ALBERT HERTER

‘SOME POSITIVES DESPITE WEAK EMPLOYMENT?,’ from Fidelity Viewpoints at fidelity.com.

In Uncategorized on December 2, 2009 at 21:38

We’ve seen some surprises—both good and bad—in the past month’s economic data.

The economy continues to show signs of recovery, but there are indications of a bumpy ride. For instance:

Even though unemployment numbers were surprisingly high, leading indicators for the job market are improving.

Consumers are still uncertain about their current economic situation, but there are signs that consumer spending is slowly recovering.

While housing has been the worst hit sector during this contraction, pending home sales have rebounded strongly.

The manufacturing sector has been through the worst production declines in decades, but orders are beginning to rise. This should remove the U.S. oversupply of inventories and trigger another uptick in production.

Global demand has also recovered and this, coupled with a weak U.S. dollar, can improve U.S. exports.

The combination of a rebound in growth and a still weak labor market produced a massive upswing in corporate earnings and helped propel the capital markets higher.

Let’s take a closer look.

Unemployment disappointingly high

The October unemployment rate unexpectedly surged well above consensus to 10.2%. The job market weakness was broad-based with only one third of industries adding to payrolls. This large step up in unemployment took many analysts by surprise since many leading indicators for unemployment had been signaling some improvement in job trends. For instance, layoff announcements and initial unemployment claims were down, temporary employment hiring was up, manufacturing hours worked increased, and overtime hours continued to rise.

The hardest hit were younger workers and those with high school or lower education. Workers younger than age 24 lost nearly half a million jobs, while adults (those over age 24) with less education (high school or lower) lost 508,000 jobs. On the other hand, adults with more than a high school education gained 463,000 jobs. The job market weakness was broad based with only one third of industries adding to payrolls in October.

But in any economy, jobs are constantly being created and destroyed. When the economy is in an expansion mode, more jobs are created than lost. As an economy enters recession, this dynamic changes and job creation fails to keep pace with job destruction. The JOLT (Job Openings and Labor Turnover) survey from the U.S. Bureau of Labor Statistics helps capture this natural churn in the economy. In September, the survey reported that 4.01 million new hires or jobs were created, but 4.31 million jobs were lost.

Going forward, therefore, it becomes important to understand where jobs are being created and where they’re being destroyed. On the job creation side, there was some good news from the Institute for Supply Management’s manufacturing survey. While the overall survey is an excellent leading indicator of U.S. industrial production, it also provides details on what supply managers see in terms of orders, production, and hiring. In November, the employment subindex fell back to 50.8, but this remains consistent with improving manufacturing employment. This has typically signaled future job increases in the manufacturing sector. On the job loss side, the story is also improving. Initial unemployment claims and layoff announcements have both fallen significantly from the extreme levels earlier this year. Overall, while the unemployment rate highlights the very rough environment we’ve been through, the leading indicators are showing that the worst of the storm may be over.

Consumers optimistic about the future

Two closely followed consumer sentiment surveys, the Conference Board Survey and the University of Michigan Consumer Sentiment Survey, ask consumers how they felt about current and future business conditions, employment, income, spending, inflation, and finances. In November, the surveys recently showed that consumers are not feeling good about their current financial positions and have low expectations for income, employment, and spending—not surprising given salary and benefit growth rates are at their lowest on record. When the same individuals were asked about how they felt about future financial conditions over the next 6-12 months, however, they were much more positive. They are expecting the overall economy to improve, as well as business and employment conditions—another sign that the worst may be behind us.

Consumer spending still weak

During this recession, consumers increased their savings and paid down debt at the fastest rate in recorded history. Nevertheless, consumer spending has begun to recover. Retail sales and real consumer spending both appear to have bottomed as long ago as December of last year. Improvements from the lows, however, have been slow and halting. There’s still a strong unwillingness to “spend on things you don’t necessarily need.” But there’s a natural replacement cycle within consumer spending that should continue to boost spending. One excellent example comes from the vehicle sector. While vehicle sales were temporarily boosted by the “Cash for Clunkers” program, it appears that spending has held up better than expected after the program’s expiration. One reason may be that the average age of a vehicle on the road is now 9.4 years. As the maintenance cost for these cars begins to soar, it becomes very compelling for more households to replace their older cars. We may just be seeing the start of this cycle.

Inventory cycle could boost GDP

The manufacturing inventory cycle is a powerful driver of gross domestic product (GDP) both going into and out of recessions. While excess inventories were a key driver of the collapse in industrial production in late 2008 and early 2009, it may be the same indicator that signals a dramatic rebound. In the fourth quarter of 2008 and the first quarter of 2009, manufacturers experienced a dramatic decline in demand as the worst of the recession hit. As a result of the demand decline inventories were well in excess of normal levels and producers shut production and sold their inventories. This is a decision producers make during every recession, but it results in a decline in production and jobs well in excess of the decline in demand.

Production declines, however, create inventory declines. As we’ve moved through 2009, consumer demand has stabilized and begun to recover. As a result, inventories have begun to come in line with demand and the need for new production has begun to recover. This is the point at which inventories could become a powerful upward force on GDP. The ISM manufacturing survey was the first to signal this change in production. Indeed, industrial production has increased for the past four months. Going forward this can signal that the need for workers is likely improving. So is the recovery sustainable? The inventory cycle is now a wind at our back, which has typically been a key variable for sustainability.

Global demand can increase U.S. exports

In terms of the global economic picture, the U.S., which historically has led other countries out of a global recession, is currently in the middle of the recovery pack. U.S. leading economic indicators are rising at a 3-month annualized rate of 6.8%, consistent with economic recovery. The OECD (Organization for Economic Cooperation and Development) countries, which are a collection of the largest developed economies in the world, are seeing their leading indicator rising at a 3-month annualized rate of 16%, the highest rate since the end of the 1975 recession. This shows that the global economy is growing at a faster rate than the U.S. economy. Much of the higher growth has been spurred by demand from countries like China, India, and Brazil where consumer spending is rising. This growth, coupled with a weak U.S. dollar, creates an excellent export environment for U.S. companies. The increased exports from the U.S. should be a powerful positive increment to U.S. GDP growth.

How to invest

How might investors take advantage of these economic developments? An extremely high productivity rate, an increase in output per hour, and falling employment costs are signaling stable and increasing corporate profitability. Corporate profits rose in the second and third quarters of 2009 and stocks could continue to be strong if profits continue rebounding.

The early cyclicals (sectors and companies that tend to do well in the early stages of an economic recovery) such as home builders, autos, and retailers have already rallied. Next, investors could expand their portfolios to other sectors to include a wide variety of asset classes as corporate profits rise and the expansion broadens. The next wave of growth could be in technology and industrial stocks. This stage of the cycle, however, may be choppy. While the overall market will likely follow earnings trends, the market has already rebounded strongly and it appears to be a stock picker’s environment. For example, in the area of consumer staples stocks, some companies may grow at a faster rate due to their increased share in the market, despite somewhat slow growth in overall consumer spending. Identifying those market share leaders both in the U.S. and global markets may be a recipe for investing success.

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