Claims back on track

Weekly claims for unemployment came in as expected, and as this chart shows, the seasonally adjusted level of claims and the 52-week moving average both still appear to be trending down. On an unadjusted basis, claims last week were almost 15% below the level of a year ago, which is actually quite impressive. Taken together, these numbers confirm that the downtrend in this series is still intact, and the upward surprise of a few weeks ago was the result of faulty seasonal adjustment factors.

It is also impressive that the total number of people receiving unemployment insurance has declined by 1.2 million, or 16.8%, over the past year. This means that more people are finding jobs, and also that more people have a greater incentive to find and accept jobs. On the margin, the dynamics of the labor market are still positive.

Energy price update

One month ago, I noted in a post that "the threat of higher gasoline prices is receding." Some readers as well as some economists and analysts noted at the time that energy prices appeared to be tracking the strength of the economy, and that therefore they would rise if the economy improved, and fall if the economy got weaker. My point, in contrast, was that higher gasoline prices were not necessarily a reason to worry about the economy, and in any event, internal market dynamics were already pointing to a decline in gasoline prices. I'm not sure if anyone can claim victory here (are gasoline prices driving the economy, or is the economy driving gasoline prices?), but the issue is important enough to warrant posting some updated charts.

As this first chart shows, gasoline prices at the pump peaked in early April at $3.94/gal. and have fallen since to $3.75, according to the folks at the Automobile Club.

This chart compares the price of gasoline futures (white line) with gasoline prices at the pump (orange line). My point a month ago was that pump prices naturally lag futures prices, and the decline in futures prices was already pointing to declining pump prices. That continues to be the case, so pump prices could fall another 15-20 cents in the next few weeks.

This chart shows the tight correlation between gasoline futures prices and crude oil futures prices. A month ago I noted that gasoline prices were unusually high relative to crude prices, and that this also argued for lower gasoline prices. That is still the case today. So once again, I think the conclusion is that "since pump prices are high relative to wholesale prices, and wholesale prices are high relative to crude prices, it is reasonable to think that pump prices are at least unlikely to rise further, absent a significant increase in crude prices, and could well decline."

In conclusion, to the extent that expensive energy represents a headwind to growth, this is one more reason to not worry about the U.S. economy suffering a relapse.

Eurozone banks: the sum of all fears

As these charts show, Eurozone financial conditions are still under a lot of stress; Euro swap spreads reflect a significant degree of systemic risk. The U.S. has largely avoided Eurozone contagion, but the threat of a banking collapses in Europe still weighs heavily on investor sentiment around the world.

This chart compares the S&P 500 Banks Index (white line) with the Euro Stoxx Banks Index (orange line). Here we see that the capitalization of Eurozone banks has been in sharp decline since October 2009, while U.S. banks have been roughly unchanged since then. Eurozone banks are now just inches from their crisis lows of March 2009, while U.S. banks have recovered significantly over the same period.

This chart shows the ratio of U.S. bank stocks to Eurozone bank stocks to put the divergence in performance into perspective. Since the panic lows of March 2009, U.S. stocks have outperformed their Eurozone counterparts by 235%. (The Euro/$ exchange rate is about the same today as it was then, so this is a valid comparison.) The relative performance differential is simply astonishing—U.S. banks are still 63% below their 2007 highs—and it highlights just how much the Eurozone banking system has suffered as the risk of sovereign defaults has surged.

Eurozone banks are bearing the brunt of the deterioration of sovereign debt prices because they have been the most significant holders of this debt. This illustrates how debt defaults are zero-sum games: Greece benefits from its debt restructuring because it is relieved of the need to make burdensome debt payments, while Eurozone banks (and their shareholders) are punished because their future cash flows are now much less than originally expected. Meanwhile, life goes on for most of the rest of the world. Debt defaults don't destroy the productive capacity of the world, they simply are the consequence of imprudent and unproductive investment decisions. The funds that were lent to Greece and other PIIGS were misspent (e.g., on lavish pensions for public sector workers) and there is nothing to show for it. The Eurozone's scarce resources were wasted and frittered away for years, and that has already been reflected in weak growth and high unemployment. The economic damage of lending to unproductive nations has already been done.

The main threat posed by Eurozone sovereign defaults is that the Eurozone banking system implodes, and the severe underperformance of Eurozone bank stocks and the still-high level of Eurozone swap spreads shows that investors are very much aware of this threat. But painful and frightening though this may be, it is not a reason to expect the end of the world as we know it. Eurozone banks can be nationalized and/or recapitalized, and the ECB can lend massively—which they've been doing. The vast majority of the people working in the Eurozone will continue to work even if more sovereign debt is written off. Debt defaults and restructurings are like an economic version of neutron bombs: they destroy the net worth of lenders, but they leave productive resources intact. Eurozone economies need not collapse, and the U.S. economy needn't suffer very much.

Meanwhile, the solution to Europe's problems is not all that difficult. As Mark Perry noted in a recent post, Sweden has made significant progress in recent years by eschewing the Keynesian solutions that have failed elsewhere in Europe. Cutting back on public sector spending while reducing tax burdens on the private sector is the perfect way to solve the problems facing Europe, and the U.S. for that matter. Most of Europe is still refusing to acknowledge this, but sooner or later more people will understand that growth-oriented policies such as are being pursued in Sweden and Ireland are the not only the least painful solution, but also the best solution for countries that are burdened by too much government spending and too much debt.

There is a way out of this mess, so there is no reason to despair.

5 million new private sector jobs and counting

The April gain in employment was less than expected, but with substantial upward revisions to prior months, net employment gains were actually slightly higher than expected. So there's no reason the news should be viewed as negative or disappointing. In fact, when you dig into the numbers and include the household survey in your dataset, the news continues to be mildly encouraging. The chart above focuses on gains in private sector employment, and what stands out is that the household survey continues to pick up more jobs than the establishment survey. This is fairly typical in the early years of a recovery, since the household survey is better at finding new startup companies and people who have gone to work for themselves. The establishment survey only surveys companies that have been in existence for awhile. According to the household survey, things have really improved over the past year.

According to the household survey, the private sector has added about 5 million jobs since the low in employment at the end of 2009; that works out to an annualized gain of 1.9%. But over the past year, the household survey shows a gain of 3 million jobs, which is a gain of 2.5%. The chart above shows the 6-mo. annualized gain in private sector jobs according to each survey, and here we see how the pace of jobs growth has picked up of late, especially in the household survey. If you just split the difference between the two, private sector jobs growth now equals or exceeds the best years of the prior business cycle (which doesn't say all that much, since it wasn't a very robust growth cycle). Jobs growth is going to have to pick up a lot more, of course, before the economy can begin to get back on track, but at least we continue to make progress towards that goal.

As an aside, here's an updated version of the chart from yesterday's post. With the upward revisions to the BLS numbers released today, it now looks like ADP's jobs number has been pretty close to the BLS. In fact, ADP has consistently underestimated private sector jobs growth, but not by much: year to date, the ADP total is +730K, while the BLS reports 827K., for a monthly difference of only 24K. That's a mere rounding error for this data. Same goes for the past year, with ADP reporting +1.85 million, and the BLS +2.03 million, for a monthly difference of only 16K.

Other than the fact that this recovery has been fairly tepid given the depths of the prior recession, this recovery stands out as being the first during which public sector jobs have taken a serious hit. This is painful for those involved, of course, but it is very encouraging from a macro perspective, because the public sector has enjoyed disproportionate gains over the past decade. As the chart above shows, the private sector has experienced only a very small gain since early 2000, while the public sector, after losing about 700K workers since the 2009 peak, is still 7% larger than it was at the beginning of 2000. If our fiscal house is going to be put in order, the public sector is going to have to slim down even more in the years to come. And that is especially true for compensation (including pension benefits), since numerous surveys now show that public sector employees enjoy substantially higher pay than their private sector counterparts.

Overall, I'd say that the news today was mildly encouraging. So far, however, the market seems to be disagreeing with me, with stocks down and bond yields down. But with the economic fundamentals continuing to improve, albeit only modestly, the market should eventually reconsider and reverse today's action.

Still no sign of a recession

Although recent data have not reflected any unexpected economic strength, it is also the case that to date there is no evidence that the economy is sinking into another recession. That's very important, because the level of Treasury yields and the level of equity PE ratios strongly suggests that the market continues to worry about a weak economy. If the economy simply avoids a recession and continues to grow at a moderate pace of 2-3%, the market is going to eventually reprice to more optimistic expectations of the future—Treasury yields and equity prices are going to rise.

In April, publicly announced corporate layoffs, as tallied by Challenger, Gray & Christmas (love that name!), remained at extremely low levels. No sign here of any deterioration.

The April ISM Service Sector report was weaker than expected, but this index has been unusually volatile in recent years, and it remains above 50, suggesting that the sector is growing, but only modestly. It would be nice to see it higher, but at the current level it is not consistent with recessionary conditions. The employment subindex also weakened in April, but remains at a relatively high level, pointing with more emphasis to continued growth. On balance, today's service sector report is perfectly consistent with an economy that is growing slowly but not experiencing any serious problems.

As the above two charts show, systemic risk in the U.S. (as reflected in swap spreads) is low, and systemic risk in Europe, while still relatively high, looks to be improving on the margin (note the continued improvement in Euro basis swap spreads, which reflects healthier liquidity conditions in the Eurozone banking sector). Conditions in the Eurozone are far from healthy, but on the margin they are getting better.

The only reason that the world is holding 2-yr Treasuries yielding 0.26% and 10-yr Treasuries yielding 1.9% is that the market collectively is very fearful that the U.S. economy will follow the Eurozone into another recession, and that the Fed will therefore need to keep short-term interest rates at or close to zero for as far as the eye can see (well, at least for another two years). If the market were to be convinced that the economy would grow by at least 2-3% for the next several years, it is my contention that Treasury yields would be significantly higher than they are today, because continued growth would remove the need for any additional Fed easing and accelerate the need for an eventual tightening. Equity prices likely would be much higher as well, since corporate profits today are at record levels, but PE ratios are below average.

Readers can infer that I am not in agreement with the conventional wisdom that says that Fed purchases of a significant portion of the Treasuries issued in the past year or so to fund the federal government's $1.3 trillion annual deficits are responsible for the depressed level of Treasury yields. The Fed could purchase all of the current year's deficit (although they are highly unlikely to make any net new purchases unless the economy sharply deteriorates) but that would still leave over $9 trillion of Treasuries in the hands of investors, institutions, and central banks around the world. And it would still leave many tens of trillions of MBS and corporate bonds that are priced at relatively low spreads to today's extremely low Treasury yields. The Fed is no longer making net new purchases of Treasuries, and they won't buy more unless the economy deteriorates significantly. So today's extremely low level of Treasury yields means the world is content to hold tens of trillions of high quality bonds with historically low yields, because the world is very concerned that the future looks bleak.

Weekly claims back on track

Weekly claims for unemployment came in way below expectations, but that says nothing about the economy, since it is now clear that the unusual and unexpected rise in claims in recent weeks was an artifact of the seasonal adjustment process (it appears that April is a particularly hard month for the seasonals to get right—we saw a similar surge in April of last year that was subsequently reversed). Claims are back on track.

The first chart above shows unadjusted claims, while the second chart shows adjusted claims. In both cases the gradual downtrend in claims that we have seen for the past three years remains intact. (The purple line shows the 52-week average of claims to abstract from the seasonal adjustment process.) So the story with claims is that there is nothing new here: the labor market continues to gradually improve, and that means that the economy is likely also continuing to grow at a moderate pace. Most importantly, given the market's fear of an economic downturn (as reflected in the extremely low level of Treasury yields), there is no sign here whatsoever of any deterioration.

Chart updates

We've been tied up with our trip to the north, and have just now got back to Tucumán. I know this is by now old news, but I wanted to briefly recap this week's new data releases.

The ISM Manufacturing Index was stronger than expected, and there is no denying that this was good news, coming as it did in the midst of ongoing fears that the developing recession in the Eurozone will spill over into the U.S. To be fair, I should note that the correlation between the level of the index and the growth of GDP hasn't been nearly as good in the current business cycle as it has been in the past (see top chart). Evidently, the manufacturing sector has been a good deal stronger than the rest of the economy, so the current ISM figure doesn't necessarily argue for 4% real GDP growth in the current quarter—2-3% is probably a better guess. Nevertheless, it seems clear that with the manufacturing index doing so well, and with the employment subindex much higher than the average of recent decades, there is not even a hint of emerging weakness. Worrying about the entire economy rolling over into another recession at a time when the manufacturing sector is improving on the margin is one more sign of the pessimism that is still ruling the market.

Auto sales have softened in recent months, but sales are still up a healthy 9.6% in the year ended April. The rebound in auto sales from the depths of the recession has been very impressive. When one sector of the economy rebounds so impressively, it is bound to drag other sectors along with it in a trickle-up effect.

The ADP payroll number was weaker than expected, but is this fresh evidence of an emerging downturn? I'm not sure at all. From the looks of this chart, the blue line appears to be doing about the same as the red line, only with a difference of one month. If Friday's BLS number is weaker than it was a month ago, then it might make sense to worry that the economy was indeed softening.