Weekly Economic Commentary by Scott J. Brown, Ph.D.

Employment, GDP, and the Fed
October 5 – October 16

The September Employment Report was disappointing, but not horrible. Some of the recent softening in the pace of job growth may reflect seasonal issues. Stronger seasonal hiring in May and June should naturally lead to more seasonal layoffs in August and September. That is unlikely the only explanation. Concerns about global growth and financial market volatility may have made firms, especially smaller firms, reluctant to hire. Estimate of 3Q15 GDP have been declining, while underlying domestic demand have remained strong. All of this complicates the Fed’s decision to begin normalizing monetary policy.

Nonfarm payrolls rose less than expected in September, while figures for July and August were revised lower. That is disappointing, to be sure, but not a disaster. One artifact of the financial crisis was a sharp drop in summer jobs. Labor force participation rates for teenagers and young adults fell sharply. The economy has been improving and the drop in gasoline prices was an enormous tailwind for tourism this summer. As teenagers and young adults head back to school, we should see more seasonal layoffs than usual.

Prior to seasonal adjustment, the economy added 1.5 million jobs in education (public and private), about the same as in September 2014. However, we shed 958,000 jobs outside of education, compared to 812,000 a year ago. Labor force participation fell 0.2 percentage points in September, but not for the key cohort (those aged 25-54).

There are issues beside the seasonal adjustment. Slower global growth has had an impact on U.S. manufacturing. The ISM Manufacturing Index was close to zero in September, reflecting mixed conditions. Recent volatility in global financial markets has likely reduced business confidence. The ADP estimate of private-sector payrolls showed slower gains at small and mid-sized firms in recent months. Job growth at smaller firms had been a key factor in job market strength.

With the third quarter now behind us, we still don’t have a complete picture. However, we’ll get a better focus as the economic data roll in. At this point, recent reports remain consistent with the general theme of domestic strength and global weakness. A wider trade deficit and slower inventory growth are expected to have subtracted significantly from 3Q15 GDP growth. How much is hard to say. We have foreign trade and inventory data for July. However, we have consumer spending figures for August and unit auto sales results through September. Inflation-adjusted consumer spending (70% of GDP) appears to be on track to have risen at a 3.5-4.0% annual rate.

Where does this leave the Fed? Since the FOMC meeting in mid-September, officials have been making the case for an initial rate increase by the end of the year. The September Employment Report would seem to put that in doubt. The federal funds futures contracts dipped after the report, with a 25-basis-point rate increase not fully factored in until March. Still, the Fed sees a further reduction in labor market slack over the next several months and it is appropriate to consider a very gradual path back to a normal policy position.

It’s worth pointing out that the payroll figures are often revised. The “softening” in private-sector payroll growth may not hold up in revisions, or it could appear worse. While corporate layoff announcements continue to make headlines, when you add them all up, the monthly totals have remained relatively low. Moreover, weekly claims for unemployment benefits have continued to trend low (note that this is entirely consistent with large seasonal job losses for teenagers and young adults, who typically don’t file claims when they go back to school). Job destruction is not an issue.

For the financial markets, the key takeaway is that the upcoming economic data will be important. Plenty of reports will arrive before the Fed policy meeting in mid-December.

Nearing normalization / shutdown shuffle – part 2
September 28 – October 2

Fed Chair Janet Yellen downplayed concerns about the rest of the world and indicated that she was among the majority of Fed officials expected to raise short-term interest rates this year. Meanwhile, while John Boehner’s resignation as House Speaker may signal an agreement on the budget, Congress has moved further away from future compromise.

In the revised dot plot, the graph of senior Fed officials’ forecasts of the appropriate federal funds target rate for the next few years, there is no indication of which dot corresponds to which official. It was speculated that Chair Yellen may have been one of the four officials who didn’t expect to raise short-term interest rates this year. In her post-FOMC press conference, Yellen was obligated to speak for all Fed policymakers. However, in her speech at UMass Amherst, Yellen placed herself among the group expecting a rate hike by year-end. The stock market has often reacted poorly to the possibility of a Fed rate hike. However, investors seemed to be encouraged by Yellen’s expressed confidence in the U.S. economy. Why the Fed would raise rates matters. Yellen downplayed worries about the rest of the world and played up the prospects for the domestic economy.

Real GDP rose at a 3.9% annual rate in the government’s 3rd estimate for 2Q15 (revised from 3.7% in the 2nd estimate). In July, the Bureau of Economic Analysis introduced a new measure: real final sales to private domestic purchasers. This figure is simply GDP less the change in inventories, net exports, and government – a less-volatile measure of underlying domestic demand. Private Domestic Final Sales rose at a 3.9% annual rate in 2Q15, up 3.5% from a year earlier. That’s strong.

One of the key themes in the U.S. economic outlook is the split between the rest of the world and what’s happening at home. Softer global growth and a strong dollar are likely to restrain exports and corporate earnings from abroad. However, falling prices of oil and other commodities should continue to provide support for U.S. consumers and investors. Inventories and foreign trade account for much of the quarter-to-quarter noise in GDP growth and at this point we only have figures for July. However, we should see net exports and slower inventory growth subtracting from GDP growth in 3Q15, perhaps a very large drag on headline growth (which is another good reason to focus on Private Domestic Final Sales).

On Friday, John Boehner announced his resignation as House Speaker effective at the end of October. The only surprise here is the timing. His decision was driven largely by disagreements with the Freedom caucus (a group of ultra-conservative House Republicans) and Tea Party members. Their dissatisfaction with Boehner was largely over his willingness to compromise.

Boehner was blamed for Congress’ inability to overturn the Affordable Care Act. Two years ago, Boehner acquiesced to Tea Party demands to shut the government down. The government does not save money in a shutdown. The 16-day shutdown in 2013 added about $2 billion to the government’s budget shortfall that year (government salaries are still paid, contracts have to be honored, and there are added costs to starting the government up again). It also shaved 0.1 to 0.2 percentage points from GDP growth (mostly activity is shifted from one month to the next). Some private-sector output is lost.

The 2013 shutdown led to a postponement of several economic data releases. It also interfered with the government’s collection of economic data, distorting figures over the following few months.

Boehner’s resignation should significantly reduce the odds of a government shutdown over the budget this week. That was the trade-off. Boehner would work with House Democrats on the budget, but that would cost him his job. At the same time, Boehner’s resignation substantially increases the odds that we’ll see a shutdown over raising the debt ceiling in early December. Boehner’s replacement (the new House Speaker) will be less willing to compromise. The debt ceiling is a much bigger problem than the budget, as it raises the possibility that the Treasury could miss a payment on its debt.

We’ve been through this before. Congress took the Treasury to the brink of default in August 2011. Treasury bill rates briefly spiked higher. Standard & Poor’s downgraded the U.S. credit rating, but that did not have a lasting impact. In fact, Treasury bond yields fell rather than rose.

A government shutdown need not be unsettling for the U.S. economy, but it may add uncertainty for the financial markets. Looking ahead, Washington is expected to become even more dysfunctional that it is now.

Nearing normalization / shutdown shuffle
September 21 – September 25

“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

– from the September 17 FOMC policy statement

The key line that was added to the Fed’s policy statement suggests a sharper focus on what’s happening in the rest of the world, but let’s be clear. The Fed is not reacting to overseas developments per se, but to what shifting global economic and financial conditions mean for the U.S. economy. In focusing on the Fed’s decision to delay policy normalization, investors have ignored the increased risk of a government shutdown.

Fed officials remain optimistic about the domestic economy. Net exports may be soft, but policymakers anticipate moderate growth in consumer spending and business fixed investment. Inflation is low, due largely to transitory forces, according to the Fed, and is expected to move toward the Fed’s 2% goal “as the labor market improves further and the transitory effects of declines in energy and import prices dissipate.”

The dots in the dot plot drifted a bit lower, a consistent theme over the last year. There was no consensus about the likely year-end federal funds target rate in 2016 and 2017. All but four officials expect a rate increase this year (the Federal Open Market Committee meets in late October and mid-December). One official, almost certainly Minneapolis Fed President Narayana Kocherlakota (who will soon leave the Fed), is calling for a negative federal funds target range. That isn’t as crazy as it sounds. A number of other central banks have gone to negative rates. A longer trend in low inflation and a decline in inflation expectations implies a higher real interest rates – that is, even if nominal rates are unchanged, monetary policy tightens as inflation falls. The FOMC noted in its policy statement, “market-based measures of inflation compensation have moved lower.”

Some of the narrowing in inflation compensation could be a flight to safety in Treasuries, but an extended low inflation outlook should be a serious concern for the Fed. Officials have consistently underestimated inflation over the last several years.

While market participants have been focused on the Fed, another concern has been growing in recent weeks. The federal fiscal year ends on September 30. Congress has yet to come up with the appropriation bills or a Continuing Resolution that would fund the government into October. Without that, a partial government shutdown looms. Notices were sent out last week to government agencies to prepare for a possible shutdown. While there is still time, the odds appear to be better than even that we’ll see a shutdown.

Tea Party Republicans, who drove a two-week shutdown two years ago, are threatening to shut down the government again unless funding for Planned Parenthood is removed from the budget. Controversy over some edited videos, purporting to show hired actors acquiring fetal tissue samples, has heightened the risk of a shutdown. The non-Tea Party Republicans are having trouble controlling the process and there is some chance that House Speaker Boehner may lose his position.

Even if Congress manages to fund the government in the near term, there is a possibility of a government shutdown over the debt ceiling. Treasury has already reached the debt ceiling, but it can dodge that constraint for a while through some creative accounting. Such actions have limits, and the federal debt limit is now expected to become truly binding in early December.

A short government shutdown need not be too unsettling for investors (“been there, done that”), but it’s not going to help. In her post-FOMC press conference, Fed Chair Janet Yellen said that the possibility of a government shutdown played no part in the Fed’s policy deliberations.

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