The Market Today
Fed Confident, Jobs Surprise Again, Slack Remains; Trade Tariffs Kick in
by Craig Dismuke, Dudley Carter
Strong Job Gains Again in June but More Slack Revealed as 601k People Return to Labor Force: Yet again, the June payroll report proved better-than-expected. The economy added 213k nonfarm payrolls during the month and an additional 37k were added to the previous two months’ reports. The 3-month average rose to 205k while the average for all of 2018 is now at 212k – only surpassed by 2014 and 2015 for average monthly job gains during this cycle. Sectors seeing stronger-than-average growth were manufacturing (+36k), business services (+50k), education and healthcare (+54k), leisure and hospitality (+25k), and government (+11k). Unusually weak sectors included retail (-22k), transportation (-4k), and construction (+13k).
The household report was not quite as solid with the unemployment rate rising from 3.75% to 4.048% (rounded 3.8% to 4.0%) on a mass re-entrance to the labor force, mostly in the form of unemployed persons. The number of people reporting as not in the labor force fell 413k as 601k more people reported as in the labor force. The ranks of the unemployed swelled 499k while those employed rose 102k. The participation rate rose from 62.7% to 62.9%. While this may sound very discouraging on a headline level, the re-entrance shows a continued amount of slack which is likely at least partly to blame for the weaker-than-expected earnings growth. True to form, average hourly earnings grew less-than-expected, up just 0.2% MoM keeping the YoY rate in-check at 2.7%. Economists expected earnings to tick up to 2.8% YoY.
Bottom line – The June labor data show an economy adding jobs as a surprisingly strong and surprisingly stable rate. They also show more people on the sidelines waiting to re-enter the job market (a stealth form of slack) which could continue to delay the realization of the Phillips Curve (the economic model that proposes rising inflation (wages) as the unemployment rate falls). This batch of data will give ammunition to the hawks on the Fed who want to continue rate hikes. It will also give ammunition to the doves who can continue to point to weak traction in earnings growth. At the end of it all, it is likely a wash as it relates to monetary policy over the next few months.
Also released this morning, the May trade deficit did fall from $46.1 billion to $43.1 billion as the good trade balance report projected. This will be a boost to 2Q GDP.
Yesterday – Stocks Rallied, Curve Flattened as Fed Minutes Showed Support for Additional Gradual Rate Increases: Stocks rallied as they returned from the Fourth of July holiday, with strength in tech pushing the Nasdaq (+1.1%) out in front of the Dow (+0.8%) and S&P 500 (+0.9%). And while it was the technology sector that sat atop the S&P 500 at the close, the gains were broad-based. Three additional sectors gained at least 1% and 11 of 12 finished higher than their Tuesday close. Energy companies were the only sector to falter, following a move lower in the cost of U.S. crude. U.S. inventories grew last week by 1.2MM barrels, a much different result than the 5MM barrel draw expected. That dented WTI crude prices by 1.5%. The Treasury curve finished flatter after the Fed’s June Minutes signaled support for continued gradual rate increases (more below) and solidified the pre-release trends. The 2-year yield closed up 2.6 bps at 2.55%, 3.5 bps below its cycle high, while the 10-year yield actually fell 0.2 bps to 2.83%. With the 10-year yield stubborn to move too far from near its lowest levels since mid-April, the increasingly popular 2s10s spread fell to a new cycle low of 28 bps (or 0.28%).
Overnight – First Round of U.S.-China Tariffs Take Effect: Global markets are mixed Friday as the first round of U.S.-China tariffs took effect and investors readied themselves for the BLS’s June nonfarm payroll report. Beginning today, a 25% tariff will be charged on $34 billion of goods brought in from China. China announced that it had allowed tariffs on an equal amount of U.S. goods imports to take effect in retaliation. The swing factor for markets could be whether this is the first shot in an extended trade war or the final step before more diplomatic negotiations. On that front, President Trump said charges on another $16 billion of Chinese imports, to total the $50 billion previously promised, could be put in place within a couple of weeks and implied the full balance of over $500 billion may be ultimately subjected. China said the U.S. had started “the largest trade war in economic history.” Asian markets, which had been beat up in recent weeks by the tariffs talk, were actually Friday’s bright spot as that talk finally turned into action. Chinese equities rose 0.7% amid broader gains. There’s been less excitement elsewhere, with U.S. futures and the Stoxx Europe 600 both modestly lower. Considering the tariffs had been anticipated for months, there was little evidence of a flight to quality. German Bund yields and the U.S. Treasury curve were essentially unchanged ahead of this morning’s payroll data. After that report, Treasury yields moved lower, equity futures trimmed their losses, and the Dollar weakened.
ISM Non-manufacturing PMI Showed Continued Strength in Services Sector Activity to Close Out First Half of 2018: Similar to the manufacturing survey, the ISM’s services PMI rose unexpectedly in June signaling economic activity remained firm heading into the second half of 2018. The headline PMI rose to a four-month high of 59.1 and held near its highest levels of the cycle. Unlike the manufacturing report where the monthly gain was driven almost entirely by slower supplier delivery times, the services PMI was supported by even gains in new orders (second highest since 2005) and overall production (highest since 2005); both indexes added roughly 2.5-percentage points. Unlike the manufacturing sector, pressures on the services supply chain appeared to ease somewhat with fewer respondents reporting slower delivery times. Disappointingly, the employment index dropped to 53.6, matching its second lowest level since April 2017, and down a full 8.0-percentage points from January’s all-time high. The secondary indexes that don’t affect the main PMI also reflected moderation. Just like the manufacturing report, concerns in the comments section were infused with mentions of tariffs, transportation capacity issues, and a tight labor market.
FOMC Showed Support for Gradual Rate Increases to Continue in Response to “Very Strong” Economy: The Minutes from the Fed’s June meeting read as expected with little in the way of a surprise. Growth was described as “very strong” and supported by a tightening labor market, stimulative fiscal policy, accommodative financial conditions, and elevated household and business confidence. Generally, the group is more confident about sustained 2% inflation but there was evidence that the debate had continued. A number noted it was too early to declare victory while some others were concerned above-trend growth posed upside risk to inflation. On the risks front, the Fed touched on each of the hot topics: most said trade risks “had intensified”, a few noted “that fiscal policy posed an upside risk”, and many indicated they saw possible downside risks from developments in Europe and emerging markets. Putting it all together, almost all supported the June hike and there was general agreement “that it would likely be appropriate to continue gradually raising the target range for the federal funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020.” They immediately went on to list a host of factors reinforcing just gradual increases, however, counterbalancing somewhat the hawkish sounds of supporting a restrictive overnight rate. On other topics, they discussed modifying the description of policy as “accommodative” in the Statement. There was healthy debate of why the yield curve was flattening and what signals it was sending. Some said the dynamics behind the flattening “might temper the reliability” of it as an indicator while several said they doubted “the information content” was distorted. A number said it would be important to watch going forward while several noted it was just one of many factors that should affect policy. And the relationship between the effective Fed Funds rate and the IOER rate were covered. Bottom Line: Officials remained upbeat on near-term growth, were more confident near-target inflation will be sustained, and are aware of the various risks to the outlook. Generally, the agree that continuing to gradually raise rates is the best way to foster continued strength of the second longest expansion in modern history.