Things look so bad they can only get better

To judge by the level of Treasury yields, the outlook for the U.S. economy has never been so bad. At 0.2% and 0.9%, respectively, 2- and 5-yr Treasury yields are lower today than they have been at any time during my lifetime. Far lower. Lower even than they were at the end of 2008, when the market was priced to years of deflation, a global depression, the default of as many as half the companies in the country within the next 5 years, and a global financial collapse. Wow.

The only thing that makes sense of these extremely gloom-and-doom yields that we are witnessing today is that the market is pricing in a massive default of European sovereign debt that in turn would result in the collapse of the Eurozone banking industry, and such an implosion might bring down the entire global economy. In other words, we have a market that is essentially priced to an end-of-the-world-as-we-know-it scenario.

In order to reach this grimmest of all possible scenarios, the market is making the dangerous assumption that all the bad things going on are going to get much worse: that Obama and the Democrats are never going to triangulate to a real pro-jobs program, that the Fed is going to print us into oblivion, that the economy is headed straight down, that the PIIGS are never going to veer from their big-spending, big-borrowing path, and that Europe is going to eventually implode.

Can things really be this bad and get even worse? Is there no hope for a turn to the better? Yesterday I read an amazing policy piece put out by the progressive think tank Third Way. In it they propose sweeping tax reforms, most of which make perfect sense, and if implemented would very likely usher in a new wave of economic growth and renewal. Art Laffer might have ghost-written most of the piece for all I know. It's a stunning contribution to good public policy, especially coming from the Left. Today Obama bowed to the reality of a weak economy and asked the EPA to withdraw its new stringent air-quality standards. Ireland has already opted to slash spending; maybe the Greeks will figure out that they have no other choice.

With his popularity plunging, and the economy on the ropes, Obama is being forced to change. I can't imagine that he will not adapt further, eventually supporting pro-growth, pro-business policies. The electorate doesn't like what's been happening. Keynesian stimulus policies have been proven not to work, and next week he simply can't reiterate his calls for more stimulus spending and more unemployment benefits. I've never seen so much political, economic and financial tension in the markets. This is not a long-run equilibrium situation; something has to change for the better, and it can't wait until next year's elections.

August jobs data do not point to a recession

The U.S. economy is not entering a recession just because there were no new jobs created in August. The number reported today that is making headlines is the result of applying seasonal adjustment factors that are often wrong to data that are almost sure to be revised significantly a year or so from now. (Before seasonal adjustment, I note that 118K nonfarm payroll jobs actually were created in August, according to the establishment survey.) You can't jump to huge conclusions based on one or even two months' worth of jobs data—they are just too volatile and always subject to later revision.

Yes, jobs growth appears to have slowed down a bit in recent months. The six-month annualized growth rate of private jobs, according to the establishment survey, has slipped from 2.1% in April to 1.5% in August. But as the chart above shows, the bigger picture is that the economy has managed to create between 2.1 and 2.4 million private sector jobs since the end of 2009, depending on which survey you look at, and to my eye, the trend in both is still upwards. It's not a robust upward trend, since the economy is still struggling and fighting headwinds, but taking into account a range of key indicators (e.g., flat weekly claims, strong factor orders, strong commodity prices, rising C&I Loans, strong corporate profits, a steep yield curve, low swap spreads, rising capital goods orders, consumers' improved financial health, rising industrial production, rising retail sales—all documented in my posts of the past month), I believe that on balance the economy is still making forward progress and is not in danger of sinking into another recession.

I am not saying that the economy is in great shape; I'm just trying to make the point that things are not nearly as bad as the headlines would have you believe. From an investor's point of view, it is not enough to know that the economy is weak—you have to know whether the economy is weaker than the market believes it is. I think there is room for optimism because the market has an exceedingly bearish outlook for the economy (best found in the extremely low level of Treasury yields) that in the fullness of time is likely to be proven wrong.

Manufacturing slows, but still grows

The August ISM manufacturing index slipped a little, but was nevertheless somewhat stronger than expectations (50.6 vs. 48.5). As the chart above shows, at this level the index is consistent with overall GDP growth of about 2%. For most of the recovery to date, the manufacturing sector has been the star performer, but now it too has slowed down, along with the rest of the economy.

But this does not mean we are on the cusp of another recession. The economy has been fighting numerous headwinds this year (e.g., the Japanese tsunami, bad weather, increased regulatory burdens, and the threat of a Eurozone banking system collapse), so forward progress has been slow. However, it's my belief that growth and expansion are the natural state of affairs when it comes to the U.S. economy. It takes an awful lot to stop it or to drag it down to recessionary levels. Left to its own devices, the economy will expand by roughly 3% a year. Given the proper incentives, and given the unusually large amount of idle resources present these days, the economy could easily enjoy 5-6% growth for several years. That the economy is not doing a lot better is the problem, not that it risks slipping into a recession. The notion that slow economic growth is like "stall speed" for an airplane—below which you abruptly lose altitude—is terribly misleading; analogies are not always helpful aids to understanding.

The rather abrupt slowdown in growth this year is reflected in an equally abrupt decline in productivity. After rising at an almost 4% annual rate in the two years ending last December, productivity plunged to -0.7% in the first half of this year. This in turn has meant a sharp increase in unit labor costs, as shown in the chart above. A highly productive labor force contributed to low inflation through the end of last year, but now, weak productivity is contributing to higher inflation via higher unit labor costs. But as the chart also suggests, all of this is fairly typical in the early years of a business cycle expansion, so it is not deeply troubling. Recessions oblige business to drive down costs and increase worker productivity, and most of those gains have now been realized. Going forward, growth will be more a function of new hiring, rather than getting more out of the existing workforce.