The week's economic reports

An employment report that showed surprising strength, while continuing to receive criticism of its underlying methodology, highlighted the week's economic data. Stocks and bonds ended with the S&P 500 Index up 1.6 percent to 1,505, now up 6.1 percent for the year, and the yield of the 10-year U.S. Treasury note rose 15 basis points to 4.12 percent.

ISM Manufacturing Index: The broadest measure of manufacturing activity declined for the fifth consecutive month, from 50.9 in October to 50.8 in November, remaining just slightly above the 50 level that separates expansion from contraction. After a rebound earlier in the year that has faded gradually over the last six months, it will be important to watch where this index goes in the months ahead. Despite the declines over the last twenty years, manufacturing is still an important part of the U.S. economy, though certainly not as important as it once was.

Prices paid rose sharply (from 63.0 to 67.5) while production gained (from 49.6 to 51.9) and a lower dollar helped push new export orders higher (from 57.0 to 58.5). The employment index declined (from 52.0 to 47.8) and is now at its lowest level since 2003. Manufacturing employment has been declining slowly but steadily since 2003, after approximately 3 million jobs were lost during 2001 and 2002. Manufacturing employment still stands at roughly 14 million, so it is a declining but still important part of the workforce and jobs in this sector generally pay better than service industry jobs.

Productivity and Labor Costs: Consistent with last week's upward revision to third quarter economic growth, productivity during the third quarter was revised up sharply from an initial annualized rate of 4.9 percent last month to 6.3 percent in the latest report. This follows a 2.2 percent rate during the second quarter and a string of lackluster productivity gains over the last few years. Unit labor costs fell at an annualized rate of 2.0 percent, revised downward from the initial 0.2 percent decline reported last month.

ISM Non-Manufacturing Index: The ISM non-manufacturing index fell from a reading of 55.8 in October to 54.1 in November, led lower by a decline in new orders. Here too, prices paid jumped sharply (from 63.5 to 76.5) as higher energy prices continue to be felt throughout the service sector.

Labor Report: The Labor Department once again reported modest job growth as November payrolls increased by 94,000 after an upwardly revised gain of 170,000 in October and a downwardly revised increase of 44,000 in September. Notably, while the October revision was +4,000, the September revision was quite large at -52,000. On a year-over-year basis, the multi-year downward trend continues, however, despite higher initial claims for unemployment and a slightly dimmer outlook for jobs in consumer confidence surveys, distress in the labor market is largely absent.

In addition to the usual categories showing employment increases - education and health services, leisure and hospitality, and government - other categories posted strong gains in November led by trade (up 34,000) and professional services (up 30,000). As expected, construction (down 24,000) and financial activities (down 20,000) continue to suffer as a result of housing and credit market troubles and manufacturing (down 11,000) continued its long, slow descent.

Average hourly earnings jumped 0.5 percent in November following a downwardly revised gain of 0.1 percent in October and the unemployment rate held steady at 4.7 percent when most analysts were expecting it to move higher. There was a huge rebound in employment indicated in the household survey, reversing the bad news from last month and further confounding those analysts who continue to believe that the job market is much weaker than reported and that this will appear in the labor department data with each monthly news release.

This has been very much of a "slow-motion" deterioration in the labor market, over a period of a few years, that has been complicated by the inherent difficulty in collecting and tabulating such a complex set of statistics. In my view, as a result of a tighter credit, a general pull-back by the consumer, and dwindling tax receipts, things will change rather dramatically in 2008 and job losses will become an important election year issue.

Consumer Sentiment: The Reuters/University of Michigan consumer sentiment index dropped precariously close to the level seen following Hurricane Katrina in 2005, falling from 76.1 in November to an initial reading of 74.5 in December, as high energy prices and deteriorating housing and credit markets continue to take their toll. The final reading for December will be released in two weeks.

Note the distinction in the chart between the late-2005 pattern and the current one, where, the loss of life and property caused by Gulf Coast storms along with soaring energy prices were essentially a three-month "shock to the system" rather than the gradual erosion of confidence as seen throughout 2007.

Expectations for the future, the most important category in this survey, dropped from 66.2 to 63.2 and stands at its lowest level since the early 2003 invasion of Iraq.

One-year inflation expectations continue to rise, from 3.4 percent in November to 3.5 percent in December, consistent with the sharp increase in inflation expectations seen in the Conference Board's Consumer Confidence report last week. Obviously, this is not good news for the Federal Reserve as they look sure to continue cutting short-term interest rates next week just as consumers are really starting to feel rising prices.

Summary: Manufacturing and consumer sentiment continue to decline while the job market remains relatively steady, though far from robust. The employment data is about the last piece of the "economic slowdown" puzzle to fall into place, but month after month, new strength is seen in one service sector category or another, prompting many to rethink the overall strength of the economy and its future prospects.

At this point, it all really depends on the consumer and credit markets - how willing consumers are to continue their borrow-and-spend ways and how willing credit markets are to fund this activity amid rising defaults. Next week's retail sales report may offer new and interesting surprises on this subject.

The Week Ahead: The week ahead will be highlighted by the FOMC meeting on Tuesday and reports on retail sales on Thursday and consumer prices on Friday. Also scheduled for release are pending home sales on Monday, international trade and import/export prices on Wednesday, producer prices on Thursday, and industrial production on Friday.