It was yet another tough week for financial markets with a lot of red ink across the board. Most developed equity markets were down around 3% to 4%. Emerging markets and China-dependent markets overall were down closer to 5%.
A lot of emerging markets' damage occurred on Monday, when a pair of purchasing manager reports out of China was soft. To many of our readers, weakness in the Chinese manufacturing sector is anything but new. Still, the relentless flow of modestly weaker economic data, combined with poorly performing equity markets and the general belief that the Chinese government has lost control of the situation, raised concerns around the world.
Although China is indeed the world's second-largest economy, we believe that investors are overestimating China's impact on world economies, especially developed ones. China is less than 1% of U.S. GDP, 3% of Germany's, and just 6% and 2% of China poster children Australia and Brazil, according to data from Morningstar's Daniel Rohr, CFA, director of our basic materials team.
U.S. bonds were stronger with the 10-year bond yield down to 2.12%, perhaps a safe-haven bet more than anything else. Oil was also soft, down 3% on generally softer news on the world economy. However, most of the generalized commodity indexes were down less than 1%, and we are not quite sure why.
In general, a lot of European economic data was also a lot softer than we may have hoped with weaker-than-expected reports on Germany's manufacturing sector and France's employment. In addition, the European Central Bank reduced its European growth forecast by 0.1% to 1.4%. It also hinted on Thursday that more quantitative easing was a real possibility, which helped ease some of the pain of poor economic performance.
U.S. data was generally but not uniformly strong with the employment report sending mixed signals. Meanwhile, auto sales, monthly spending at 
Costco (COST), and even non-residential all looked stronger than most of us would have guessed. The U.S. consumer is clearly not hitting the panic button, at least not yet.
The employment report was not unusually weak or strong in August, especially given that August employment is incredibly volatile. However, with just 173,000 jobs added, the report missed the consensus of 215,000. Disappointingly, job growth was highly concentrated in health care and government, with declines in many other categories. However, with wage growth at 2.2% year over year, a small increase in hours worked in addition to 2.2% employment growth, the news was not all bad.
Normally a down-the-middle jobs report would be good news, not too strong and not too weak. Unfortunately, the ambivalent report left everyone still confused over what the Fed might do next. If the number had been clearly bad, say fewer than 100,000 jobs added, the market may have cheered as that would have taken away the possibility that the Fed would be raising rates in two weeks' time. And job growth of 300,000 would have proved once and for all that the U.S. was at least partially immune to China, which also may have sent markets higher. The middling result that we got left everyone uncertain about both growth prospects and the Fed's next move. And markets hate uncertainty. They can deal with the actual news, good or bad, but uncertainty can be a real killer.
While the markets continue to fret, we see U.S. economic strength. Leave no doubt, we believe the U.S. economy is stronger than anyone realizes and for the first time in four years, we think there is a real shot that the U.S. could grow faster than 2% to 2.5% in 2015, led by autos, housing and construction in addition to the normally reliable consumer.
August employment report a mixed bag
On the surface, the employment report was a modest disappointment to the market, with the U.S. economy adding 173,000 total non-farm jobs versus earlier expectations of 215,000 jobs. That job total compares with the six-month average of 220,000 and the artificially inflated 249,000 jobs of the previous 12 months. However, the prior two months were revised upward by 44,000.
Although August was no barn-burner, the economy managed to avoid the full brunt of the August jinx. August is the lowest and most revised month in the employment data series. With today's revisions, the total worker employment data was consistent with what everyone had been expecting and the average over the past six months.
There was other good news, too. The unemployment rate dropped surprisingly to 5.1% through a combination of job additions and a slightly smaller work force. The somewhat silly (because of baby boomer retirements) labour force participation rate remained steady for the third month in a row at 62.6%. The year-over-year, averaged data showed more of the same steady-state employment growth of just over 2% that has characterized most of this recovery. The steadiness has occurred despite large month-to-month swings that usually manage to cancel each other out.
Wage rates and hours worked made progress, too
As we always point out, employment gains are usually only half of the story, with gains in the hourly wage and the number of hours worked contributing the other half of total wage income available for spending. On the jumpy month-to-month basis, hourly wage rates were up 0.3%, one of the larger gains this year. Some earlier months of hourly wage data were also boosted, providing further fuel for the consumer.
On a year-over-year basis, the hourly wage has grown just over 2%. However, in an environment where year-over-year inflation has proved to be almost nonexistent, that 2.2% (single month, not averaged) growth goes a long ways. The table below shows the data for the private sector only, the government does not report on hourly wages.
Hours worked managed a small increase, also providing an ever-so-tiny boost. I do caution that the trend has been to have these improvements revised away in subsequent months.
The mix and breadth of the job gains was modestly worrisome
The two big job gainers this month were government (33,000 jobs) and health care and education (62,000). This is great for overall levels of economic activity going forward, but they aren't particularly indicative of underlying economic strength. Plus, the government number, which is the best result for this category in years) was driven primarily from the hiring of teachers.
I am modestly concerned that this large jump is more likely to be a reversible seasonal factor (an earlier start to the school year) than a new hiring boom in education. Some of the more economically sensitive sectors didn't do nearly as well. Manufacturing lost a surprising 17,000 jobs, mining and extraction 10,000 jobs, and construction grew a surprisingly light 3,000 jobs despite some stunningly strong construction numbers elsewhere. Even on the service side the information category disappointed economists with a small decline, while retail added a surprisingly low 11,000 jobs (it usually averages closer to 30,000).
Manufacturing soft, for some surprising reasons
While a lot of economists are chalking up a poor manufacturing sector to a stronger dollar and weak exports, there is a lot more to the story than that. One item we delved into this week with our retail team was job losses in the food manufacturing industry (which hasn't been doing great employment-wise and lost 6,000 of the 17,000 job losses in August). Apparently Americans have been eating out more along with eating healthier by eating less packaged foods. This has been hitting packaged goods companies like Kraft, Kellogg and ConAgra.
And many other weak manufacturing items are soft due to the commodity cycle and weak worldwide demand. Machinery (probably used to process commodities including oil) and fabricated metals have also looked weak, at least in terms of employment.
We are still hopeful that an already strong housing sector will begin to pull more through the manufacturing sector, including lumber, furniture and appliances and remodelling supplies. Therefore, I would not be expecting to see accelerating job losses in manufacturing in the months ahead. In fact I believe that the manufacturing sector could again be adding jobs by the end of the year.
Trade may not be a big hole in the third-quarter GDP report
The overall trade report continues to puzzle us. In a developed world that is growing slowly and a U.S. economy that appears to be accelerating, it is no surprise that export growth is nil, but truly shocking that imports of both petroleum and non-petroleum items continues to erode, at least on a year-over-year basis. Month to month, the deficit fell to US$41.9 billion in July from US$45.2 billion the month before. Exports month to month increased a minuscule 0.4% while imports declined 1%. On a year-to-date basis exports are down 3.3% and imports are down by 2.2%, which makes a little more sense, but not much.
The result is, a strong U.S. dollar and a weak world economy have not wreaked havoc on the trade balance and GDP report as expected. Trade was a net add to the GDP report in the second quarter and could do so again in the third quarter, based on the July report (the July deficit was less than any single month of the second quarter). And a large, but most likely temporary, drop in aircraft and related parts in July should reverse itself in August and September. Though working in the other direction, cell phone imports have been falling sharply, which is likely to reverse as soon as Apple (AAPL) ships its new iPhone in September. Pharmaceutical imports also dipped surprisingly in July and that may not prove to be sustainable, either.
Using our year-over-year metrics and inflation-adjusted data, imports don't look quite as weak, especially when excluding petroleum. Still, year-over-year import growth has slipped from over 7% this spring to just over 4% currently when excluding petroleum-related commodities. Exports are also slipping. I am still clinging to the thought of exports slowing because of commodities and commodity processing equipment, and not a general loss of U.S. competitiveness. The one area on which the dollar is having an impact has been the auto industry, which has seen exports fall by US$4.5 billion while imports have risen by US$12 billion on a year-to-date basis. Booming U.S. demand has managed to hide the net export slide in autos. The shift in manufacturing to Mexico may explain some of the deterioration in the net trade of automobiles.
Auto sales surprisingly strong in August (by Roland Czerniawski)
Automakers reported strong sales figures for August with a seasonally adjusted annual rate, or SAAR, of 17.7 million units, up 2.8% compared with the same month last year. The results were surprisingly good, as last August included Labour Day weekend, while this year the holiday will be included in this September's report. Also, just like August last year, this one had five Sundays, which tends to inflate the month-to-month comparison.
Nonetheless, it is good to see that automakers are doing well, which speaks volumes about the health of the consumers and their ability to spend on big-ticket items despite the recent stock market volatility. So far this year, the SAAR averaged 17.1 million units, while 2014 SAAR average was about 16.8 million. Ford (F) appeared to be the biggest winner in August with 5.7% year-over-year growth, which, according to our auto analyst David Whiston, was the company's best August in nine years. Fiat Chrysler (FCAU) also posted solid results with a 1.7% advance year over year. While those figures are a great representation of consumers' willingness to spend, it is important to highlight that with such high sales numbers, the year-over-year growth rates are bound to diminish. As a result, the additional direct contribution from the auto industry to the GDP will be limited going forward.
Non-residential construction catching fire
We have been purposely neglectful of the monthly report on construction. The data is very late in the economic reporting cycle, frequently revised, hard to interpret, and not a very big portion of GDP to boot (about 5% even when we combine government and private data). On an annual basis the private-sector portion has contributed between 0% and 0.3% to real GDP growth of around 2% for the past three years. That's probably why I have missed the recent surge in construction units. We have been all over the improvement in the residential market but missed this quiet boom in other construction activity.
Certainly some of the winter-related bust has inflated some of the more recent comparisons, though this market is still surprisingly strong. The other good news is that the Architectural Billing Index remains in the mid-50s and near recovery highs, suggesting this boomlet is not over just yet. The ABI indicator is powerful because it is difficult to build a major project without building plans drawn up by architects. Not to belabour the point, but combined public and private, non-residential construction comprises over 5% of GDP. U.S. shipments of goods and services to China comprise less than 1% of GDP.
Limited data due next week: job openings, small business sentiment, and federal budget deficit
After a busy calendar this week, next week's is almost empty. Both the job openings report and the small-business report should help confirm that this week's employment data was nothing to get too worried about. With summer coming to a close, it will be interesting to see if seasonal jobs ending begins to push down the number of job openings. I suspect that openings will remain relatively high--most likely over 5 million openings--for yet another month, although a small decline would not surprise us. We keep hearing of spot shortages in new industries (chefs at restaurants is one of the latest), though a generalized, across-the-board labour shortage hasn't materialized. The JOLTS report, along with the employment and wage section of the small-business report, should give us a feel if recent subdued hiring is a function of finding employees rather than a lack of corporate desire to hire.
Federal budget data has been surprising most analysts in a very good way for many months, with the deficit potentially running 10% below last year's levels, possibly hitting the low-US$400 billion level. Many things have been going right. The list includes more capital gains collections, better employment, interest rates lower than anyone imagined, and even a US$30 billion unexpected bonus from the sales of frequencies to communications carriers.
It seems like we have had such a good run that it may be time for one of those periodic mishaps that bring us back to earth. The usual suspects for problems include Medicare adjustments, defense spending, and student loans. When these turn up, they can be surprisingly large--in the tens of billions of dollars. I don't know anything new, but things have been a little too good for too long. I don't have any particularly insightful forecasts on the August deficit other than it should be smaller than last year's US$129 billion, which was hurt by double sets of payments for some government programs because of a holiday on Sept. 1, 2014, that forced September checks to be mailed in August. August is typically a big month for deficits because there are no quarterly payments due from corporations or individuals, and August is usually the biggest spending month of the year. On the other hand, September is generally the second-highest collections month after April. (September is the last month of the U.S. government's fiscal year.)
