2nd Quarter 2004: The Three Faces of Jobs

Second Quarter 2004
Market Commentary

The Three Faces of Jobs

Now that the economy seems to be responding favorably (albeit with plenty of stimulus ), the mindset of the market has been riveted to the one area of the economy, which up to now, has been a laggard for the past three years. That area has been jobs, which over the past 2 ½ years have been continually slumping, until its sudden resurgence over the past six months.

This report will attempt to examine the recent reports on jobs and job growth, along with a review of the different methods of collecting job data, and a look at how and why outsourcing has become such a critical issue in the overall discussion on jobs. We felt it important to address these issues because, increasingly, jobs and job growth are becoming the most watched domestic economic indicator, and as it goes, so goes the market.

Historically, job growth has been linked with economic growth; and America has always been a land where anyone wanting a job and willing to work, would find a job. Indeed, the strength of our economy depends upon a strong, well-educated, and talented labor force.

In order to determine the health of the job market, economists rely on monthly data and statistics from the US Department of Labor. The primary report for this information is what the government calls the Establishment Survey. This report samples the hiring and firing statistics of 1,000 large industrial companies. For some time, this report has produced a string of decidedly negative numbers, with close to 2.5 million jobs lost between the beginning of 2000 until August of 2003. Since then, we have witnessed a slow but steady recovery. The fourth quarter of 2003, which was really the turning point for job creation, began to show net positive job growth. Recently, however, reports from this survey have topped expectations, with over 300,000 new
Jobs being created in March alone. Add to that upward revisions of previously reported numbers in January and February, and the first quarter total now exceeds over 500,000 jobs.

Moreover, the trend is accelerating, and some economists believe this could promise to be the last piece to be in place for a solid economy recovery.

Interestingly, there is a second "face" of jobs, a report also put out by the Labor Department called the Household Survey. This survey conducts a monthly random sample of 60,000 households, as to whether they have jobs or are looking for one. The jobless recovery picture uses the Household Survey for calculating the unemployment rate, but uses the Establishment Survey for the number of jobs created.

Neither report measures people who have given up looking for a job, and who thus have been statistically excluded from unemployment numbers. In addition, either/or both reports may be skewed by young adults leaving the work force to go back to school, or women resigning jobs for maternity leave. Having said that, the jobs report from the Household Survey has been substantially better than the Establishment Report; in that its figures show net job additions of over 400 thousand since the beginning of 2001. These additions are exclusive of the Establishment Survey, which only samples job changes at larger companies. On the one hand, it may be more indicative of what is really happening than the larger report, as small business has traditionally been the engine of growth for America. On the other hand, corresponding incomes are not correlated; thus many of the later reports of the Household Survey could well be lower paying jobs. Nevertheless, the Household Survey falls under the official radar screen, and is

used only for the unemployment rate, but neglected insofar as the total number of jobs are concerned.

Complicating this picture is yet another "face" of jobs, and one that is likely to be the most contentious in this highly charged election year. What we are referring to is "outsourcing," or the practice of firing US employees here, then having the same job done oversees by foreigners at a much cheaper cost. This phenomenon is met with both positive and negative responses.

Outsourcing is really a subset of global trade. Global trade has been building for a long time, and is generally accepted as a positive economic development for all countries involved. This opinion, in essence, builds from the idea that if something can be produced more cheaply abroad, then we're better off importing it than producing it at home. Economists call this the "law of comparative advantage."

A number of leading economists, including Gregory Mankew, the Chairman of the Council of Economic Advisers, along with Federal Reserve Governor Ben Bernanke, and Treasury Secretary John Snow have endorsed outsourcing as an essential ingredient to free trade.

The Information Technology Association of America, which represents hi-tech companies, whose numbers have been among the most aggressive in outsourcing, and where job losses are among the greatest, also favors outsourcing. Their position is that the United States runs a large trade surplus in information technology services3, and that outsourcing contributes to that. From the point of view of corporations who can produce the same goods overseas at a cheaper price than they can at home, outsourcing has many benefits. It leads to higher profits, which over the longer term, will increase savings, which in turn will induce capital investment, and which in turn will create jobs.

The cycle of investment mentioned above can be a long cycle, and can be interrupted by a number of events; such as a recession, which slows investment, or Federal Reserve Monetary Policy, which often leads to higher interest rates, and/or a contraction in the money supply. Either of these aforementioned actions stretches out the unemployment cycle for those out of work. So before corporate profits and productivity can lead to the creation of new jobs, the
period of time for this to happen can become extended and costly. Lou Dobbs, host of one of America's foremost business news programs (CNN), has emphasized the above points, and taken a decidedly negative view of this issue. He sees outsourcing as an impediment to US economic growth.

The State of Ohio, which is right square in the middle of the Rust belt, is among the most afflicted areas of outsourcing. At present count, over 200,000 employees in Ohio have lost their jobs, and are unsympathetic to arguments that they are better off for it. As a consequence, Ohio
also boasts one of the higher unemployment rates in the country, and is likely to be a real political battleground as the fall elections draw near.

Moreover, one of the assumptions underlying the theory behind outsourcing is that retraining is available for those out of work; and that the Federal Government will help finance that. Unfortunately, many of the same voices calling for increased global trade (which contains outsourcing as an important ingredient), are also ones who vote against government involvement with the retraining. Its also suffice to say that many of the workers laid off from assembly lines in the auto, steel or rubber industries may not be trainable in some of the new technologies where job growth exists.

So, from the perspective of labor in general, many see outsourcing as a serious threat to their livelihood, whether or not their jobs are in jeopardy. Sometimes the perception is worse than the reality. Nevertheless, the perception is very real, and there are enough horror stories out there among the workers to quite probably make this the number one issue in this year's election.

As an example of this, we point to the Investor Business Daily (April 7th, 2004) IBD/TIPP Economic Optimism Index, which has a good track record of foreshadowing the confidence indicators put out later each month by the University of Michigan and the Conference Board. We found it interesting to note that even on the heels of the strong 300,000 plus job figure, this TIPP Survey indicated that "while most Americans continue to be very optimistic, in about 30%
of households, someone has either lost a job, or fear they might lose a job in the next 12 months."

Our Thoughts:
Our view is that outsourcing is essentially a subset of not only global trade, but globalism. We are all in favor of global trade as long as it's a level playing field. The United States has a long history of trading with Great Britain and the other European countries, and for many years, it has paid big dividends on both sides of the Atlantic. These arrangements for the most part have been with developed countries, who have similar laws and guidelines with respect to labor, healthcare and the environment. That is a level playing field.

In recent years, however, various trade agreements (such as NAFTA) with less developed countries have sharply increased trade with the third world. Mexico, for example, has little or no unions, no health benefits, no minimum wage, no environmental restrictions, no retirement benefits, no workers compensation, and no trial lawyers. This is not a level playing field. China is even worse. They have essentially become a subcontractor to the Western world, and have done it so well that we're now running a $120 billion annual trade deficit with China.

We wonder to what extent is our trade with Mexico a political response to our immigration problem? To what extent is our trade with China a reflection on the long term potential of
1.2 plus billion people coming into the modern world, representing a huge market for global business? Thus we see a lot of moving parts to this discussion, which may or may not directly involve jobs.

The recent supermarket strike in Southern California, which threw tens of thousands of employees out of work, was really a reflection on this phenomenon. The reality is that Krogers

(Ralphs) and Vons (Safeway) are losing market share vs. Wal Mart and Costco. Wal Mart is non-unionized and as such, has become a focal point for those opposed to globalism. Wal Mart
used to only buy American; but in recent years they have scanned the world to relentlessly push down prices and offer goods produced overseas at these lower prices; goods produced without any of the peripheral benefits offered to employees here. Yet, it was our own government that mandated most of the attendant costs that have pushed many companies to go overseas in the first place.

A microcosm of the same issues can be seen here in California. Our workers compensation costs, just to hit on one issue, are approximately three times the national average, and have forced hundreds of companies to leave California for better pastures, such as North Carolina and even Arizona. So where does it start, and where does it end?

The Federal Government tried to respond to the steel industry on the issue of outsourcing by putting tariffs on Japanese, Chinese and Russian steel. All were reportedly dumping their steel onto our markets below cost in order to cover their fixed costs and earn a contribution margin to keep their labor employed and their factories running. The roar of complaints against this action forced the US to rescind this tariff. The World Trade Organization (an outgrowth of the old General Agreement on tariffs and trades) opposed this action because it violated their regulations, to which we are a signatory. Domestic steel users also cried wolf, because they contended that paying United States prices for domestically produced steel would cause them to go out of business, along with many of their customers; some of which were major corporations such as the autos who employed more people than the steel industry. Thus, in a globally integrated economy, it's hard to protect one industry at the expense of another industry.

Our bottom line is that we are a strong believer in the United States economy and the free market. Our corporations are the best managed in the world, and their business goals are to grow, and to produce the best products at the lowest cost. Capitalism and our way of life has produced the best standard of living for any people in history. There are bound to be ups and downs in our economy as we progress into the future; just as there are in the stock (and bond)

markets. There are also a lot of forces within our government and without, such as bilateral agreements and central banks (G7), that are trying to stabilize the situation. We say let the free
market decide how far and how fast globalism will develop. After all, if we don't like what is happening, we can always stop purchasing imported goods. We intend to continue monitoring this situation, and will give periodic updates on our thoughts as they develop.

The Economy
Meanwhile, the economy is moving ahead on all fronts, so much so, in fact, that we are now beginning to hear some Wall Street concerns that the economy is rebounding too quickly; and some economists and bankers are calling for the Federal Reserve to revisit their stance on keeping interest rates at a 45 year low. As mentioned previously, we agree that interest rates will rise; but we do not foresee any sharp increase in the near future.

The economic outlook is positive. Recent reports by Kiplinger4 look for GDP growth of 4% in 2004; along with a modest jump in 10 yr treasury rates to 4.8% by year-end. Note (They are currently trading at 4.3%, up form 3.75% just two weeks ago).

Earnings reports look positive. Corporate profits in the 4th quarter of 2003 rose at the fastest pace in nearly 20 years,5 (up 29%), and analysts look for further growth once 1st quarter numbers are reported. With almost 20% of S&P companies now having reported, over 70% have exceeded analyst expectations; and First Call consensus in the aggregate is for additional 20% growth, in the 1st quarter along with strong top line performance.

Finally, we look for job growth to continue, but at a lower rate. In a strong economy, Wall Street expects 200 thousand new jobs per month. Higher job numbers will accelerate the call to raise interest rates, which could hurt the market at this point; lower numbers (as long as they are positive) will probably cause the stock market to rally - as under those conditions, fears of impending interest rate hikes will be contained. Jobs are likely to become a bigger and bigger

issue, but we believe jobs have turned for the better; and being a lagging indicator, are likely to improve further.

Bottom line - Absent any terrorist attacks, we see relatively smooth sailing for the next few months, but within the context of a continued choppy market. (See below). For the time being, concerns that we issued in our last commentary6 such as our growing budget and trade deficits will be contained.

Finally, any discussion on the market would be remiss without an update on Iraq. Fortunately, or unfortunately, all we know is what we read in the papers, or see on TV. What we will say is that this is the tail that wags the dog - and depending on how and when we resolve this issue will largely impact the future direction of our financial markets. Because of the uncertainty surrounding Iraq, the June 30 deadline for turning over control of the country to a governing council, and the continued death toll of our soldiers; we have to conclude that we will be in a choppy market until a clearer picture emerges from the Middle East.

So in our view, the economy heads north and will prosper; and corporate profitability will rise. Debt levels and trade imbalances will be contained for the time being. News from Iraq however, may well offset positive economic news and any major increase in hostilities will cause the market to go down. On the plus side, any positive news from Iraq would reinforce the positive economic news we're seeing and could lead to a strong upsurge in the market.

Best regards.


Bill Schnieders
Jim Schnieders, CFA
*Please call the office at 626-584-6168 for a copy of the graphs.

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