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Plop, Plop, Fizz, Fizz, Oh What a Relief It Is

A week of worrying news ended on a high note.

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Monday I was really beginning to sweat, as oil prices reached almost $115 per barrel. On Wednesday, the ISM purchasing managers' report on non-manufacturing companies registered one of the biggest drops in its relatively short history. Then initial unemployment claims spiked on Thursday to a level higher than a year ago. Yikes!

But late-week statistics saved the day. Thursday's same-store retail sales reports came in 2 full percentage points ahead of expectations at an annual 8.5% increase. But much as I loved Thursday's retail sales report, I was left scratching my head about just where the consumer was finding all that extra cash. The answer came from Friday's stunningly strong employment report that showed robust job growth in April. Just as importantly, data for the two previous months were revised upward. From the same report, real wages finally flattened out after a breathtaking fall in the previous two months. The new data and the revisions will likely lead to a meaningful increase in consumer incomes and maybe even the GDP report itself.

Then came the best news of the week. By Friday, it looked like the commodities bubble may have had some of the air let out of it, as oil closed below $100 for the week. That is fantastic news for the economy, because commodities have been the largest contributor to the recent inflationary bubble that had been hurting consumers' attitudes and real wages. 

Strong Employment Report Calls Other Government Reports Into Question
The official employment report for April was stunningly strong, with private sector employment growing by 268,000 people, the best improvement in more than five years. Revisions to past months' data showed that employment growth has been better than most of us thought. Over the last three months, employment growth has made a major step up from the mid-100s to the mid-200s.

 Private Sector Monthly Employment Growth
Week EndingJob Growth
May 201048
June 201065
July 201093
August 2010110
September 2010109
October 2010143
November 2010128
December 2010167
January 2011103
February 2011252
March 2011231
April 2011268
Source: Bureau of Labor Statistics

If one annualizes the April employment figure, it implies employment growth of 2.5%. Given that consumer incomes and spending generally grow slightly faster than employment, the prognosis for accelerating GDP growth in the second quarter is outstanding. In fact, because of revisions from several earlier months, it is increasingly likely that the first-quarter GDP growth rate will have to be revised upward when the next revision is released at the end of month (originally reported as 1.8%).

Hours worked were relatively flat as employers opted for new hires instead of working existing employees harder. My preferred measure of hourly wages, for production and non-supervisory, managed a 0.3% increase before adjusting for inflation. (Even though this is a narrower wage metric, it has a longer track record and seems to lead the other wage metrics.) At that pace, wages didn't lose any more ground to inflation, unlike the previous two months when real wages for the combined months took close to a 2% hit.

As we discussed in this week's video, the employment gains were widespread. Every major category, with the exception of government, showed some improvement. Even the lowly construction sector managed to eke out a small gain. The retail employment growth rate was shockingly good at 57,000 jobs added. In fact, the growth rate was probably too good to be true. In my view, the late Easter holiday held back job growth in March and was additive to growth in April, perhaps to the tune of 20,000 jobs. That adjustment would mean baseline employment growth of around 250,000 for a combined March/April period. Therefore, don't panic when next month comes in at 250,000--it shouldn't be viewed as a decline from the reported 268,000, but a continuation of an ongoing trend of 250,000 jobs per month.

Uptick in Unemployment Rate Not Statistically Meaningful
The unemployment rate also crept up, to 9.0% from 8.8%, unfortunately for the wrong reasons. The deterioration was not a result of an influx of new people seeking jobs. The increase in the rate was due to the fact that the household unemployment survey is based on a different database that showed a less robust job market than the establishment survey. The household unemployment survey has been far stronger than the establishment survey for some time; this month the establishment survey played catch-up. I don't view this month's uptick as anything more than a statistical artifact.

I caution that it will be difficult for the unemployment rate to make much headway until the job-heavy construction market comes back in 2012 or beyond. The math to get to that calculation is straightforward but involves a fair number of assumptions. There are some meaningful ifs here, but if the population rate continues to grow at its current pace (0.77% from 239 million people over age 16 in April), if the labor force participation rate held constant (64.2%), and if job growth remained the same (250,000 per month), the unemployment rate would fall to 7.0% from 9.0% over the next 12 months.


Initial Unemployment Claims Look Awful, but Other Data Disagree
At this point in the recovery, initial unemployment claims aren't always a very meaningful indicator. However, the last three weeks of data have been so bad that I really do need to make a comment. First off, the numbers look bad--really bad. In three weeks we have lost almost a year's worth of improvement in this metric. On the other hand, the Challenger Grey and Christmas layoff report showed month-over-month improvement.

Furthermore, the hiring metric in most of the purchasing managers' reports remains in nicely positive territory. With the exception of companies involved in mergers and a couple of special situations ( Nokia (NOK)), the chatter out of companies seems to be about more hiring and not more layoffs. There's a lot of blather out there about why the numbers might look fishy, including Japanese auto-related issues, the late Easter holiday, processing issues in California a couple of weeks ago, and poorly calculated seasonal adjustment factors in some states. I can't independently evaluate all of these factors, but it seems to me that a few more weeks of observing the data without panicking may be in order, especially in light of this week's impressive jobs report.

Retail Sales Looking Good
As much as we all worry about rising gas and commodity prices, consumers continued to accelerate their spending during the month of April. The headline same-store sales, as reported by the International Council of Shopping Centers, was a stunning 8.5%, compared with their forecast of an already strong 5%-6%. Both the actual and forecast numbers for April were substantially inflated by a late Easter that pushed more sales into April. However, in the chart below it can be seen that even when I average March/April, it looks robust compared with last year.

 Retail Sales Year-Over-Year Percent Change
Total Comparable1. 5.3
Total Less Drugstore2. 6.3
Apparel3. 5.2
Department0. 4.3
Luxury6. 7.2
Discount1. 3.3
Drug- 2.5
Wholesale Clubs5. 11.9
Source: International Council of Shopping Centers

Even though these numbers are not adjusted for inflation, it appears consumers are still clearly in a spending mood. That spending appears to be a little more evenly distributed than in past months, when luxury goods stores crushed discounters. I caution that after the Easter holiday sales typically soften meaningfully the following month. The ICS is forecasting growth of 3%-4% in May compared with April's 8.5%. That's still in the range of recent, non-holiday-related sales growth figures. Recent job growth and declining commodity prices could also help May's sales figures.

Auto Sales Hang In
With supply issues primarily related to Japanese manufacturers and high gas prices, there was some fear that April auto sales might disappoint. However, consumers came through again as April sales results of 13.2 million units (seasonally adjusted annual rate) were not far off February's recovery high (excluding one Cash for Clunkers month) of 13.4 million units. In fact, auto sales have been over 13 million units for three consecutive months. This month's 13.2 million units was the second highest of the recovery, just slightly below February 2011's sales.

Apparently high gasoline prices didn't scare consumers out of dealer showrooms. It appears that those car buyers in general were interested in smaller cars.  GM's (GM) new compact Chevy Cruze sold 25,000 units in April, more than triple the shipments of its predecessor the Cobalt sold last April. Pickup truck sales remained robust, but even here there was some shift from large V8 engines to smaller six-cylinder engines.

The impact of the Japanese earthquake was not really seen in April as dealers had at least some Japanese cars in stock. However, Japanese manufacturers did see slower sales growth in April than their non-Japanese competitors, a trend we expect to intensify in the months ahead.

Purchasing Managers: Manufacturing Looks Great, Services Take a Plunge
The purchasing managers' survey for April remained in strong expansion territory with a reading of 60.4, down only modestly from March's level of 61.2. According to ISM's official correlation statistics, this level is consistent with GDP growth of more than 6%. Though these correlations were formulated when manufacturing was a bigger percentage of the economy, the continued strong stats out of the ISM seem to indicate that there's considerable room for the U.S. economy to grow faster than the measly 1.8% reported in the first quarter. New orders, production, and employment all slipped a bit in April, but all remained above 60 and weren't far off the figures for the prior month. The only really disturbing news out of the manufacturing report was the price paid index, which showed another increase to 85.5 from 85.0.

News on the services side of the economy was not as benign. I found these statistics a bit disturbing as this recovery has been leaning hard on both manufacturing and consumer durable goods. The recovery in services has been anemic (though the first quarter looked a little better), which is unfortunate because it represents a much larger portion of the economy.

The ISM non-manufacturing index fell to an eight-month low of 52.7, down sharply from 57.3 the prior month. New orders took a particularly big hit, falling to 52.7 from 64.1. About the only good news here is that the prices-paid index dropped to 70.1 from 72.1, indicating a fallback in price pressures on the services side of the equation. The anecdotal comments portion of the report focused almost exclusively on the potential effects of rising gasoline prices. Other than those comments, the remarks didn't seem nearly as negative as the headline numbers suggested.

I took some solace in April's employment report, which showed better growth in the services sector than in the previous month. The employment data below seem to indicate there may be a problem with this month's rotten ISM non-manufacturing report.

 Service Sector Monthly Employment Growth
 Job Growth
May 201047
June 201065
July 201065
August 2010111
September 2010115
October 2010142
November 2010120
December 2010163
January 201156
February 2011180
March 2011194
April 2011224
Source: Bureau of Labor Statistics

Inflation, Next Week's Big News
While this week's commodities rout might take a little air out of the inflationary bubble, the move comes too late to have any impact on April's consumer and producer price indexes, which will be reported at the end of next week. Expectations are for the more volatile PPI to be 0.8%, just up a touch from March's 0.7% and well off the year's high of 1.6% in February. Expectations are for the CPI to moderate some, from 0.5% in March to 0.4% in April. More important than the headline number is ripping apart the report to see how broadly inflation has spread beyond commodities and energy. Stay tuned.

Inflation Will Be Up but Won't Reach Critical Mass to Blow Up the Economy
While inflation continues to scare me, I believe the economy can sustain another few months of higher prices before the collapse of the economy becomes a forgone conclusion. Looking at past recessions, it looks as though it takes year-over-year inflation somewhere between 4% and 5% to push the economy over the edge into recession. Even with a monthly reading of 0.4% in April, the headline year-over-year inflation rate will still be around 3%, and it will take two or three months of 0.4% monthly inflation growth to push the annual rate past the critical 4% level. Although I confess that this analysis is a bit simplistic, the data support the fact that inflation needs a pretty big bump to really scare consumers, and sometimes that required bump can be large as it was in the 1970s and 1980s.

My simplistic analysis does miss the possibility that higher interest rates and not inflation is what kills recoveries. Inflation and interest generally go hand in hand, so finding the correct cause is a bit of a moot issue. However, this time with the Fed promising to hold rates low for the indefinite future, it becomes more critical to determine the root cause of a collapsing economy. If the root cause is interest rates, the next recession is probably a long way off given recent Fed statements. If it is inflation, we still have a few more months of watchful waiting, but then the economy could begin to weaken. The clock is ticking.

Will the Comprehensive Retail Sales Report Surprise on the Upside?
Based on this week's ebullient same-store sales report and respectable auto sales reports, the official retail spending report for next week should look pretty good; growth of 0.8% is well within the realm of possibilities. But again the devil is in the details of these reports.

My key question will be whether restaurant sales managed to hold up in the face of higher gas prices. Department store sales and auto sales have done far better than I would have expected in a high energy price environment. Something has to give somewhere, and I suspect restaurant sales might be one area that remains vulnerable. 

It will also be interesting to see whether higher gas prices continue to drive online sales at the expense of brick-and-mortar stores. Additionally, grocery store sales took a surprising hit last month for a category that isn't supposed to move much. I would either expect a revision to last month's number or a really big number for this month--maybe both.

See More Articles by Robert Johnson

Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.