Good News on Inflation and Growth

Recent reports out of the Departments of Commerce and Labor are encouraging for the market. Last week's GDP report and today's report on labor costs and productivity should be construed as good news for the prospects for economic growth and controlled inflation in 2007 in our view. The 3.5% rise in GDP provides a positive backdrop for business while improved productivity may ease concerns about falling profit margins and inflationary pressures - at least for the near term.

Despite some hawkish Fed comments, we don't expect significant changes in interest rates. And, the strong economic growth evident in recent reports will help support solid earnings growth in the corporate sector. Solid earnings growth and stable interest rates are usually a recipe for rising equity prices.

So, for now we're looking for stock market gains for 2007.

Some better news!

Maybe there will be more than just coal in investors' stockings after some fairly positive news on the economic front today.

Labor Department data released today provided some more evidence that inflation is not spiraling out of control. Unit-labor costs were revised much lower in both the second (from +5.4% to -2.4%) and third quarter (+3.8% to +2.3%). As a result, instead of rising at a 5.3% rate over the last twelve months, unit-labor costs were revised down to a reasonable 2.9% annual gain.

Productivity figures were also revised upward to 0.2% from flat in the third quarter as initially reported. While this result was disappointing to some, we would note that the sharp slump in residential construction may be putting undue pressure on the productivity figure given that home builders either can't or won't reduce employment as fast as the decline in construction activity. We suspect that once homebuilding "normalizes" the solid productivity gains in other sectors of the economy will become more of a positive factor.

This is an important and positive report on inflation which significantly reduces the risk of further Fed rate hikes for the foreseeable future in our view. And stable rates should at least be neutral for the stock market.

On another front, the ISM services index rose to 58.9% from 57.1% in October surprising most economists - who had been expecting the index to slip to 55.8%. This is counter to the fall below 50 for last month's manufacturing figure and should assuage some fears that the economy will fall into recession next year.

Bottom line, these results should offer some comfort and joy to investors.

No Productivity Gains in the Third Quarter

The Labor Department released productivity figures for the third quarter and they aren't very encouraging. In fact productivity for the quarter was unchanged and the prior quarter was adjusted downward significantly (read the release here). As we mentioned in a recent post, rising productivity offsets rising employment costs and helps to keep a lid on inflation. So right now, companies are not able to offset rising labor costs with productivity improvements and will either try to raise prices (bad news for inflation) or take a hit to their profit margins (bad news for earnings growth). Either way, this is not a positive for stocks.

For the optimists in the crowd, we observe that the productivity numbers can be a bit flaky as the measurement of output in some sectors is quite difficult. How does one measure the output of the financial sector for example? So wait to early December for the report on nonfinancial productivity before jumping out the window.

Employment Cost Index Up - Bad News for Inflation?

The Labor Department reported today that the Employment Cost Index rose 1% (or more than 4% annualized) in the third quarter and 3.3% for the latest twelve months.

Many, including myself, view the ECI as the "super core" inflation measure since employment is the predominant cost of doing business in our service-based economy. When the ECI runs above the CPI, as it is doing now, it has to raise concerns of further acceleration of the consumer price index as businesses raise prices to offset rising costs. The implications for Fed policy, interest rates and the stock market if the ECI continues to track above the CPI are not positive, in our view.

Before you panic, however, there is another key figure due out later this week - productivity. This measure of output per man-hour is a critical offset to the ECI. Simply put, if productivity grows at least as rapidly as the ECI, the chances of accelerating inflation are lessened and the pressure for the Fed to act is reduced.

Stay tuned!