Q1 Productivity: Ignore the Quarterly Chop—Trend Favorable for Inflation

Nonfarm labor productivity growth nearly stalled out in the first quarter. Output per hour worked increased at an annualized rate of 0.3%, a sharp slowdown from the prior quarter’s 3.5% rise. Robust hiring and soft real GDP growth over Q1 presaged the outturn.

This is not the first time productivity growth has eased considerably in Q1 and undershot expectations. The pattern follows weaker-than-expected output and stronger-than-expected job growth in the first three months of the year.

These seasonal dynamics have obscured the view of productivity’s sequential growth rates at the turn of the calendar, thus we often look to annual comparisons to gauge the underlying trend. Relative to Q1-2023, labor productivity is up 2.9%, or the strongest annual gain in three years. The year-ago change has steadily ticked higher over the past four quarters, indicating a solid pace of expansion. For context, labor productivity expanded at a 1.5% average annual rate during the 2007-2019 business cycle.

U.S. Department of Labor and Wells Fargo Economics

Amid the softer gain in productivity and another strong quarter for hourly compensation growth (+5.0% annualized), unit labor costs (ULCs) picked up to a 4.7% annualized rate in the first quarter. Unit labor costs can be viewed as the productivity-adjusted cost of labor, making it a useful gauge of the extent to which the nominal pace of compensation growth is problematic (or not) for the Fed’s 2% inflation objective.

While today’s reading is on its own yet another unfriendly print for the Fed’s efforts to corral inflation, the jump is reminiscent of the first quarters of 2022 and 2023 when ULCs also leapt, hinting at the possibility of residual seasonality in both productivity and compensation data.

Taking a slightly longer view shows a less worrying picture. Over the past year, unit labor costs are up 1.8%. Smoothing out the inherent choppiness of this report’s data a little more and looking at the year-ago change in the four-quarter average of ULCs also shows the inflationary pressure coming from labor costs continues to subside. While, overall, labor costs are still making it difficult for inflation to return to 2% on a sustained basis, the improving trend in productivity is supportive of inflation resuming its downward path ahead.

  

Ed Yardeni:

Unit labor costs (ULC) is simply hourly compensation divided by productivity. It is the most important measure of the underlying inflation rate in the labor market and is highly correlated with the CPI inflation rate when both are measured on a y/y basis (chart). ULC inflation was actually down to 1.8% y/y during Q1, suggesting that consumer price inflation could fall to 2.0% in coming months.

Inflation is generally higher than ULC. Headline inflation (used by Ed above) is higher than ULC growth 68% of the times and by 0.3% on average (same median). So +2.1% headline inflation.

Core inflation is higher than ULC 75% of the times since 1958 and by 1.3% on average (same median, see below chart). On that basis, with ULC up 1.8%, the probabilities are that core CPI will be +3.1%.

Core PCE inflation is higher than ULC 62% of the times since 1958 and by 1.2% on average (same median, see below chart). On that basis, with ULC up 1.8%, the probabilities are that core PCE will be +3.0%.

The Treasurys Market Is Getting Squeezed From All Sides Inflation and deficits are lifting yields and jarring the stock market

(…) The government funds spending on Social Security, the military and other areas in part by selling bonds at regular auctions. As Washington has run up larger budget deficits in the wake of the pandemic, those auctions have ballooned, drawing warnings that Wall Street might struggle to absorb the debt.

Few investors fear a failed auction, an unlikely scenario that could potentially trigger prolonged market turmoil. Still, many worry that tepid demand could rattle markets and hurt the economy. Those fears intensified after a series of weak auctions this past month drove Treasury yields higher. Demand improved somewhat at recent auctions. But more outsize issuance is coming soon.

The Treasury Department said Wednesday that it would sell roughly $1 trillion of bonds in total from May to July, keeping its auction sizes steady. The plan maintains an approach started after weak auctions late last year, when Treasury eased market pressures by shifting issuance toward short-term debt. At the time, the Fed also signaled a pivot toward easier monetary policy, with hopes for imminent rate cuts reassuring investors about the strategy.

Now rates might stay higher for some time, and the nonpartisan Congressional Budget Office forecasts the deficit will grow from 5.6% of U.S. gross domestic product to 6.1% in the next decade. Public debt is set to expand to $48 trillion from $28 trillion over that period. Few investors expect either party to push for sharp spending cuts after the November election.

Yields held steady after the Treasury’s announcement Wednesday, with investors saying it was widely expected. But Treasury also said that it likely wouldn’t have to increase auction sizes for “at least the next several quarters,” a longer period than some analysts anticipated. (…)

“In the past, the Fed hiked slowly and cut aggressively, but this time they hiked aggressively and will likely cut gradually,” said Jacobsen. “That isn’t lighting a fire under investors to get out of cash and into longer-term bonds.”

One force that could ease the strain: The Fed on Wednesday also said it would slow the pace at which it is reducing its bondholdings, which it had grown during the pandemic in an attempt to boost the economy. That, on the margin, should reduce pressure on the Treasury to issue bonds to investors because the central bank will need to buy more new Treasurys to keep its holdings from shrinking too quickly as some of its older bonds mature.

Some investors remain skeptical that the recent yield climb is being driven by bigger auctions, greater public spending or the onset of an era of higher interest rates.

Blake Gwinn, head of U.S. rate strategy RBC Capital Markets, said the recent Treasury selloff is rooted more in first-quarter data showing that the labor market remains tight and price pressures persist in parts of the economy.

“I don’t think what we’ve seen postpandemic suggests some new paradigm,” he said. “I think we’re just kind of getting back to normal.”

But, what is normal?

• The first chart plots 10Y Ts minus core inflation (CPI):

• This next chart swaps core CPI with inflation expectations per the Cleveland Fed calculations:

Inside the AI research boom

China leads the U.S. as a top producer of research in more than half of AI‘s hottest fields, according to new data from Georgetown University’s Center for Security and Emerging Technology (CSET) shared first with Axios. (…)

• Roughly 32% of AI research focused on computer vision, which grew 121% in those five years.
• Natural language processing — what large language models (LLMs) do in ChatGPT and other generative AI tools — accounted for another 11% of AI papers and grew 104%.
• Research in robotics grew slower than in vision and natural language processing — by just 54% — and made up about 15% of all AI research.

That tracks with the fact that anecdotally “a lot of the topics open in robotics have proven really hard to fix,” Arnold says. “At the same time, there has been very rapid progress in language tasks, for example.”

• And AI safety research made up just 2% of all research, despite growing 315% between 2017 and 2022.

The top five producers of sheer numbers of AI research papers in the world are Chinese institutions, led by the Chinese Academy of Sciences.

• The dominant narrative for years has been that while Chinese institutions generated the greatest quantity of papers, the quality of those papers wasn’t as high and research in the country largely came from applying fundamental advances made by researchers in the U.S., Europe and elsewhere.
• But when CSET researchers narrowed their analysis to highly cited papers, the Chinese Academy of Sciences was still the leader. Google is second, followed by China’s Tsinghua University, Stanford and then MIT.

At the country level, the U.S. had the top spot in producing highly-cited articles.

“China is absolutely a world leader in AI research, and in many areas, likely the world leader,” Arnold says, adding the country is active across a range of research areas, including increasingly fundamental research.

• The U.S. still has an edge on China in natural language processing. Google and Microsoft were the top organizations in this cluster of research.
• But researchers in China produce more papers on computer vision than other countries in the world. Tsinghua University was the top organization in the world on this topic. China’s strategic priorities for AI include autonomous vehicles, manufacturing, surveillance and other applications that require advances in computer vision.
• India — and three Indian institutions, including Chitkara University —was the top producer of AI applications for plant disease detection.

The data only account for research papers published in English and don’t capture scientific work in other languages. (…)

Data: Emerging Technology Observatory Map of Science. Chart: Axios Visuals

Research on robotics: check this guy out!! https://www.youtube.com/watch?v=AePEcHIIk9s

FED UP?

Jay Powell’s presser:

• It will take longer than originally thought to get the confidence that inflation is returning to 2% on a sustained basis.
• On rents: “The lags are significantly longer than we thought.”
• Omitted that “it will likely be appropriate to begin dialing back policy restraint at some point this year”.
• Policy remains “restrictive” so it is “unlikely” that the FOMC will need to hike again.
• He refused to add the word “sufficiently” to restrictive saying time will tell. “In terms of the peak rate, I think…the data will have to answer that question for us”.
• “Of course we’re not satisfied with 3% inflation, three percent can’t be in a sentence with ‘satisfied.’ ”

March JOLTS: Cooler Turnover and Labor Demand Point to Easing Wage Pressures

Job openings at the end of March fell to 8.49 million, leaving them down 12% over the past year and 30% below their peak in March 2022. At 5.1%, the opening rate has fallen to more than a three-year low. The moderation adds to the latest readings on small business hiring plans—which currently sit at a nearly eight-year low—and Indeed job postings signaling that employers are less interested in bringing on new workers. The number of job openings per unemployed worker in March slipped to 1.32, and while still above the 2019 average of 1.19, demonstrates that labor market continues to gradually loosen. (…)

The hiring rate fell back to 3.5% to match its lowest rate outside the throes of the pandemic since 2014. The lower rate of gross hiring comes as more workers are staying put in their current roles. The quit rate sank to 2.1% in March, its lowest level since the summer of 2020, and remains notably below its pre-pandemic average. With retention significantly improved over the past year and demand for new workers ebbing, we would expect to see employment costs resume their downward trend in the quarters ahead.

On net, the March JOLTS data point to a jobs market that continues to normalize but is far from falling apart. The lower rate of voluntary departures is reducing the need to backfill positions and is thus contributing to the overall reduction in job openings. Openings, however, remain elevated relative to the number of job seekers, and a subdued rate of layoffs suggest businesses are still reluctant to part with workers.

Yet with demand for workers ebbing further and businesses no longer having to scramble as intensely for workers, there are signs that despite Q1’s hot employment cost index reading, labor cost growth should continue to subside as we move further into 2024. The FOMC has made clear it will need to see actual progress on the wage and inflation front before gaining the confidence to ease policy, but the tamer readings on turnover and demand for workers suggests that the underlying downward trend in inflation is unlikely to have gone into reverse.

Indeed postings are down another 3% in April but still 16% above their pre-pandemic level. Total employment is up 3.8% in the meantime.

I don`t know the contribution of small businesses to the above surveys but the latest NFIB surveys revealed a sudden sharp drop in small biz hiring plans:

Gavekal:

Small businesses are a key source of employment in the US. Thus, when owners report a significant decline in hiring plans, as they have done recently, it is an ominous signal that unemployment is set to rise. We cannot rule out the possibility that the same thing might happen this year. Over the last two decades the share of employment represented by small businesses with under 500 employees has dropped below 50% and now stands at about 46%. That remains a sizable chunk of the labor market, but it is no longer dominant. If large businesses continue to hire workers, this effect could more than offset any mild contraction in employment by small businesses.

We are about to test that on Friday. This chart suggests a significant drop in private payrolls growth going forward:

NFIB hiring intentions versus private payrolls changes (000s)

We get the PMI Services at 9:45 Friday, right after the BLS job release. But last week`s flash PMI warned us that a surprise may be coming soon:

Signs of demand weakness impacted hiring plans at companies in the US at the start of the second quarter. A number of survey respondents indicated that they had held off on backfilling positions following the departure of staff. As a result, employment decreased for the first time since June 2020.

The overall reduction in workforce numbers was centered on services, where employment decreased solidly and to the largest extent since mid-2020. In fact, excluding the opening wave of the COVID-19 pandemic, the decline in services staffing levels in April was the most pronounced since the end of 2009. In contrast, manufacturing employment continued to increase modestly.

Recall that service-providing employees represent 86% of all non-farm employment in the U.S.

Slowing quits rate points to cooling wage pressures

Within the [JOLTS] report we focus on the quits rate as that has been the single best guide for the path of labour costs, which are so important for the inflation outlook. It slowed to 2.1% of all workers quitting their jobs to move to a new employer from 2.2% in February, which suggests that the jobs on offer are not particularly enticing, either because of the role or the rate of pay and workers are choosing to stick with what they’ve currently got. It hit 3% in April 2022 at the peak of the job frenzy.

As the chart below shows, it points to a further slowing in the employment cost index (ECI), which was surprisingly strong yesterday. Less turnover in workers means the incentive to pay staff more to retain them is weakening. Consequently, the ECI should soon resume a softening trend given today’s quit rate plus pay rate numbers for jobs website Indeed, the Atlanta Fed wage tracker and today’s ADP wage series which all point to a clear cooling in pay pressures.

Slowing quits rate points to cooling wage pressures

Source: Macrobond, ING

U.S. Manufacturing PMI: New orders down for first time in four months

The seasonally adjusted S&P Global US Manufacturing Purchasing Managers’ Index™ (PMI^®) posted in line with the 50.0 no-change mark in April to point to stable business conditions at the start of the second quarter. The reading was down from 51.9 in March and signaled an end to a three-month sequence of improving operating conditions.

Manufacturing new orders decreased for the first time in four months during April, albeit modestly. Respondents signaled caution among clients and a reluctance to commit to new business amid subdued market conditions. The reduction in total new business was recorded in spite of sustained growth in new export orders. New business from abroad increased for the third month running, but only slightly.

Manufacturing production increased for the third consecutive month, albeit at the slowest pace in this sequence. With new orders down, output was often supported by work on previously received orders.

Work on backlogged orders led to a further depletion of outstanding business, with the latest solid decline the most pronounced since January.

The latest expansion in manufacturing production was supported by a fourth successive month of job creation, with the pace of hiring quickening to the fastest in nine months. According to respondents, the increase in employment reflected the replacement of leavers and positive expectations regarding output requirements in the months ahead.

Indeed, firms remained confident that production will rise over the coming year, in part linked to capacity expansions but also hopes that demand conditions will improve. That said, the reduction in new business in the latest survey period acted to dampen optimism, with sentiment at a five-month low.

While staffing levels were raised over the month, manufacturers scaled back their purchasing activity in response to the reduction in new orders.

The fall in purchasing and a general reluctance to hold excess inventories at a time of declining new orders fed through to a further solid reduction in stocks of purchases, with the pace of depletion the most marked since last November.

On the other hand, stocks of finished goods increased marginally following a fall in March. The reduction in new orders meant that finished products were sometimes kept in stock awaiting sale.

Input costs increased sharply, with the rate of inflation quickening for the second consecutive month. Higher prices for oil and metals were mentioned in particular. The overall rise was much slower than those seen during 2021 and 2022, but the second-highest seen over the past year. Meanwhile, output prices increased solidly, but to the least extent in three months.

This was reflected in yesterday`s ISM release:

Source: Institute for Supply Management and Wells Fargo Economics

Is something finally biting? All 3 construction spenders have stalled or cut spending in recent months. Construction employment keeps rising.

RENTS

While everybody debates on what is market rent and why it is not showing in official data, Invitation Homes Tuesday revealed that “Blended rent growth came in at 4.4% in Q1 which was a 10bp acceleration from 4Q23 and below the 7.1% posted in 1Q24 and compares to the company’s outlook of the high 4s to the low 5s for all of 2024.”

It’s not that “The lags are significantly longer than we thought.” It’s that lease renewals are more than 90% of all leases, there is still a shortage of housing, house prices are up 45% since the pandemic and mortgage rates are north of 7%. Simple supply and demand.

Tiff Macklem says higher interest rates having more bite in Canada than U.S.

Mr. Macklem told the Senate committee on banking, commerce and the economy on Wednesday that he and his team are growing more confident that inflation is on a sustainable path back to 2 per cent. (…)

“The Canadian data and the American data are evolving in a slightly different way,” Mr. Macklem told the Senate committee. “Six months ago, the U.S. economy was getting some pretty good inflation readings, while our inflation was kind of sticky. In the most recent three months, we’ve been getting some more encouraging inflation readings.”

Consumer Price Index inflation in Canada has been slightly under 3 per cent for the past three months, while core measures of inflation have also been trending lower. In the U.S., headline inflation has been running closer to 3.5 per cent while core inflation has been moving up.

“More broadly, our economy has been much weaker than the United States. Monetary policy looks like it’s having more traction in Canada,” he said, pointing to the difference between U.S. and Canadian mortgage markets as one possible explanation.

In Canada, mortgage rates tend to reset every five years, while in the U.S., homebuyers can lock in for much longer terms. Canadians are also carrying much higher levels of household debt, making them more sensitive to rising interest rates. (…)

Around 60 per cent of Canadians with a mortgage have seen their payments reset since the central bank started hiking rates. And so far, the data “don’t tell a story of a high level of stress,” Ms. Rogers said. Mortgage defaults remain at historical lows and the number of households in arrears, while rising, are still roughly in line with prepandemic levels.

The next leg of renewals could be more challenging. The other 40 per cent of homeowners will renew over the next two years, and many who took out mortgages at rock-bottom rates during the height of the COVID-19 pandemic are likely to face large payment jumps.

Ms. Rogers said that both banks and household are taking steps to manage this risk. “What banks are telling us is they are reaching out proactively to those borrowers. And most of them, they are preparing, so there we see people holding larger savings or liquidity buffers.” (…)

Subdued performance of Canada’s manufacturing sector continues in April

The seasonally adjusted S&P Global Canada Manufacturing Purchasing Managers’ Index^TM (PMI^®) signalled another deterioration in operating conditions during April, extending the current downturn to 12 months. However, the rate of contraction was again marginal, with the PMI registering 49.4. That was slightly down on March’s 49.8 and a three-month low.

(…) New orders fell for a fourteenth successive month. Although modest, the decline was the steepest since January amid reports that high prices and soft market demand were weighing on sales. Weak underlying global demand was also reported to have led to a reduction in new export orders during April, extending the current downturn to eight months. The rate of contraction was also marked and the steepest since January.

Manufacturers were understandably reticent when it came to input buying, instead signalling a continued preference to utilise existing inventory wherever possible. Overall, purchasing activity declined for a twenty-first month in a row, though only slightly. Meanwhile, stocks fell again but only modestly and to the weakest degree since January.

In contrast, firms took on additional staff for a third month in a row. The marginal increase in employment reflected efforts to keep on top of workloads (…).

Eurozone production downturn continues to cool in April despite sharper fall in factory orders

The HCOB Eurozone Manufacturing PMI posted in sub-50.0 contraction territory for a twenty-second consecutive month in April. At 45.7, down from 46.1 in March, the headline figure signalled a slightly faster rate of deterioration in euro area manufacturing business conditions.

There remained considerable differences in country-level trends during April. The southern parts of the eurozone continued to perform the strongest, with Greece and Spain registering growth. They were joined by the Netherlands, which saw manufacturing conditions improve for the first time since August 2022. Expansions in these three nations were more than offset by deteriorations elsewhere, however. Germany and Austria were again the worst performers, albeit with declines softening.

April survey data indicated falling manufacturing production in the euro area. However, the rate of decline eased for a second consecutive month to the slowest in a year. A shallower drop in output came despite overall factory orders decreasing at an accelerated pace. The fall in total sales was marked and the sharpest in the year-to-date. April survey data also highlighted a slightly stronger drag from export markets, as new orders from abroad declined at a quicker rate.

In a bid to dampen the adverse impact of lower new order intakes on production, euro area manufacturers made further inroads into their backlogs of work in April. The rate of depletion was sharp overall and marginally faster than that seen in March. Job losses were nevertheless sustained, extending the current period of falling employment that started in June last year. That said, the rate of decline was modest overall and the softest for seven months.

After decelerating in each of the previous five months, April saw the decline in purchasing activity strengthen. Stocks of inputs were also reduced, and to an extent that was slightly stronger than seen on average across the current 15-month period of inventory drawdowns.

For a third month in a row, eurozone goods producers reported shorter lead times on their purchased items. The degree to which vendor performance improved was the most marked in eight months.

Elsewhere, eurozone factory input costs continued to fall in April. There was a marked easing in the rate of decrease, however, with overall input prices falling only marginally and at the softest pace since they started falling in March 2023. Prices charged were reduced for the twelfth consecutive month.

Lastly, eurozone manufacturers turned more positive towards the 12-month outlook for production in April. The overall level of positive sentiment strengthened for a second successive month and was its highest since February 2022.

Europe Takes Radical Steps to Boost Production EU official Thierry Breton wants state spending to support domestic manufacturing to compete with China and the U.S.—a reversal of longtime policy to clamp down on national subsidies

(…) But in March, the bloc unveiled a €1.5 billion plan aimed at buying more of its defense equipment domestically. And when European leaders met soon after for a summit in Brussels, a central topic of their talks was how to boost funding further for the continent’s defense industry, and whether to do that through debt.

The effort for the defense industry is just one example of Europe’s new willingness to break longstanding taboos in a bid to build up domestic businesses. The EU is aiming to keep the continent’s industrial base competitive with the U.S. and China, whose governments are lavishing firms with hefty subsidies. 

At stake is Europe’s manufacturing sector, the bedrock of its economy, which is losing ground in the race to build the industries of the future. Chinese electric-car companies are starting to flood Europe with affordable EVs. Europe’s share of global semiconductor production, critical for high-tech products including cars, is a fraction of that of the U.S. or China. And the U.S. is expected to surpass Europe in production of batteries by 2030, with China far ahead of both. 

Hamstrung by expensive energy, high interest rates and anemic domestic demand, the cradle of the Industrial Revolution risks becoming a museum for rich American and Chinese tourists.

The €100 billion defense fund was proposed by the EU’s internal market commissioner, Thierry Breton, a former tech CEO, theme park developer and French Finance Minister with a strong belief in the power of the state to shape the economy. In recent years, Breton has also helped steer new plans through the EU’s slow-moving bureaucracy to allow European governments to match massive U.S. clean-tech subsidies and to earmark billions in public money for the semiconductor industry. (…)

In the years before the pandemic, the total reported aid governments granted to businesses was in the range of €100 billion to €150 billion a year. (…)

The EU’s share of global manufacturing shrank to around 16% in 2022, the latest year available, from 24% in 2008, while China’s share rose from 14% to 31% over the period, according to World Bank data. (…)

Meanwhile, the U.S. Inflation Reduction Act, which among other things aims to tackle the climate crisis by investing in clean energy manufacturing, is luring international businesses with grants and subsidies worth as much as $1.2 trillion through 2032—about half of EU manufacturers’ entire net annual output. (…)

In March, the European Commission endorsed a plan that was championed by Breton to encourage European governments to move toward buying nearly half their defense equipment domestically, including by encouraging large joint purchases.

Initially, the commission wants to set aside €1.5 billion to give governments a financial incentive for joint procurement and to offer subsidies to help companies produce more.

Officials have said that much more would be needed to prop up domestic production. To fill that gap and support Ukraine in its fight against Russia, some European leaders have called for joint borrowing modeled on the bloc’s roughly €800 billion pandemic recovery plan. For that fund, launched in 2021, the European Commission sells common bonds to international investors to finance public investment across the continent.

Most major powers subsidize their defense industries, but a shift to large-scale funding at the EU level would mark a big change for the bloc. (…)

The rise of Breton, a confidant of French President Emmanuel Macron, coincides with the broader ascendancy of French economic ideas. Having the government intervene to shape companies and the economy, an approach long sneered at by free-market economists as a Parisian obsession with a poor track record of picking corporate winners, is back in vogue. Around the globe, countries are bankrolling new industries, from chip-making to green energy.

Breton pointed to the futility of defending pure pro-market ideals when governments around the world have taken much more active roles in directing economies. “It’s the end of naiveté,” Breton said. “Was Europe naive toward China? Of course, of course, of course.”

China funneled subsidies worth as much as 1.7% of gross domestic product to domestic businesses in 2019, compared with 0.4% of GDP for Germany and the U.S., according to a 2022 report by the Center for Strategic and International Studies, a Washington-based think tank. (…)

Instead of solely focusing on national subsidies, Breton would like the EU to spend more as a bloc. He previously called for a Sovereignty Fund financed by joint borrowing to support the EU’s response to the U.S. Inflation Reduction Act.

The Sovereignty Fund is on the back burner for now, slapped down by Germany and other member states. EU leaders continue to debate how much exactly should go into the defense industry, and some of Breton’s other efforts to favor European companies have been vetoed during the bloc’s internal decision-making process.

Critics say the risk for Europe is that it wastes billions of taxpayer dollars on projects or sectors that don’t become self-sustaining or competitive. That would further undermine the continent’s costly social-welfare model and leave Europeans poorer, not richer. (…)

THE GREATER FOOL GAME

First time I see this chart of market cap divided by M2. Not stupid! Equity values per unit of M2.

Using real M2 would make it even scarier. Inflation has taken away that punch bowl.

“Never argue with a fool, onlookers may not be able to tell the difference.” ― Mark Twain

Thanks for your Twain note John. Loved it.