Key reports illustrate the economic recovery in the U.S. and Europe

Market Weekly Compass: The recovery picture in the U.S. and Europe became increasingly clear thanks to several key reports issued over the last week.

Last week I laid out a few things to watch in June. Well, several of the reports that I highlighted were released in the last week. Here are some key takeaways:

May’s U.S. jobs report: Keeping an eye on wage growth

As I suspected, U.S. non-farm payrolls growth fell short of expectations, but only modestly. I think of this as a “Goldilocks” type of jobs report: not too hot and not too cold. There were 559,000 jobs created in the U.S. in May — well below the “hot” job creation we saw in March, when 785,000 jobs were added to the economy, but well above the “cold” job creation in April, when only 278,000 jobs were added to the economy.¹ The 5.8% U.S. unemployment rate for May¹ beat expectations, which was positive.

However, one area of concern is wage growth. Average hourly earnings rose 0.5% from April to May, on the heels of a similar month-over-month rise from March to April.¹ This makes sense — even though job creation was concentrated in the typically lower-paying leisure and hospitality sectors of the economy — because there is a high level of job openings in the United States. I am not too concerned about this significant rise in average hourly earnings given that I think it is relatively short-term in nature.

Employers are clearly having difficulty sourcing employees and are therefore having to pay more for them, but I believe that labour shortage is temporary. I expect September will be the first month in which we see a return to a more normal environment for labour given that enhanced unemployment benefits will expire by then (for some states, they will expire even sooner)² and that is when schools are back in session in person, which solves most people’s childcare issues. I also assume that by then, public transportation schedules may have largely returned to normal, and fears of COVID-19 infections will have subsided further as vaccine rates continue to rise and COVID-19 cases continue to fall.

U.S. Federal Reserve Beige Book: The economy is improving

The main takeaways from the Beige Book are no surprise — it’s what we have been hearing for several months now:

The economy is improving moderately, and is expected to accelerate further. The outlook is getting brighter:

“All contacts were optimistic for the rest of 2021 and some revised their forecasts up.

Contacts were optimistic that consumer spending would continue to improve in the coming months thanks to growing vaccination numbers and easing of government-mandated restrictions.

Bankers, accountants, and bankruptcy attorneys continued to report that relatively few problems with bad debt had emerged.

Survivors in the retail and restaurant sectors are reporting strong sales and profits even against 2019 levels. Rising vaccination rates and an anticipated return to “normal” are feeding positive expectations for the remainder of the year”.³

As a result of the improving outlook, businesses may want to hire more employees:

“Staffing levels increased at a relatively steady pace, with two-thirds of Districts reporting modest employment growth over the reporting period and the remainder indicating employment gains were moderate.

Manufacturers described ambitious hiring goals: one planned to hire 10,000 workers and another had open positions equal to more than 10 percent of total staff.

Recent hiring and near-term hiring expectations improved for firms of all sizes; however, large firms reported significantly stronger hiring tendencies”.³

However, greater demand for labour and lower supply is creating wage pressure, although it has been generally temperate thus far:

“Overall wage growth was moderate, and a growing number of firms offered signing bonuses and increased starting wages to attract and retain workers. Contacts expected that labor demand will remain strong, but supply constrained, in the months ahead.

Wage pressures were moderate overall. Wage growth among the large majority of contacts remained below 3 percent on an annualized basis.

Wages continued to rise modestly. The percentage of nonmanufacturing firms reporting higher wage and benefit costs per employee edged above one-third, while the share reporting lower wages remained very low. Prior to the pandemic, the share of firms reporting compensation increases averaged well over one-third. Across all sectors, firms continued to report raising wages and offering signing bonuses, retention bonuses, and referral bonuses to compete for scarce labor resources.

Wage pressure picked up from April through mid-May, and upward pressure was most notable among low- skilled positions. Within this segment, reports of wage increases were more widespread with referral and signing bonuses becoming increasingly more common.

One (staffing) firm reported sharply higher pay rates for selected positions and said that the higher rates reflected a combination of labor scarcity and growing business confidence.”³

However, most of the reasons for labour scarcity are temporary:

“Among the barriers to labor supply, firms cited generous unemployment benefits, childcare responsibilities, and safety concerns.

Many business contacts ranked staffing as a top business concern, especially at the lower end of the wage spectrum, and attributed this to a combination of workers’ health concerns, child-care constraints, and generous unemployment benefits.

Many employers continued to state that expanded unemployment insurance benefits and stimulus payments were keeping would-be workers on the sidelines; others indicated that childcare, transportation issues, and the inability to guarantee hours were key factors in preventing potential workers from seeking employment.

Employers, temp agencies, and workforce development organizations pointed to a number of factors limiting labor supply, including health safety concerns, childcare challenges, cutbacks in public transportation schedules, job search fatigue, and financial support from the government.”³

Labour scarcity isn’t the only issue affecting employers. The other significant headwind is supply chain disruptions:

“Contacts cited two main limits to growth: labor scarcity and supply chain issues.

Contacts reported that continuing supply chain disruptions intensified cost pressures.

Contacts continued to note severe supply chain disruptions impacting most sectors of the economy. Microchip shortages continued to limit current and future production plans, and container shortages continued to disrupt logistics.”³

We will of course follow this situation closely, but I must note that if you told me a year ago that we would have strong economic re-openings and increasing consumer and business optimism — but also suffer from labour shortages and supply chain disruptions — I would have been elated. All in all, these are pretty good problems to have, especially since I expect labour shortages to be relatively temporary for the most part.

I was also hoping that the Beige Book would report widespread capex spending plans from businesses. That didn’t happen, but we did hear from the Chicago Fed, which indicated that such spending has been moderate in its District, and helped illuminate why capex spending hasn’t been more robust:

“Business spending increased moderately in April and early May. Capital expenditures were up moderately, and contacts expected a moderate increase over the next twelve months. Several contacts said that long wait times for equipment were holding back spending”.³

I believe supply chain issues are the key reason that business spending has been tempered. Once those problems have been worked out, I expect increased capex spending in the U.S.

Eurozone data: Strong economic growth is emerging

Purchasing Managers’ Indexes (PMI) show that the eurozone is following in the footsteps of the U.S. with strong economic growth. Composite PMI for the eurozone clocked in at 57.1, and manufacturing PMI was a very strong 63.1.⁴ As Chris Williamson, economist at IHS Markit, explained, “Eurozone manufacturing continues to grow at a rate unprecedented in almost 24 years of survey history, the PMI breaking new records for a third month in a row. Surging output growth adds to signs that the economy is rebounding strongly in the second quarter.”⁴

It wasn’t just the manufacturing sector; the service sector is also on the rise with a PMI of 55.2, a sign of the robust economic re-opening starting in the eurozone.⁵ Williamson described it best: “The eurozone’s vast service sector sprang back into life in May, commencing a solid recovery that looks likely to be sustained throughout the summer.” Individual country PMIs were impressive, with some countries’ manufacturing PMIs hitting multi-year highs. Spain gets honorable mention for its services sector, as its services PMI is at the same level as its manufacturing PMI (59.4).⁵ (In addition to the eurozone figures, we got PMIs for the United Kingdom, which were very impressive: 65.6 for manufacturing and 62.9 for services.⁶)

Now, this is not an entirely rosy picture. As with the U.S., there are supply constraints and difficulty finding enough employees: “A growing area of concern is capacity constraints, both in terms of supplier shortages and difficulties taking on new staff to meet the recent surge in demand. This is leading to a spike in price pressures, which should ease as supply conditions improve, but may remain an area of concern for some months, especially if labour shortages feed through to higher wages.”⁵ As with the U.S., I would expect these challenges to be temporary, but we will need to follow the situation closely.

All in all, it is shaping up to be a strong second quarter in Europe – and an even stronger third quarter as the re-opening progresses.

Eurozone retail sales: April figures fell more than expected

Retail sales for April were disappointing, falling more than expected. Clearly the lockdowns took a very substantial toll. This is not dissimilar to what we saw in Japan, where April retail sales fell 4.5% due to lockdowns.⁷ But in my view, this data point is less important than the PMIs given that the April retail sales figure is akin to looking in the rear view mirror, while the PMI data is looking ahead. The good news is that the future looks brighter than the recent past given the dissipation of lockdowns in the eurozone, underscored by the strength indicated in the surveys.

U.S. Federal Reserve to sell bond assets

One other thing occurred last week that I think is important to mention. The U.S. Federal Reserve (Fed) announced its decision to begin selling off the asset portfolio of one of its emergency lending facilities, the Secondary Market Corporate Credit Facility. There was concern that this would be viewed negatively by investors, who would interpret this as the start of Fed tapering. However, I view this as a non-event.

Keep in mind this facility was launched in the spring of 2020 as part of the Fed’s “triage” in the face of the pandemic; it was intended to provide liquidity for outstanding corporate bonds. However, this facility saw its asset purchases halted by year end by then-U.S. Treasury Secretary Steven Mnuchin. When that happened, the winding down of its portfolio became an inevitable next step, in my estimation. We also have to keep in mind the miniscule size of the facility – think of it as a toy boat and the Fed’s balance sheet as the Queen Mary.  As of April 30, the facility only had $13.8 billion of loans outstanding, including $8.6 billion of corporate bond ETF holdings and $5.2 billion of corporate bonds.⁸

Looking ahead

In the week ahead, I will be paying closest attention to the European Central Bank (ECB) meeting. As I have said before, the eurozone is following in the footsteps of the United States in terms of a strong economic recovery, and so the ECB’s expected timeline to begin tapering will be on the minds of central bank watchers — especially now that eurozone inflation rose above the ECB’s somewhat confusing below-but-close-to 2% target in May.⁹ I should stress that I don’t think the ECB feels any pressure to even talk about talking about tapering, but I will be following closely for any insights on the ECB’s current views. We also want to see if the ECB remains concerned about the euro, given that the March ECB minutes indicated concern about euro strength.¹⁰

Also worth following: Eurozone ZEW Economic Sentiment, China’s Producer Price Index, U.S. Consumer Price Index, and University of Michigan Inflation Expectations among other data points.

In terms of markets, I believe the environment remains supportive of risk assets, although that doesn’t mean we won’t see heightened volatility as the Fed gets closer to talking about tapering and then ultimately tapering. I believe the growing popularity of dividend-paying stocks globally in recent months is a positive development. They have certainly benefited from the outperformance of cyclicals over defensives, but I believe the main catalyst has been investor expectations that dividend cuts are over now that the economic crisis is over, and perhaps some dividend increases are in the offing given the improving economy and corporate earnings. I remain excited about dividends as a complement to a diversified fixed income portfolio in terms of providing yield for investors, especially given that rates are likely to remain relatively low in many parts of the world for some time to come.

1 Source: Bureau of Labor Statistics, June 4, 2021

2 Source: CNET, “Which states are ending unemployment benefits early? The lowdown on $300 bonus checks,”June 6, 2021

3 Source: Federal Reserve Beige Book, June 2, 2021

4 Source: IHS Markit, “Eurozone manufacturing PMI hits record high for third straight month,” June 1, 2021

5 Source: IHS Markit, “IHS Markit Eurozone Composite PMI^® – final data,” June 3, 2021

6 IHS Markit

7 Source: Reuters, “Japan’s April factory output rises on capital goods demand,” May 30, 2021

8 Source: U.S. Federal Reserve, Periodic Report: Update on Outstanding Lending Facilities Authorized by the Board under Section 13(3) of the Federal Reserve Act May 9, 2021

9 Source: Wall Street Journal, “Eurozone Inflation Above Target Sooner Than The ECB Expected,” June 1, 2021

10 Source: European Central Bank, minutes for meeting of March 10-11