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For the Week Ending March 09, 2018

The financial markets heaved a collective sigh of relief on Thursday when president Trump presented a less strident face to the stiff tariff proposal on steel and aluminum announced last week, exempting imports from Canada and Mexico and indicating that more allies, including Australia, might also be excluded. To be sure, the exemptions come with caveats, as Trump indicated they might only be temporary depending on how Nafta negotiations progress. Ironically, the modest backtracking comes a day after Gary Cohn, who was adamantly opposed to the tariffs, announced his retirement as chief economic advisor to the president.

Even with the modifications the tariffs heighten the risk that protectionist sentiment will spread to other countries and invite retaliatory measures, which could impede global trade and have unintended consequences for the economy as well as the financial markets. This is a saga that will play out over months, if not years, and the potential outcomes will be in a constant state of flux depending on the ebb and flow of measures and countermeasures between the U. S. and its trading partners. The markets viewed the latest twist as a positive omen, if only because it slightly defused what many thought would be a headfirst rush into a mercantilist-type trade war. It remains to be seen how long the conciliatory tone sounded on Thursday persists. While unrelated to trade, the announcement that president Trump agreed to meet with the North Korean leader, Kim Jong Un, sometime this spring to discuss nuclear disarmament also reinforced a sense that foreign affairs may become less combative going forward. Anything that lessens geopolitical tensions is a positive influence in the financial markets.

No doubt, the markets will be buffeted by negative as well as positive news on the trade and geopolitical fronts going forward. But investors received unequivocally good news on the domestic economy this week, fueling another strong leg up in stock prices. On Friday, the Labor Department reported that the economy generated an eye-opening 313 thousand new jobs in February, the strongest monthly increase since October 2016 and well above the roundly 200 thousand consensus forecast. What's more, the total increase for the previous two months was revised up by 54 thousand, lifting the three-month average gain to 242 thousand. That's well ahead of the job-creating pace of last year, which saw an average monthly increase of 182 thousand.

Pacing the gain, construction payrolls leaped by 61 thousand in February, the largest gain in eleven years. While head-spinning, strong demand for construction workers comes as no surprise given the upsurge in housing starts and the hectic pace of renovations and remodeling caused by the horrific winter storms. What is surprising is the ability of builders and contractors to find so many workers in light of the widespread reports of labor shortages in the construction industry. Likewise, the sturdy increase in retail employment in February is also surprising, given the record number of store closings reported by retailers, as consumers are abandoning brick-and-mortar venues in favor of online shopping. Jobs at fulfillment centers continue to increase at a solid pace, but the 50 thousand surge in retail payrolls last month was the largest in two years. After shedding an average of 2.4 thousand workers a month in 2017, retailers boosted payrolls by 65 thousand in January and February.

We suspect that weather patterns played a role in the outsized increase in jobs last month. February was considerably warmer than January, which probably boosted activity and employment in the construction sector. Still, even after allowing for seasonal quirks that inject volatility into the monthly data, the trend in job growth is pointing decidedly higher, which is surprising so late in the business cycle. For some time, economists have underestimated how long job growth can exceed the increase in the labor force without generating the wage inflation typically associated with tight labor markets. That imbalance has been sustained for several years, driving the unemployment rate down to near a post-war low of 4.1 percent. At this point, growth in jobs should be slowing, if only because the economy is running out of available workers. Alternatively, the sustained strong demand for workers in the face of a dwindling supply should be driving up wages, as companies compete more aggressively to fill open positions.

But neither development has taken place. The pace of job growth is picking up, not slowing, and wages are only modestly accelerating. Indeed, one of the more disappointing aspects of an otherwise sterling jobs report is that wages actually took a step back last month. Average hourly earnings for all private-sector workers increased by a paltry 0.1 percent following promising increases of 0.3 percent and 0.4 percent in the previous two months. Hence, the annual pace through February slipped back to 2.6 percent from a 2.8 percent in January and 2.7 percent in December. Nor can the setback be blamed on the mix of job growth last month with, for example, more workers in low-paying sectors garnering a bigger share of the increase. In fact, jobs paying more than the average wage of $26.75 an hour accounted for well over 60 percent of the payroll increase last month.

Clearly the disconnect between the outsized growth in jobs and lackluster wage gains is the most perplexing issue facing the Federal Reserve. With wage inflation remaining in check, there would seem to be little urgency to step up the pace of rate increases. The inflation doves within the Fed have long argued that the low unemployment rate does not truly measure how much slack there is in the job market because of the huge number of people outside of the labor force who could be drawn back in. Their argument got a big boost from the February jobs report, as the labor force participation rate increased 0.3 percent to 63.0 percent after remaining stuck at 62.7 percent for four consecutive months. Simply put, instead of driving up wages, the strong demand for workers is pulling workers off the sidelines, indicating that there is still room to run before the current pace of job growth leads to an overheated job market.

That said, it would be a mistake to overemphasize the pop in the participation rate for a single month. The rate has hit that level twice over the past year, only to slide back in subsequent months. Odds are, there is still a shadow pool of workers outside of the labor force, but that slack is rapidly diminishing. The 4.1 percent unemployment rate may not be the lowest it can go in a noninflationary environment, but the floor is not much below where it is now. We suspect that a few more months of job growth in excess of 200 thousand would easily drive the rate down below 4 percent for the first time since December 2000. For its part, the Fed would most likely react more aggressively once the unemployment rate dips to the 3 ½ -4.0 percent range, even if wage growth lags behind.

Indeed, even the surprising slowdown in wage growth last month does not mean that worker pay is stuck in the mud. For one, blue-collar workers fared better than the their upper-echelon colleagues. Average hourly earnings for production and nonsupervisory workers increased by a more robust 0.3 percent in February compared to the tiny 0.1 percent increase for all private-sector workers. Whereas the annual growth for the latter slowed from 2.8 percent to 2.6 percent in February, it accelerated from 2.4 percent to 2.5 percent for production and nonsupervisory workers. And again, we urge against putting too much stock in one-month changes. Over the past three months, average hourly earnings have increased at a 3.2 percent annual rate, significantly faster than the 2.6 percent 12-month increase.

Put simply, we see upward wage pressures starting to build, albeit modestly, and suspect that the slowdown in February will not derail the expected rate hike by the Fed at its upcoming meeting on March 20-21. Interestingly, the unexpected strength in job growth so far this year flies in the face of what is shaping up to be slower growth in GDP for the first quarter. The bad news implied by this divergence is that the already sluggish productivity growth has slowed even further during the period. When productivity is weak, companies are reluctant to grant workers larger pay raises, which would erode profit margins unless the increases can be passed on to consumers in the form of higher prices. We expect that the relief valve allowing some pass-through of higher labor costs will open wider in coming months, underpinning a gradual rise in inflation towards the Fed's 2 percent target.

Even with the skimpy increase in wages last month, the collective paychecks of workers will get a sizeable boost from the jump in payrolls as well as the increase in hours worked. That combination lifted the proxy measure for wages and salaries by a robust 0.7 percent in February, matching the strongest monthly increase since November 2014. Hence, the torrid pace of job growth is putting more purchasing power into the hands of consumers, setting the stage for a healthy rebound in the economy's growth rate in coming quarters. That, in turn, should keep the Fed on track for at least three rate increases this year; from our lens, it is more likely that four hikes will be put into effect.

Not only are consumers riding a wave optimism from the robust job market, they also continue to benefit from the ever-growing wealth generated by rising stock and property values. Data released by the Federal Reserve this week show that household net worth increased by another $2.1 trillion in the fourth quarter to a record $98.7 trillion. Granted, the wealth bulge is concentrated among upper-income households that own the vast majority of appreciating stocks. While only a small fraction of this increased wealth will find its way into the spending stream, the positive impact is more than trivial, providing additional fuel for the economy's growth engine. All in all, it's been a momentous week for the financial markets. It started off on rocky terrain but ended on a high note, with a less menacing omen on the trade front and a more promising outlook on the geopolitical front. A much better-than-expected jobs report was the icing on the cake that lit a fire under the stock market even as it kept the bond vigilantes at bay.