spring fever in April spending (+1.0%), it would be unsound (or disingenuous) to overreact to this bump, The year-on-year changes in personal income (+3.3%) and spending (+3.0%) are both near the middle of the range they’ve been in the last seven months.
Construction spending fell to a 4.5% year-on-year rate – maybe, because the data is subject to substantial revisions. The trade deficit narrowed, improving the latest outlook for second-quarter GDP, now floating in the 2.5% range.
There isn’t much on the docket next week, with the Wednesday JOLTS report (labor turnover) and Thursday wholesale trade report the top of the list. Neither has much immediate market impact. Since light news weeks tend to follow the previous week’s trend in the stock market (up, in this case), that should bode well for prices. June can be treacherous, though. so don’t hesitate to cash in any gains.