-- The following article was written by Real Money Guest Contributor Marco Mazzocco CFA.
The expression "it's always darkest before the dawn" captures perfectly what happened in markets last week. As we headed into Friday morning, markets were reeling again from a further drop in oil and more angst over Chinese capital markets.
At 8:30 am we got the best piece of news we could have gotten, and that was a very strong December nonfarm payroll report. The headline number of 292,000 jobs added was a surprise to even the most bullish of forecasters. In fact, the average gain since the economy stopped losing jobs in September 2010 is 205,500, so you can see how strong the December number really is. Some people will argue that it was on the weak side, but I don't believe that's the case. The issue with wage growth data is that it is subject to demographic factors that are skewing it to the low side. Higher paid, older workers are leaving the workforce while lower paid, younger workers enter it. This is a structural issue and not a cyclical one, so regardless of Fed policy wages will look low, even though the labor market is tight. This Baby Boomer Effect is also what is driving the drop in the labor force participation rate, as demonstrated in this WSJ article. All this said, we should be celebrating the December NFP report because it's showing continued growth in the most important sector, private service-providing jobs (PSP).
That brings me to the crux of this, which is the importance of the services-based economy. Using the December payroll data, we see that PSP jobs account for 71% of total nonfarm payroll employment and were also 79% of the month's gain. Unfortunately, the broad services sector is often described in the financial media as comprising low-skilled, low-paying jobs when it actually includes some of the highest-skilled and highest-paying ones. The PSP jobs spectrum includes computer hardware engineers, programmers, electrical and mechanical engineers, medical professionals, scientists, accountants, lawyers, architects, advertising agents, commercial drivers, CEOs and your local custodial arts person. So let's take a look at where the earnings power is really coming from in the overall labor force.
In the below table, I have compiled the actual earnings generated by different sectors of the labor force.
Three major points to take away from the table above:
- Four of the top five earning sectors are in PSP
- Oil, gas and mining employment make up less than 1% of earnings
- While food services jobs have grown, they are still a small part of total earnings
Quite often I hear the argument that good, high-paying manufacturing jobs are being replaced by bad low-paying services jobs like bartenders and waiters. This type of analysis is not only lacking in substance, but is also derogatory to a whole industry that works very hard. If anything, the growth in bartenders and waiters should be welcomed as a sign of people having the discretionary income to create demand for additional wait staff. Not to mention, it shows that people are going out and enjoying themselves, which is not recession-type behavior. With that said, let's compare the growth trends between professional and technical services (PTS) and manufacturing. Notice from the table above that PTS are already out-earning manufacturing jobs while its labor force size is growing.
Now that we have established the significance of services employment, the question becomes how the services economy is doing. The answer: just fine.
** All IS- related data is taken from ISM directly. https://www.instituteforsupplymanagement.org/
On Wednesday, we got the release of the Non-Manufacturing ISM report, or NMI. The NMI is the best gauge of the services economy out there. It is sponsored by the Institute for Supply Management (ISM), which was founded in 1915 and works in more than 90 countries. The NMI index itself goes back to 1997 and includes all the sectors that make up the private service-providing supersector in the NFP report. The December NMI came in well in expansionary territory at 55.3 (great than 50 equals expansion) and also above its lifetime history average of 54.2. ISM compiles 10 indices for the NMI report, but only four are used in equal weights for the NMI.
The first three (business activity, new orders, and employment) are all straightforward. But supplier deliveries needs a second look. The logic behind the inclusion of SD times is that if suppliers are busy, delivery times get longer. But we know that there have been great advances made in logistics in the last few years and that companies are focused on speeding up all aspects of a business. For that reason, I'm a bit suspect of the relevance of the SD index. It also happens to be that in December, the SD component was the only drag on the NMI. Without SD, the NMI would have been 57.5. That said, business activity, new orders and employment are very clear cut business indicators and deserve a greater weighting, in my opinion, but I'll let the readers decide that for themselves.
Also in the NMI report, we had a nice uptick in the employment index that meshed well with the increase in PSP jobs from December's NFP report. I think NMI data will become much more of a focus as a tool to help predict NFP data given the significance of PSP jobs in the total labor force. Also of note in the NMI data was a jump in new export orders to 53.5 from 49.5, bringing the index back into expansionary territory. All in all, the December report is a solid reading and shows a healthy services economy.
Also covering the services economy is Markit Economics. Markit puts out a flash (initial) and final services reading each month. The Markit PMI services data only goes back to 2009, so it's a bit limited for analysis in comparison to the ISM NMI. This month's PMI came in at 54.3 vs. 56.1 in November and also below its lifetime average of 55.8. A bright spot in the report was that employment grew in December as well. The moral of the story here is that both the NMI and PMI reports show a healthy services economy. We'll have to wait till next month to see if they decline again, in which case we may have cause for concern. Just remember, anything over 50 is good.
Manufacturing
I would be remiss not to mention the manufacturing side of things, having written so much about non-manufacturing. Unfortunately, there is nothing great to report here. The Manufacturing ISM index is in contraction at 48.2 while the Markit Manufacturing PMI is almost in contraction at just 51.2. It's no mystery that the shift towards the more sustainable and consistent services-based economy has taken its toll on the manufacturing industry. The strong dollar, which makes our exports less competitive, only adds to the misery. But it's interesting to note that new export orders moved up into expansionary territory in both ISM reports. This is a testament to the fact that the U.S. is the best game in town for certain goods like aircraft, industrial supplies/services and various types of engines. To be realistic, I'm just not expecting much out of manufacturing and any uptick will be an added bonus. This is not to say that manufacturing doesn't matter anymore, but it will play less and less of a role in our economy.
Prospect Theory
In behavioral finance, prospect theory (PT) deals with how emotions interact with decision-making. PT looks at how people tend to overestimate low probability events (China implosion) and underestimate the high-probability ones (continued economic expansion). It is this behavior that is helping to fuel the wild swings in markets today, but, at the same time, is also creating great opportunity. It's times like now when investors with a steady hand and common sense can take advantage of the volatility. The key is to look at the major drivers of market volatility and assess the relevance of their impact. First, we have the China situation. Believe it or not, the PBoC does actually have a plan for the Renminbi devaluation. The end game of that plan will be a freely floating currency. China is not looking to have a currency war to stimulate its exports, as they have clearly stated the intent to transition to a services-based economy. The problem here is that the road to a freely-floating currency and a services-based economy will be a very bumpy one. The good news is that China has the political and, more importantly, the financial power to overcome any issues that may come their way.
Secondly, there is oil. I am a firm believer that low oil is a great benefit for developed markets like the U.S. and Europe. Consumption is the key to driving our economy. The more money folks have in their pockets from not spending it on gas and heating bills, the more consumption there will be. Now, the downside of low oil is that there will certainly be some bankruptcies in the U.S. energy credit space, but it will be limited. Already, we've had professional credit guys talking about the opportunities arising from the problems in energy-related debt. As for the collapse in oil causing contagion across the high yield credit market, investors there have also come in to sift through the rubble for unfairly beat up credits. So we see that as the overreactions occur, investors are coming in to take advantage of them. The key is to stay focused on the actual data and not to get caught up in the financial media frenzy of constant impending doom. This way, when the dawn breaks, you'll be in the best position to capitalize on it.
