US Economy’s Big Soft Spot

Why has nonfarm business productivity growth been so weak during the current economic expansion? That’s been an ongoing puzzle. I have noted that most of the jobs gains since payroll employment troughed during February 2010 have been in service-producing industries, where productivity tends to be weaker than in goods-producing industries that can deploy automation and robotics more effectively.

Since that employment bottom back in February 2010 through August of this year, payrolls are up 14.9 million, led by a 13.2 million increase in private services employment. However, that’s not a new development. The ratio of goods-producing payroll employment to total payroll employment has been declining since August 1943. It is down from 44.1% back then to 13.6% now. In other words, the percentage of total employment in services is up from 55.9% to 86.4% over the same period.

The big surprise in the economy’s productivity slowdown is the remarkable weakness in manufacturing productivity during the current expansion. That has weighed heavily on the slowdown in overall nonfarm productivity.

The ratio of nominal goods output in real GDP has also been on a downward trend since Q1-1948. It has declined since then from 52.3% to 29.6% currently. However, manufacturing industrial production managed to rise to a record high during December 2007, and it has regained 18.8% since its recent recession bottom during June 2009, though it has remained stalled since mid-2014 at 5.8% below its previous record high.

The quarterly productivity release tells the same story for the real output of manufacturing, which also has stalled since mid-2014, though back at its previous record high during Q1-2008. The sad part of the story is that the y/y growth rates in both measures of factory output have slowed significantly during the current expansion down to zero, contributing to the slow pace of overall economic growth, including the significant slowdown in overall productivity.

The problem may be that many factories have reached “peak productivity.” They are fully automated. They are extremely productive from a supply-side perspective. In a world of secular economic stagnation and plenty of excess capacity, the demand side of the productivity equation is weak. As I have noted before, the productivity of the most efficient widgets plant in the world is zero if there is no demand for widgets.

There’s lots of demand for US manufactured goods given that the sector’s real output is back at the previous cyclical high. It just isn’t growing. Auto sales seem stalled at a cyclical high of around 17.0 million units (saar). Housing starts have recovered but have yet to rise meaningfully above previous cyclical lows. Real merchandise exports have been relatively flat for the past two years in record-high territory. Non-defense capital goods orders excluding aircraft is down 6.5% over the past 24 months through July. The weakness in exports and capital goods has coincided with the weakness in demand for energy-related goods and services since mid-2014.

Let’s have a closer look at some of the other recent unhappy numbers for manufacturing:

(1) Productivity. Hours worked in manufacturing has declined by 27% from the start of the data in Q1-1987 through Q2-2016. Over the same period, the sector’s output is up 85% as a result of big productivity gains. During the current expansion, manufacturing productivity growth has been practically zero since Q3-2012.

The 20-quarter (five-year) growth rate in manufacturing productivity plunged from a high of 8.5%, at an annual rate, during Q1-2008 to 0.9% during Q2-2016. The data for this growth rate start in 1992. I’ve constructed a proxy for manufacturing productivity (using monthly production and employment data for manufacturing), which currently shows a comparable growth rate of just 0.4%, the lowest on record starting in 1952!

(2) Purchasing managers. I thought that the slowdown in manufacturing was mostly attributable to the plunge in energy businesses’ activity resulting from the plunge in oil prices. Now that they have recovered somewhat from their lows at the beginning of the year, I expected to see better manufacturing numbers by now. That’s not happening, so far.

Indeed, August’s M-PMI was certainly disappointing across the board. The overall index as well as its three major components (orders, production, and employment) all were just under 50.0 last month.

Some of the weakness in manufacturing may be starting to rub off on services. The NM-PMI dropped 4.1 points from 55.5 during July to 51.4 in August. Here too, all three major components dropped last month, though they all remained above 50.0.

(3) Regional surveys. The averages of the composite, orders, and employment indexes of the business surveys conducted by five Fed districts (Dallas, KC, NY, Philly, and Richmond) all were slightly negative last month. So they are confirming the weakness in the latest national M-PMI survey.

(4) Bottom line. The Atlanta Fed’s GDPNow model forecast for real GDP growth in Q3-2016 was 3.5% on September 2. As I noted recently, the labor market and consumer spending indicators support that solid forecast. However, the manufacturing data and the services PMI do not. If Fed officials are intent on getting one rate hike done this year, following last year’s one-and-done, they might consider doing it at the upcoming FOMC meeting on September 20-21. The next batch of economic indicators might not give them another chance to justify a rate hike this year. We are in a fine mess if the Fed can’t justify one measly 25-bps rate hike per year.

FRB Governor Stanley Fischer may be about to lose all his credibility. He predicted four rate hikes at the beginning of the year for 2016. Last week, he was down to two rate hikes for the year.

Abnormal Normalization

When in doubt, simulate. That was my second takeaway from Fed Chair Janet Yellen’s highly anticipated Jackson Hole speech on Friday. The first takeaway was the one that made all the headlines. She is joining the chorus of Fed officials who have been saying it is time for another rate hike: “Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.” That seems to be the Fed’s new party line, as recently also expressed by Fed Vice Chair Stanley Fischer and FRB regional presidents William Dudley (NY), John Williams (SF), Dennis Lockhart (ATL), and Loretta Mester (CLE).

To make sure that we are left with no reason to be certain about what the Fed will do, she added, “And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course.”

Then she really let us have it by offering a chart of the Fed’s known unknown. It shows a line tracing the median path for the federal funds rate through the end of 2018 based on the FOMC’s summary of economic projections in June. Its Figure 1 also shows a shaded region on either side of the line, which is based on the historical accuracy of private and government forecasters. The amazing result is that there is a 70% probability that the federal funds rate will be between zero and 3-1/4% at the end of next year and between zero and 4-1/2% at the end of 2018! Yellen may be test-marketing this “fan chart” to replace the quarterly “dot plot” of the federal funds rate reflecting the forecasts of the FOMC participants.

I wish I could get away with such wide-ranging forecasts. My latest view is that it will be one-and-done for federal funds rate increases this year and one-and-done next year. That would bring the federal funds rate up to 1.0% by the end of next year. And that might be all for a long time. In other words, I expect that the process of normalizing monetary policy will be abnormally gradual and limited in scope and duration. I call it “abnormal normalization.”

Yellen provided the following explanation for her drive-a-convoy-of-trucks-through range for the federal funds rate outlook: “The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook changes, monetary policy needs to adjust. What we do know, however, is that we want a policy toolkit that will allow us to respond to a wide range of possible conditions.” Fed officials call that “forward guidance.” In other words, we are on our own.

The rest of her presentation was a relatively technical discussion of the subject of her speech titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.” In other words, it was addressed to the high-powered monetary intelligentsia in the room rather than all the rest of us among the rabble. She reviewed the rather limited pre-crisis toolkit, then the tools that have been added since the crisis. Allow us to cut through the jargon:

(1) Post-crisis toolkit. Yellen noted that in 2006, Congress approved plans to allow the Fed to pay interest on banks’ reserve balances beginning in 2011. In the fall of 2008, Congress moved up the effective date of this authority to October 2008. She stated, “That authority was essential. Paying interest on reserve balances enables the Fed to break the strong link between the quantity of reserves and the level of the federal funds rate and, in turn, allows the Federal Reserve to control short-term interest rates when reserves are plentiful.” They certainly were plentiful, as the Fed implemented a series of QE programs starting in November 2008. Yellen also touted “forward guidance” as another new post-crisis tool in the toolkit.

(2) Too close to zero. Until very recently, the Fed was focused on “normalizing” monetary policy very gradually so as not to undermine what seems like self-sustaining economic growth. Now, the Fed is starting to worry about the next recession and whether there will be enough room between the federal funds rate and zero to stimulate the economy. Yellen observed that most forecasts currently show the federal funds rate rising no higher than 3% in the longer run. Between 1965 and 2000, it averaged more than 7%. “Thus, we expect to have less scope for interest rate cuts than we have had historically,” Yellen stated.

(3) Why so low? The reason that the federal funds rate isn’t expected to rise any higher than 3% is because inflation is expected to stabilize around 2%, while the “neutral” real federal funds rate is expected to be only 1%. Get it? 1+2=3. During past economic expansions, the real rate seemed to be more like 2%-3%.

The real rate is supposed to be the federal funds rate minus expected inflation, which is hard to measure. There are survey data for expected inflation. There is also the yield spread between the 10-year nominal bond yield and the comparable TIPS. In my opinion, it doesn’t make much sense to use expected inflation over the next several years to inflation-adjust an interest rate that is for funds borrowed and deposited overnight by bankers. So I use the actual core CPI inflation rate instead.

The “neutral” real rate, that neither boosts nor slows the economy, dropped in recent years, according to Fed officials. Why is that so and why might it remain depressed? Yellen offers the following smorgasbord: “Several developments could have contributed to this apparent decline, including slower growth in the working-age populations of many countries, smaller productivity gains in the advanced economies, a decreased propensity to spend in the wake of the financial crises around the world since the late 1990s, and perhaps a paucity of attractive capital projects worldwide. Although these factors may help explain why bond yields have fallen to such low levels here and abroad, our understanding of the forces driving long-run trends in interest rates is nevertheless limited, and thus all predictions in this area are highly uncertain.”

Or as Stanley Fischer recently admitted in his 8/21 speech on the slowdown in productivity: “We just don’t know.” Indeed, no one even knows if the neutral real rate concept makes any sense whatsoever. It can be lumped together with the Loch Ness monster, leprechauns, unicorns, and UFOs. None of them have ever been convincingly sighted by sober observers.

Some sober critics of the Fed and other central banks have observed that by keeping interest rates near zero, monetary policy may be an important source of secular stagnation, which is why the real rate is so low. Savers are earning less and are forced to save more. Corporations are using cheap money to buy back their shares rather than invest. Zombie companies that should be out of business are able to stay in business by refinancing at low rates and keeping their excess capacity on line, depressing prices and profits. And on the fiscal side, a significant portion of the government’s budget deficit is financing entitlement programs rather than infrastructure spending. The monetary authorities are enabling the fiscal authorities to do this at very low interest rates. Burdensome taxes and regulations may also be contributing to secular stagnation in the US and around the world.

(4) Fun with econometric models. When reality bites the forecasts of macroeconomists, they don’t curl up in a ball and mutter quietly to themselves in the corner. Instead, they simulate reality with their econometric models and show why they are right after all, at least in their simulated world. In her speech, Yellen acknowledged that a 3% federal funds rate (assuming that it ever gets there again in our lifetime) may not leave enough room to ease during the next average-style recession, based on previous experience.

Not to worry: A recent Fed working paper is reassuring, at least to Yellen. It is by David Reifschneider and titled “Gauging the Ability of the FOMC to Respond to Future Recessions.” Its conclusion is very reminiscent of arguments made by both William Dudley and former Federal Reserve Chair Ben Bernanke for QE2 during November 2010. They both said that the Fed’s econometric model showed that the federal funds rate needed to be lower than zero. But the Fed’s mantra back then and still now is that zero is the “zero bound.” Negative interest rates remain off the table (for now).

Back in 2010, the Fed’s model showed that a negative 0.75% federal funds rate was needed and that it could be accomplished, in effect, with QE2 purchases of $600 billion in Treasury bonds. At the time, I wrote that there was either something wrong with the model or the Fed was trying to fix a problem that couldn’t be fixed with monetary policy. (See our Chronology of Fed’s QE.)

Reifschneider’s latest iteration of this exercise comes up with the same conclusion: If the Fed’s econometric model shows that the federal funds rate should be lowered below zero during the next recession, that can be achieved effectively with another QE move and more forward guidance. Yellen admits that these tools might be pushed to their limits if the federal funds rate gets up only to 2% rather than 3%. In any event, the federal funds rate currently is only 0.25%-0.50%, and may or may not be up to 0.50%-0.75% by the end of this year. As the song goes: “It’s a long way to Tipperary.”

(5) Other options. No wonder that Yellen is reaching out to her staff and other economists for more tools to run monetary policy. Interestingly, in her speech, she didn’t mention negative interest rates. She did mention that QE purchases could be broadened to other assets. Might that include corporate bonds and equities? She didn’t say.

Yellen did mention raising the 2% inflation target, as some economists have advocated. Sorry, I think that’s nutty. The Fed can’t even get it up to 2%; why would Fed officials want to embarrass themselves by raising the bar? She mentioned that fiscal policy could play a role, but stayed clear of suggesting helicopter money.

(6) Unreal rate. Lots of accounts have been asking me to help them understand the neutral rate concept and why Fed officials are suddenly so obsessed with it. Stanley Fischer explained it better than I could in his 8/21 speech:

“And there have been other issues of concern to those particularly interested in monetary and macroeconomic policy, though probably of less explicit concern to the public: The decline in estimates of r*--the neutral interest rate that neither boosts nor slows the economy--which is related to the fear that we are facing a prolonged period of secular stagnation; the associated concerns that (a) the short-term interest rate will be constrained by its effective lower bound a greater percentage of time in the future than in the past, and (b) that the U.S. economy could find itself having to contend at some point with negative interest rates--something that the Fed has no plans to introduce; the fear that very low interest rates present a threat to financial stability; and concerns that low rates of real wage growth are increasing inequality in the distribution of income.”

Is that clear? Well, in any event, I reviewed the relationships between the real federal funds rate (using the current core CPI inflation rate) and the variables mentioned by Yellen as possibly explaining why the real rate is low. I didn’t find much when I compared the real rate to the growth rate of the US working-age population, US productivity growth, the US personal saving rate, and the capacity utilization rate.

Q2 Earnings Review

We at YRI have updated all of our chart publications that track S&P 500 revenues, earnings, and margins with Q2 data. S&P compiles both revenues and reported (unadjusted GAAP) earnings for the S&P 500. The latter peaked at a record high of $27.47 per share during Q3-2014. It then fell 31.9% through Q4-2015. That five-quarter earnings recession coincided with the collapse in oil prices and in the S&P 500 Energy sector’s earnings.

Reported earnings rebounded 24.7% during the first two quarters of this year as the price of a barrel of Brent crude oil rose 33% during the first half of this year, suggesting that the Energy-led earnings recession is over. That’s confirmed by S&P 500 revenues, which was negative on a year-over-year basis from Q1-2015 through Q4-2015, falling by as much as 3.8% y/y during Q2-2015. During Q1 and Q2 of this year, this growth rate was 0.3% and 1.1%. So far, I can’t find too many devils in the details:

(1) Revenues. On an aggregate basis, rather than per-share, revenues growth remained slightly negative during Q2 for the sixth consecutive quarter, at -0.7%. This series is highly correlated with and often identical to the yearly percent change in manufacturing and trade sales, which was down 0.6% during Q2.

One can exclude Energy earnings from aggregate revenues (not per-share). On this basis, revenues rose 2.2% y/y during Q2. Furthermore, the growth in aggregate S&P 500 revenues excluding Energy remained in positive territory throughout the recent earnings recession. The weakest growth registered during this period was 0.2% during Q4-2015, which probably reflected the knock-on effects of the Energy recession on other sectors as well as the significant appreciation of the dollar.

(2) Earnings. Before turning to S&P 500 earnings per share, let’s follow our discussion of aggregate revenues with a discussion of aggregate earnings. The complication is that there are three aggregate measures of earnings that we at YRI track. They are earnings as reported by companies and operating earnings as compiled separately and differently by S&P and Thomson Reuters (TR). S&P derives its measure of operating earnings by excluding items that S&P deems to be non-recurring ones. TR’s composite is based on the operating estimates provided by industry analysts, who tend to be guided by company managements.

I favor the TR approach because I believe that the market reflects the estimates of industry analysts while recognizing their optimistic bias. Again, focusing on the aggregates, I find that TR earnings rose to $254 billion during Q2, only 6.1% below the record high in Q4-2014. Excluding Energy, TR’s aggregate earnings is back at last year’s record high after a brief dip during Q1.

The story is more or less the same for the S&P aggregate operating earnings composite. The bottom line is that excluding Energy, it has been a growth recession rather than an outright recession for earnings.

One can’t do the same kind of analysis for earnings on a per-share basis. In other words, I can’t show you this measure without Energy. However, the TR measure of total S&P 500 operating earnings per share didn’t fall much since mid-2014. It rebounded during Q2 to $29.31 per share, only 4.0% below the record high of $30.54 during Q4-2014.

(3) Margins. Calculating the S&P 500 profit margin using the TR data for earnings per share and the S&P data for revenues per share, I can report that it edged back up to 10.3% during Q2. In other words, it continues to hover in record-high territory around 10%, as it has been since Q1-2014. So far, it has refused to revert back to the proverbial mean, as widely expected by the bears.

(4) Forward aggregates. I track forward earnings, forward revenues, and the implied forward profit margin on a weekly basis; these tend to be good leading indicators of their respective quarterly series. All three have remained relatively flat in record-high territory since mid-2014. Forward earnings and forward revenues seem to be on the verge of achieving new highs. (See our S&P vs. Thomson Reuters.)

During the week of August 11, forward earnings was $127.99 per share. That’s a time-weighted average of analysts’ latest estimate for this year ($117.86) and next year ($134.42). I am using $119 for this year and $129 for next year. I raised my S&P 500 target for next year from 2200-2300 to 2300-2400 on July 20. So far so good, especially if the market is agreeing with me that the earnings recession wasn’t much of a recession and that it is over, in any case.

(5) Leading indicators. By the way, S&P 500 forward earnings isn’t one of the 10 components of the Index of Leading Economic Indicators (LEI), but perhaps it should be. It is highly correlated with the LEI. It tends to lead the Index of Coincident Economic Indicators (CEI). July’s LEI was within 1.3% of the record high during March 2006, while the CEI rose to a new record high last month. There’s certainly no recession in either of these economic indicators.

Record-High Global Production

While the central bankers are increasingly getting most of the credit for the current bull market in stocks, let’s not forget that workers are still going to work and managers are still managing their businesses every day. Central banks have responded to slow global economic growth by flooding the global economy with liquidity. Business managers have responded by working harder to bolster their revenues, to cut their costs, to increase their productivity, to boost their profit margins, and to grow their earnings. A recession is always a good excuse for not doing any of these things beyond slashing costs. In a slow-growing business environment, there are no good excuses for not at least trying to do better.

On a global basis, all these efforts continue to pay off in growth, albeit slow growth. However, it is mostly slow growth to record-high territory. Consider the following:

(1) Global industrial production. Global industrial production (excluding construction) rose 2.0% y/y to a new record high during May. That’s not much growth, but it has a positive sign rather than a negative one, and it is happening in record-high territory.

(2) Advanced vs. emerging economies. I am not as pleased by the industrial production index for advanced economies. It has been flat-lining for the past couple of years roughly 5.5% below its record high during January 2008.

On the other hand, the index for emerging economies jumped 4.2% y/y during May to a new record high. Production is at or near a record high for the following EMs: Indonesia (up 6.4% y/y through June), China (6.0%, July), Poland (6.0%, June), Malaysia (4.6%, June), Czech Republic (4.6%, June), India (2.3%, June), and Mexico (0.3%, June).

Productivity Puzzle

There are lots of questions raised by the weak productivity numbers that were released on Monday. Nonfarm business productivity declined 0.5% (saar) as output (1.2%) increased at a slower pace than hours worked (1.8). That followed an unrevised 0.6% decline during Q1. On a y/y basis, productivity was down 0.4%, the first negative reading in three years. Annual revisions show productivity growth for 2015 was only 0.9% (up from 0.7%), while 2014’s was unrevised at 0.8% and 2013’s edged up 0.3% (up from zero). Those are all pathetic growth rates.

Why are companies hiring so many unproductive workers? Why aren’t they investing more to increase productivity? Why isn’t weak productivity boosting price inflation more? Why are profit margins so high if productivity is so lackluster? Could it be that output is being underestimated? Should high-tech freebies, such as free apps, be reflected in output? If companies are using more automation, robotics, and artificial intelligence, why aren’t these technologies boosting productivity? Might the aging of the Baby Boomers explain the productivity puzzle? Are the Millennials spending too much time playing video games?

The easy answer is that output is being underestimated. The fastest-growing areas of the economy are in services, which are hard to measure. What is the output of a hospital, for example? When I commuted to work on Wall Street from my home on Long Island, I wasted about two hours getting there and back. Now I work at my home office during those two hours thanks to the Amazon Cloud, which has dramatically lowered our IT costs and increased the reliability of our systems, requiring less IT support. Our charts are automatically updated, eliminating the need for lots of grunt work.

On the other hand, productivity in the services economy continues to lag productivity in manufacturing, which has been much easier to automate. That may be starting to change, but most of the employment gains have been in services for many years, and the lackluster pace of productivity may simply reflect that most service industries still rely on workers more than automation to deliver their services.

Another possible explanation is that, from a supply-side, companies are highly productive. The problem is that in a world of secular stagnant demand growth, their unit sales aren’t strong enough to show off their productivity. You may have the most efficient widget factory in the world, but if no one wants widgets, your productivity is zero. Consider the following:

(1) Lots of capacity. There are lots of industries and companies with too much unproductive capacity. Some have expanded too much with the help of cheap credit. Some have been disrupted by competitors using new technologies. I just can’t find too many industries that haven’t spent enough money on plant, equipment, and technology. Indeed, the industrial capacity utilization rate has dropped to 75.4% during June from a recent peak of 78.9% in November 2014. What’s puzzling is that the employment rate (which is the flip side of the official unemployment rate) has risen to 95.1% from 94.2% over this same period.

(2) Productivity cycles. While productivity growth in services has tended to lag behind that in fast-growing manufacturing, the latter is no longer fast growing. Indeed, during the current economic expansion, manufacturing productivity has been almost flat. The official manufacturing productivity data start during 1987. I have constructed a proxy for it that starts much earlier. Focusing on the long cycle in the data, I find that the 60-month growth rate is currently near zero and the weakest on record.

In the past, my manufacturing productivity proxy almost always grew significantly faster than nonfarm business productivity. During the current expansion, the two growth rates have been closer and declining in tandem. Again, it’s hard to believe that manufacturing has lost its productivity mojo. It’s possible, we suppose, that most factories are so productive that they can’t get much more so. More likely is that the demand for their products isn’t growing fast enough to boost their realized productivity. (See our new Productivity Cycles.)

(3) Margin for error. Given all of the above, why is the corporate profit margin still in record-high territory? For now, I have more questions than answers. But stay tuned, I am working on them.