Employment: Bear trap

Stephen Colbert would be pleased by the pain the employment figures have been inflicting on bears. The October figures were impressive, posting a 166,000 gain in payrolls, nearly twice the level that economists were expecting.

I should stop here, but my inner grizzly won't let me. So once again I resume my hopeless crusade and take issue with some numbers, particularly those related to construction employment.

Construction is a study in contrasts. Residential building has collapsed, with real investment falling 23% between its peak in the 4th quarter of 2005 and the past quarter, with no improvement is sight (it fell 16.4% in 3Q07 versus the year-ago period). In the same time frame, non-residential construction investment has risen steadily, a total gain of 24.5% (and 13% versus 3Q06). But given the fact that residential construction is larger than its counterpart, total construction spending has fallen over 10% over the last 8 quarters (and 6.8% in 3Q07 vs 3Q06).



And yet, total construction employment rose 1.4% between the 4th quarter of 2006 and the past quarter. During this period, residential construction employment (including contractors) fell only 3.1%, while non-residential construction employment jumped 5%. In other words, one fell very little and the other didn't rise as much as it should have. The same holds over the past year.



This graph plainly shows that the response of employment to the fall in construction investment has been remarkably muted by past standards. This is and remains very odd, in a good way, but odd nonetheless.

Economic sugar rush and other treats

Well, there's no denying that the third quarter GDP advance was pretty impressive, with growth coming in at an annualized 3.9% rate. I don't want to put a bearish spin on the numbers, so let's start with the positives:

1. Consumer spending: The 3% annual growth rate is very solid. Based on modest employment growth and rising compensation, it was strong across the board. There's no sign that consumers are slowing down due to lower home equity.

2. Investment: Residential investment is still dismal, contracting at a 20% annual rate. But nonresidential construction is going very strong (12.3% growth) and equipement and software investment posted its best showing since the 1st quarter of 2006.

3. Net exports: Real export growth was a blistering 23%, more than offsetting an uptick in imports.

4. Government expenditures: They made a positive contribution by rising 3.7%.

Now, let's look at the caveats:
1. Inventories grew very strongly, adding 0.36 to the 3.9% growth rate, which may be a modest drag on growth looking forward.

2. Residential investment will fall some more and nonresidential construction has grown at what looks to be an unsustainable pace, specially considering faltering corporate profit growth.

3. Export growth looks too high, although the dollar's fall will make net exports a key contributor to growth for the near future.

4. Federal defense outlays jumped 9.7%, also an unsustainable rate, although this variable is extremely volatile.

The end result is that the 3.9% growth rate will probably be revised down. However, the underlying rate is quite likely above 3% which is still a good result. Last year's 3rd quarter GDP advance orignally came in at 1.6% and ended up revised downwards to 1.1%.

Where does all this leave us looking forward? Yesterday's 25 bp cut in the fed funds rate certainly was a signal that a significant slowdown lies ahead. How deep will it be?

The most recent analyst survey, from The Economist, places 2007 GDP growth at 2%. This would imply, given the current numbers, a contraction of 0.3% in the fourth quarter. Ouch. Given the margin of error and the fact that this year's forecast might be raised a bit, my guess is that 4th quarter growth will come in flat. The Fed is buying insurance against the possibility of the coming slowdown becoming entrenched.

As to 2008, it all depends on the consumer. So far, they have shaken off the twin blows of rising energy prices and falling home values. It seems they believe these are temporary phenomenons and are set on waiting them out. This will continue until it stops and it's impossible to forecast when that will happen (if at all). The key, in my opinion, lies in the labor market. If job growth falters, things will get uglier very fast.

Emerging like a volcano

Mostly unnoticed, the IMF published its semi-annual World Economic Outlook today (here's the press release), which is always makes for interesting reading. As expected, it slashed its growth forecast for the U.S. in 2008 to 1.9%, versus the 2.8% it expected as recently as July.

Apparently, the IMF is a strong believer in decoupling, as its global growth forecast for next year was slightly revised from to 5.2% to 4.8%. This reflects the strength of emerging market growth, which the IMF expects at 7.4% in 2008 (the July forecast pegged it at 7.6%), led by China's 10% expected surge.

The U.S. economy remains, by far, as the largest in the world. But at the margin (that is, in terms of its share of growth in world output) it will be eclipsed by China and even India this year. Just take a look at the following chart. One may know and understand the numbers, but it is amazing nonetheless.

Housing false starts

Even if you have a pessimistic bent, the latest housing starts figures are dispiriting. They fell 10.2% in September, to 1.19 million units, well below the consensus forecast of 1.28 million units. This translates to a full 31% drop from year-ago levels.

Are we near the bottom? Not quite. If the past is any guide, they could go as low as 800,000 units. The question now is how fast we'll get there.

A couple of additional points. First, it's hard to exaggerate just how far forecasters have been behind the curve. According to the Philly Fed's third quarter survey of professional forecasters, in the fourth quarter of this year housing starts would average 1.4 million units (annual terms). Needless to say, reality has rendered this outlook worthless and we should keep this in mind when assessing 2008 growth forecasts.

Of course, this also feeds into my current pet obsession: how can this collapse in housing construction be seen everywhere except in residential construction employment?

Employment crow for breakfast

My gloomy outlook for today's payroll figures was, to put it charitable, quite misplaced. The 110k jump in September and the upwardly revised August figures certainly demonstrate a surprising degree of resilience. Which, I might add, is welcome news.

Yet....

My skepticism is not totally unfounded. Just take a look at the following graph, which charts residential construction employment and housing starts.



The relative strength of residential construction employment has been downright freakish considering that housing starts have pretty much fallen of a cliff. Yes, there are lags, but housing starts have fallen for a year and a half, while employment has fallen less than 5% from peak levels. Real estate sales and credit employment has held up just as well.

Something does not compute. In any case, Dr. Gloom himself, Nouriel Roubini, argues that the payroll figures hide some underlying weaknesses.

Unemployment Friday

Is poised to be more entertaining than usual, and I don't mean that in a good way. Apparently, the consensus expects payrolls to rise by 100,000. Now, this is not an outlandish possibility, given that unemployment claims have been pretty steady.

Nonetheless, as I argued last month, there's something very, very fishy about the employment numbers. Sooner or later they'll catch up to a rather unpleasant reality. Will it be this month? I don't know, but my hunch (yes, hunch) is that the payroll number will come in flat to slightly negative, like September. The carnage will probably start this quarter.

It'll be interesting to see how it plays out with long term rates and stocks. A flattish figure probably won't cause stocks or rates to fall much, given that most investors know that the balance of risks is tilted to the negative side.

I forgot to mention that.....

If the 23% fall in house prices in the 10 largest metro areas that housing futures are indicating comes to pass, that spells recession.

Wondering how low house prices will fall?

Some interesting results are coming out. Moody's expects prices to fall, peak to trough, 7.7% nationally (hat tip: Calculated Risk).

According to Moody's, the bulk of the adjustment will be over by late 2008. This does not square with previous housing downturns, which played out over many years (check this post).

Sounds nasty? Moody's seems positively euphoric compared to the prices quoted in the CME's recently introduced housing price futures, based on the Case-Shiller indices (hat tip: Housing Wire). The 10 city average (includes the largest urban areas) will accumulate a drop of 23% over the next four years.

Scary stuff indeed.

Cutting rates on 'potential' economic slump? The horror!

Sarcasm is hard to avoid after reading a Bloomberg article titled "Bernanke Cuts on Slum 'Potential', Adopting Greenspan Approach"

After all, isn't avoiding 'slumps' the main job of central banks? Or do they have to wait until a full-blown recession to start cutting rates?

The problem, as always, is semantics. As George Orwell noted long ago, sloppy language leads to sloppy thinking. This is very much in evidence in this article, as in most financial journalism. Concretely, one has to determine what is understood by 'potential slump'

I'm pretty sure that the author meant was that Bernanke sought a rate cut to insulate the economy from the turbulence in financial markets, much as Alan Greenspan did by cutting rates after the Russian debt/LTCM debacle in 1998.

But that analogy is incorrect. In 1998, the U.S. economy was cruising along, growing at an annual rate well over 3% in the first half of that year. Thus, the rate cuts were purely preventive in the sense that market turmoil might have led to a downturn if no action had been taken.

The situation is very different this year. A sharp slowdown, though not a recession, in the economy was pretty evident well before turmoil hit the markets. In fact, while the credit crunch will certainly aggravate the recession in the housing sector, this downturn mostly reflects an imbalance in housing supply and demand that, while obviously related to financial factors, is not determined solely by them.

Thus, the rate cut is not 'preventive': the threat of a housing-led recession is very real and growing, with the current market turmoil clearly contributing to it.

With all due respect, the persons that question the rate reduction on moral hazard (bailout) grounds are nuts, as they're asking the Fed to not do its job. The other set of critics, who state that the Fed is underestimating the risk of inflation, are on firmer ground, but not much. After all, core PCE inflation is below 2%, within the Fed's informal range, and the economy is growing below potential.

Ben's Soothing Tonic

It seems Dr. Ben decided that the patient was best served by having the patient down his medicine in big gulps rather than sips.

With short-term Treasury rates near 4.2% at the end of last week, the markets were pricing a full percentage point cut in the Fed's reference rate over the next few months. So today's decision was merely a question of how quickly the Fed would deliver. Apparently, it is alarmed enough (not surprisingly given the run on Northern Rock in the U.K.) to prescribe a large, 50 basis point dose, even if that means losing some face.

The statement offered little insight. More surprising was the massive reaction in stock prices (the S&P 500 ended 2.9% higher). I think there are two possible explanations for this reaction:

1) Lowering the cost of credit will ease losses and restore liquidity to the markets. Everything will be sunny and it'll be like the two past months never happened.

2) The economy is in danger due to the woes in the housing sector. It's good that the Fed recognizes the magnitude of the threat and is beginning to act accordingly.

Obviously, numero 1 is mucho more likely than 2, as far as investor opinion is concerned. Needless to say, I'm in the #2 camp.

Actually, make that #3: the economy is in much worse shape than generally assumed and things will get a lot worse before Ben's Magic Tonic begins to take effect in a few months. Today's reaction in stock prices was not warranted.

Before calling me Dr. Tangible Gloom, chew on this: everyone has massively, consistently underestimated the problems in the real and financial sides of the housing market, as well as their impact, over the last couple of years. I don't see that changing, yet.

I don't believe

That the payroll numbers released today, bad enough as they were, bear any resemblance to reality. It's simply not possible. To see why, let's just review some numbers related to construction and real estate activities.

First, a quick review of the most recent housing and residential construction data:

Housing starts: -20.9% (July 2007/2006)
Housing units under construction: -16% (July 2007/2006)
Housing units completed: -22.2% (July 07/06)
New residential sales: -10.2% (July 07/06)
Existing home sales: -9% (July 07/06)

And yet, the Bureau of Labor Statistics (BLS)wants us to believe that employment in real estate services rose in August (600 new positions) and is up 1.5% versus year-ago levels?
Am I expected to think that residential construction employment has only fallen 3.5% in this period?

It gets worse. BLS data shows that employment in the offices of real estate brokers and agents has kept on rising, growing 3% in July over the year-ago level.

My head feels like exploding.

But even if we take these figures at face value, it's clear that eventually payrolls will catch up to activity levels, meaning that over the next few months and quarters the employment numbers will look very, very grim. And if analysts were surprised now, I can't imagine how they'll react then.

How much more will construction fall?

So far, the only direct, significant impact of the housing downturn on the economy has been the drop in residential investment. It's certainly been a nasty fall. After representing 6.3% of GDP in the 4th quarter of 2005 (a level not seen since 1951), it stood at 4.9% of GDP in the second quarter of this year. In real terms, it has fallen 18.6% during this period.

This drop subtracted 0.3% from total GDP growth in 2006, with an additional 0.9% and 0.5% over the last two quarters. So is the bottom in sight?

Yes, according to the median forecast in the Federal Reserve's Survey of Professional Forecasters. The forecasters expect an additional 4% drop in residential investment between the second quarter and the first quarter of 2008, after which it'll start a slow recovery. That roughly implies that it'll represent, at the bottom, around 4% of GDP.

This seems a bit optimistic given recent events and historical precedent. In previous housing downturns, residential investment has bottomed at around 3.3% of GDP. In addition, housing starts are still around 1.4 million and traditionally they fall to below one million during rough times (actually, the median forecast sees this level as the bottom and sees a slow rise in 2008).

Needless to say, forecasters seem unduly optimistic on residential investment. Although they've already cut the GDP forecast for this year from 2.6% late last year to 2% currently, negative surprises seem to be, unfortunately, quite likely. (And this is not even taking into account the possible impact on consumers).