Joel L. Naroff, Chief Bank Economist
Veronika White, Economist
August 7, 1998
WEEKLY ECONOMIC COMMENTARY
The Sailplaning Stock Market Hits an Air Pocket!
The Week in Review
It has been an amazing bull market. Since January 1995, the Dow Jones and Standard and Poor's stock indices have shot up about 130% and the change from the low point to the mid-July high was about 145%. So why am I pointing this out? Because the markets took a big hit this week and once again, questions were raised about the bulls' staying power. This should not have been that much of a surprise since we have been arguing for months that the economic fundamentals did not support the surge in the markets. But should we be headed out to the woods to see if the slumbering giant has finally decided to emerge from hibernation? Maybe not yet. While earnings growth and market momentum may be waning, the economy continues to perk along in spite of the General Motors strike. Bears tend not to run wild during the growth phase of the business cycle unless a recession is looming or the Fed is out of control. There are no signs that we are headed into a downturn or that the Fed is going to put a halt to the expansion by raising interest rates sharply. That is not to say that fun times are not ahead. Whenever you ride the sailplane, the updrafts can be spectacular while the wrong thermals can cause you to plunge sharply. But the end of the bull market? Sometime, yes. August 1998? Doubtful.
What's bad for GM is bad for the nation. Did anybody win the strike that shut down General Motors? GM lost a couple of billion dollars while the workers lost up to two months of pay. Only time will tell if the battle of the titans accomplished anything, but one thing is clear, the economy lost. When you do not have the product to sell, there is a tendency for consumers to stay away from the store. And boy did people boycott the car lots in July. With GM dealers almost void of hot selling vehicles and with incentives largely gone, it was expected that motor vehicle sales would drop. But a 19.2% decline? Unbelievable.
Once again, the automakers learned the basic lesson of marketing: Cut the price, provide the vehicles and count your money. They did that in May and June and the two month sales pace was second only to the 1986 incentive craze. Vehicles disappeared from show rooms at a 16.1 million units annualized pace in May and an incredible 16.9 million rate in June. So what did consumers do in July for an encore? How about 13.7 million units, the lowest sales rate since August 1993. (See Chart 1.)
Without GM to blame what will happen to the expansion? Strikes come and strikes go and this one is history. So let's get back to the fundamentals. There is some economic softness, but if this is all we get, we will not be hurting too much. In July, nonfarm payrolls rose a pathetic 66,000 on top of a relatively modest 196,000 in June. The economy has been rolling along on the strength of huge increases in jobs and the resultant strong gains in income and spending. But there is still no reason to worry. When you adjust the data for the impact of the GM strike, it is clear that the glory days are not over. Manufacturing payrolls slipped by 29,000 in June and by 176,000 in July, with the motor vehicle and equipment employment collapsing by 111,000. A flat manufacturing sector, though, would have led to an average monthly job gain over the past two months of nearly 235,000, a very solid pace.
Not all of the loss in manufacturing employment can be blamed on the GM strike as Asia is slowing things down. The National Association of Purchasing Management's (NAPM) index slipped to 49.1 in July from 49.6 in June and export orders receded for the seventh consecutive month. But before we get carried away with worrying about Asia, a closer look at the NAPM report shows that the manufacturing sector is not cratering. The new orders index rose in July and ultimately, it will be orders that determine the direction of the manufacturing sector. While the nation's industrial sector may be feeling the pain of the Asian crises, it is not yet ready to enter Chicago Hope.
Meanwhile, back in the non-manufacturing world, conditions seem pretty good. Retailers are not suffering the same way as manufacturers and they reacted to the June surge in household spending by adding 125,000 new workers in July. Except for buying motor vehicles, it does not sound like there was a major cut back in spending to me. Finally, all that demand for housing has paid off as construction employment jumped again.
The motor vehicle sales collapse may lead to some misconceptions about the state of the economy. Durable goods consumption grew at a double digit pace during the first half of this year. That is clearly not going to happen during the second half.
With GM just beginning to ramp up production and with much of that going to 1999 models, the August sales rebound may not be that great. We will not see a repeat of the 0.6% jump in consumption posted in June or the 0.9% rise that occurred in May and July retail sales could be down sharply. Indeed, third quarter consumption could be half, or even less than half the first half of the year's 6% growth rate. General Motors may not be as important for the economy as it was in the 1950s, but when GM sneezes, the rest of the economy does catch at least a mild cold.
That said, it does not mean that we are headed into a downturn. Services constitute more than half of all household spending and boy do we like to pamper ourselves. For example, as anyone trying to plan a late summer trip knows, everything is booked solid. We borrowed from the summer during the spring to buy cars, but the long-term trend for overall spending is still good.
The threat remains the job market. One would have thought that with employment growth slowing, the labor market pressures would ease. Forget it. The labor market is still tight as can be and it is causing the economy problems. First, the inability to find workers is actually causing growth to slow. As the Fed pointed out in its beige book, "Despite the high level of economic activity in recent weeks, many Districts noted that labor shortages, shipping bottlenecks and continued weakness in East Asia were beginning to temper growth." The lack of workers is holding back businesses' ability to expand.
But more critically, wages continue to rise rapidly. In spite of a ton of high paid motor vehicle workers not making any money, the average hourly wage still managed to rise 0.2% in July and for the year, wages have increased 4.2%. The trend in wage pressures is simply up, up, up. (See Chart 2.) Once GM begins producing at peak capacity and the suppliers start seeing their orders jump, job gains will pick up and wage increases could accelerate further.
What does this mean for the stock market? Asia is hurting the U.S., there is no doubt about that, but it is not causing enough of a slowdown to risk sending the economy into recession. Once the trade deficit stops widening, and it will soon, the drag from the foreign sector will turn into a plus. The economy is currently set up to grow solidly in 1999. Once the equity markets recognize this, much of the talk about a bear market will dissipate.
However, the markets still face tremendous challenges. Asia and somewhat more reasonable household spending levels mean that corporate earnings will not be impressive. The price fundamentals are not supportive of surging stock prices since the price/earnings ratios are still high given the earnings prospects. And with wages rising and growth continuing, could a Fed tightening be possible? Why, yes! Thus, if you like the excitement of soaring, or even if you're simply a roller coaster fan, you will love the equity markets, for the volatility is here to stay. But unless the forecast is wrong, an economy that is expanding is not the foundation upon which the bear should become restless.
DATA ALERT: We know about weak retail sales and industrial production, so the key question is "Can productivity overcome the wage increases?" The second quarter numbers should provide us with some insight.
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