My Diary 349 --- The “Sausaged” Job Number, No More Party Times,

 

My Diary 349 --- The “Sausaged” Job Number, No More Party Times, Houston We Have a Problem

November 4, 2007

It is quite interesting when you piece together the recent US data, +166K NFP, +3.9% 3Q GDP and 25bps Fed cut. And many ppl already think the Fed has done its job. But what my grandfather taught me is that the appearances can be deceiving... So let us read more….

The markets did not react positively over the past week, with Dow Jones fell 1.53%, S&P declined 1.6 % and credit spreads were 10-20bp wider across the board. Rumor hitting the market on Friday night is Barclays approaching BOE for emergency funding. In fact, the price action in the aftermath of the Fed has been brutal. There is a saying, be careful what you ask for, well, the flows of rumor are write-downs in the financial sector has intensified and stocks are not liking it at all. Investors are seeking safe haven in the front end of the Treasury curve.  2yrs are nearly 90bps through Fed Funds, mere days after the Fed expressed a degree of confidence that conditions in the financial sector were improving …

 

Hmm….something smells wrong and today I will focus on the United States because the market still determines the global cost of capital, even though ppl argue that the US is not the only growth engine of world economy anymore …

 

The “Sausaged” Job Number

The Iron Chancellor of Germany, Bismark once said -- Laws are like sausages, it is better not to see them being made. I think this can be applied to the US job statistics. On last Friday, Labor Department reported that the US economy added 166K new jobs during October, following two revised-downs of August and September figures, two times greater than market estimate at 85K …Wow, it seems like, along with  4.7% unemployment rate and 3.9% GDP growth, we should at least be temporarily silence the talk about a US economic recession.

Well, maybe not, if you also look at the Household Survey, which at the same time said the US economy lost 211K jobs…Now you may need a piece of napkin to clean you glasses…but let me explain first as the Bureau of Labor Statistics actually does two different surveys – 1) one is called the Payroll/Establishment Survey, which is comprised of calling approximately 160K businesses (out of 9 Millions) and seeing how many workers they have that month. They survey enough businesses to cover about 1/3 of non-farm employees; 2) the other one is the household survey, where they randomly call 60K homes and ask how many ppl is at home and who has jobs (part-time or full-time). This survey covers people who are employed both by large and small employers, illegal immigrants, etc.

The problems of Payroll Survey are embedded in its statistics methodology as the data collectors do not contact very many small ad new bizs, which turn out to be the engine of job growth in the US. Moreover, the BLS does this by estimating the nos of new jobs in various categories that are created or lost in something called the birth-death ratio, which it will tend to underestimate new jobs when the economy is recovering from recession and overestimate them when the economy is slowing down. Remember, to the broad economy, employment is a lagging indicator and it does not turn down until after a recession has already started…. With all these in mind, the market is placing a serious doubt to the “too-good-to-be-true” job figure this time …

The reality is that investors banking on more interest-rate cuts may get some clues about what comes next from Chairman Bernanke, when he testifies before the Joint Economic Committee of Congress on next Thursday. Before that, with concerns over a credit crunch and losses in subprime mortgages refusing to go away, plus brokerage downgrading several financial stocks, investors will be anxiously awaiting the quarterly results of AIG.

After several analysts report that Merrill may have an additional $10B in write-downs, I don't think that anyone would be surprised if a write-down of this size occurred with the insurance company.  In fact, if you simply substituted Goldman, Lehman, UBS, or Barclays for Merrill, we still wouldn't be surprised.  Obviously, with Year-end is just around the corner and we will see more reporting cards from Wall Street, and the market is going to need to come to grips with the magnitude of the problems looming out there… and singled by the Super SIV Fund, I think that we are likely to see another liquidity event in the next two months… OK, have a break and more to be served… 

 

No More Party Times

The divergence of data and market viewpoints over the past week has been seemingly unmatched as the market juggles with whether we want lower rates or a better than expected economy.  When the Fed states risks are balanced, I am now seeing two large elephants on opposite sides of the scale struggling to stay on the small round gold plates - the word “Stagflation” comes to mind. 

My sense is initial GDP and jobs data should work to brighten the darkest scenario (consumer collapse) and potentially push the timing of any recession out another quarter or two. The market seems very mindful these data points get adjusted ( as I said in the above paragraph).  But many of us should cheers to the Fed for providing us with the cut expected, but also for limiting action to a level that wouldn't seem extremely inflationary given the outstanding NFP number. 

In short, corporate earnings are somewhat softer than lowered expectations but fall well short of requiring broad rating transition.  CEO's have provided guidance that imbeds the reality that the economy is softening and consumer behavior will be impacted.  Despite the broad expectation of many of these issues, the market continues to react negatively to their development.  Shorts continue to drive the more liquid synthetic market wider, cash liquidity has clearly been hurt by Bank CEO's who have had enough fun in capital markets recently…Guys, no more party times, better go to work or quit  your jobs …

The market remains focused on the potential for highly rated global banks to require additional as credit costs will escalate in coming Qs.  Bank CEO's are unlikely to sacrifice B/S to please shareholders and equity analysts who wish to make a name for themselves. Personally, I do remain concerned that the underlying tone of the economy and housing market remains negative.  I also expect non-financial earnings to continue to prove less volatile to the market over the next few weeks and I now think the Fed will not hesitate to send funds lower again (4% Fed Fund Rate) when needed. Retailer earnings and outlooks will be critical in coming weeks, as the market needs to see what consumers will behave after housing-related headlines continue and jobs/income remains supportive.  A big big question in my mind is that --- can housing implode, banks take marks and the US economy avoids recession?  Probably Not, and then the market is tempting to trade the fear and rumors and thus we will see volatility in coming weeks … So put on your safety belt, fellows…

 

Houston, We Have a Problem

I have to acknowledge that by far the resilience of the US economy is impressive, and consumer behavior is slow to change, but it will change.  Consumer confidence is waning and it is likely to be further shaken by problems at large financial institutions. Looking forward, I think we should pay close attention not only to the upcoming data, but also to three other perspectives of US economy … 

1) Fed Policy --- The Fed is in a tough position currently.  Inflation remains a concern and at the same time there is serious concern about the continued erosion of confidence in the financial sector.  The Fed is saying risks are balanced and clearly they do not want the markets to expect further ease.  The probability of weak growth vs higher inflation may be roughly equal (although I would argue for that point) but the risks of each are not.  Higher inflation is a problem which can be addressed with monetary policy.  Large institutions going down and a spiral of forced selling and lower prices of financial assets are something to be averted rather than fixed after the fact.  Furthermore, core CPI is still 2.1% YOY down from a high of 2.9% in Sep 06. Thus my call is to bring Fed Funds down to 4%, a necessary move to get to neutral.  Further cuts from there will be necessary to address credit contraction and those are not priced in.  A little inflation driven by dollar weakness is not nearly as scary as the alternative.

2) Consumer Behavior --- Household debt growth is now a fundamental problem as many Americans have realized that the punchbowl is being taken away after a very long party… Again (Loudly!!), Guys, no more parties…As a result, wealth effect from higher home values providing access to further spending has dried up.  Foreclosures continue to increase as home sales fall.  Conventional wisdom used to say that mortgage defaults would remain low unless unemployment increased.  That has proven to be very wrong.  If unemployment becomes a problem however, the housing problem will be compounded.  Employment is gradually weakening despite Friday's headline payroll.  The trend is weaker in payrolls, and in the Household survey and the continuing claims data is weaker. 

3) Inflation Trend --- Now that the Fed has taken some steps toward lowering rates, core inflation should stabilize.  Tight policy was causing inflation to recede despite a roughly YTD 12% depreciation of US Dollar.  Higher commodity prices are being caused by the weak dollar and demand from outside the US.  The US Dollar is weakening because of weaker growth here vs abroad and its higher ever deficits. Thus, Keeping rates higher to protect the currency would weaken growth and is ill-advised… so we should go to 4% …before leave for a walk, let me replay the 1995 film, Apollo 13 --- “Houston, we have a problem”…”This is Houston,say again please”…

Good night, my dear friends