It was generally a positive week for the equity markets with most major indexes finishing in the black. The S&P added +1.1% for the week while the developed market index gained +1.5% and emerging equities jumped +1.9%. Small-cap stocks were the standout laggard with a gain of +0.5%.
Bond yields dipped despite the decent jobs report on Friday. Worries about the situation in Ukraine certainly helped keep a lid on yields which fell 0.08% to close at 2.59%. Intermediate-term government bonds gained +0.6% on the week while high-yield bonds added +0.2%.
Should We Just Ignore the First Quarter?
There were two key economic reports in the U.S. this week.
First Quarter GDP
On Wednesday we discovered that the U.S. economy all but stalled in the first quarter. GDP grew at a shockingly low +0.1%, far below the roughly +1.2% expected. There were two forces at work:
- First, the large inventory build-up and spike in exports in the fourth quarter reversed themselves. The two together took 1.4% out of the GDP number.
- Second, we have the weather. This almost certainly weighed on residential and commercial construction, both of which disappointed.
The soft report was largely shrugged off because both these items are viewed as one time issues. Analysts are choosing to focus on data released since the end of the quarter. For example, this week we saw the strongest ADP jobs number since last November and the best Chicago PMI since last October.
This brings us to the second major report – nonfarm payrolls. There was something for everyone as usual in this release, but in general it was a decent report.
- Nonfarm payrolls increased +288K in April versus expectations of +218K (chart below). The average of the last three months is at the highest level in two years.
- Job gains were broad based – most key sectors saw growth.
- The unemployment rate declined to 6.3%, but the decline was entirely due to people dropping out of the labor market. The participation rate declined 0.4% to 62.8% (blue line below).
The bond market initially sold off on the news, but rallied soon thereafter. There are at least three reasons:
- The Ukraine news led to some ‘flight-to-safety’ buying.
- Another factor is the Fed. At the last meeting they dropped their unemployment threshold for future rate hikes for a more nuanced approach to the labor market. As a result the payrolls report is losing some of its ability to shake the bond market.
- Finally, we haven’t seen the unemployment rate fall enough that it will give rise to wage pressures, a precursor of inflation. ISI published the chart below that shows during the past two cycles wages have begun to accelerate once the unemployment rate hits roughly 5.6%. We are still above that level by a little less than 1%.
Furthermore, if we look at the level of long-term unemployment, the deflation picture is supported still further. The chart below shows the number of workers unemployed for 27 weeks or more. This remains well above the previous highs and is a sign that a lot of work needs to be done to get back to a ‘normal’ jobs market.
Oh, right, and before I forget, the Fed met again this week. No surprises on this front. They cut their bond purchases by another $10 billion to $45 billion and basically said they are sticking with the current plan of tapering at every meeting until QE3 is history.
Slow but Steady in Europe
There wasn’t bad weather everywhere in the world during the first few months of 2014. Spanish GDP increased +1.6% in the first quarter (the best showing since the financial crisis)…
…while UK GDP increased +3.1%….even Italian business confidence moved closer to the post crisis highs.
Finally, a survey of purchasing managers in Europe showed that factory activity rose in April in every country polled for the first time in more than six years. At least they are rowing in the same direction now.
Gauging the Recession Risks
Naturally the poor GDP report sparked talk about recession risks and potential bear markets. We lean to the view that recession risks remain low over the next few quarters. Jonathan Golub, chief U.S. market strategist at RBC Capital Markets, agrees.
He argues that recessions occur when the economy burns through excess capacity, which fuels inflation, which forces the Fed to step in, which changes the market’s direction and inverts the yield curve (when long-term rates fall below short-term rates). This slows growth and we often see a recession. He put together an interesting checklist to gauge the recession risks:
- Yield Curve – The yield curve inverted prior to the start of each recession since 1969. Currently, the curve is extremely steep.
- ISM Manufacturing – ISM weakened ahead of each of the last seven contractions and usually fell to the low 40s. The current reading is 53.9, clearly in expansionary territory.
- Inflation – Inflation spiked into six of the last seven recessions. We are actually seeing the opposite today
- Capacity Utilization – This indicator peaked ahead of six of the last seven downturns. Capacity utilization continues to rise and appears below peak levels.
- Housing Starts – Starts often roll over before contractions, typically dropping by 30% or more. While starts turned negative recently, the drop is modest.
- Average Weekly Hours Worked – Weekly hours dropped precipitously in five of the last seven recessions. Currently, the workweek is extended and therefore likely to drift lower as conditions improve. As such, only a larger drop would point to an impending recession.
Below is his handy ‘play along at home’ table that highlights where we stand today versus the past recessionary periods.
China’s Turn to Lead?
Finally, the International Comparison Program (sponsored by the World Bank) made the news this week when it published its prediction that China will surpass the U.S. as the largest economy this year. The IMF thought it wouldn’t happen until 2019. The U.S. has held the number 1 spot since 1872.
There were other notable changes too.
- Indonesia moved from the 15th largest economy to the ninth.
- The six largest emerging countries now are estimated to produce goods and services equal in value to the six largest rich nations.
This highlights the longstanding trend of growth in the emerging world. While the new report tinkered with how to measure production denominated in different currencies, the general theme has been with us for some time.
But total GDP is really a pretty poor measure of wealth. More meaningful is per capita incomes. To quote the Financial Times:
“Before the latest estimates, China’s economy ranked 93rd in per capita purchasing power terms, according to the IMF. That was just ahead of Turkmenistan and Albania but well behind Libya, Azerbaijan, and Suriname.
That means that on average China’s 1.36bn people are unlikely to catch up with Western living standards for many decades to come”
The chart below from the report itself shows real GDP per capita relative to population size.
Have a good weekend…Charles Blankley, CFA