Highly Productive Service Sector Drives US Economy

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Volume 2, Number 27

July 8, 2005


Market participants have been reluctant to acknowledge that manufacturing

activity has ceased to be a good leading indicator of overall US economic

growth. Instead, they should watch service-sector activity. Job growth as


measured in the 5% unemployment rate indicates that our forecast of 4%

growth for 2005 is intact, as is quiescent inflation and low short- and long-term
interest rates.


Highly Productive Service Sector Drives US Economy
Once again, its been another zigzag week for the US financial markets, as market participants try
to grapple with the reality of an economy whose manufacturing sector has moderated and whose
service sector is taking off. This is the nature of the once again newly restructured US economy,
which in this first decade of the new millennium, in the post-bubble environment, is stronger than
ever, buffeted by the winds of ever greater productivi ty and more wealth creation. What a glorious
environment to live in ٢& assuming one can accept little job security, portable pensions and
healthcare benefits, long hours, and constant change. This is the nature of work in the 21st
century. Of course, some will say that only highly skilled white-collar workers are benefiting in this
environment, but this is only partly true. Of course, the more education workers have, the more
likely they’ll garner a higher status and presumably a higher salary. However, these workers are
now just as likely (if not more so) to lose their jobs due to outsourcing, insourcing, or downsizing.
Lifetime employment does not exist, not even in the public sector.
The more service-sector growth and job creation, the more
homes sold or built and the more purchases made for
ISM: Nonmfg: Business Activity Index
SA, 50+ = Econ Expand
those homes. All this activity also generates more blue-
All Employees: Service-providing Industries
collar jobs and lower-paying service-sector jobs. The
Difference - Period to Period SA, Thous
problem is that the higher cost of living ends up hurting
70
600
those who have not accumulated assets. Asset
65
accumulation is the key to surviving in today’s capitalism,
400
regardless of socio-economic class. As the accompanying
60
graph shows, the ISM Non-Manufacturing Index is
200
burgeoning along at levels higher now than during the
55
Internet boom of the 1990s. This is impressive and it’s a
0
quantitative assessment of the statements above. More
50
and more, the highly productive service sector is driving US
growth.
-200
45
Also note the modest advance in service-providing payrolls
40
-400
during the last several years compared to the 1990s. While
91
92
9 3
94
95
9 6
9 7
98
9 9
0 0
01
02
0 3
04
05
overall payroll growth has averaged 175,000 during the last
Sources: ISM, BLS /Haver
07/08/05
two years, service-sector payrolls are averaging 200,000
— but this is well below the average service-sector payroll growth of 225,000–250,000 during the
1990s. This is the effect of productivity enhancements as businesses do more with fewer people,
and it’s another reason to teach asset accumulation so that when high-paying service-sector jobs
are eliminated there are assets to fall back on. Of course, this is not the whole story: An
increasingly cautious business attitude in the post-9/11 world is also contributing to less of a
willingness on the part of major corporations to beef up staffs any more than is absolutely
necessary. In most large corporations, workers complain of more work and fewer workers to do it.

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These economic facts can be hard to accept, especially for those from the manufacturing sector,
where job shrinkage is the buzzword of the day. Take a look at the grim economic reality of the US
manufacturing sector pictured in the first two graphs below. There is virtually no new job creation
to speak of even though the economy is growing near 4%. The recent decline in the ISM Index
has pushed all kinds of alarms on Wall Street. Market participants are immediately on guard after
taking just one look at the swift decline in the index, payrolls, and
ISM Mfg: PMI Composite Index
a variety of other measures of manufacturing activity. This is
SA, 50+ = Econ Expand
because, regardless of gravitating toward an economy that is 80%
All Employees: Manufacturing
Difference - Period to Period SA, Thous
driven by the service sector, most US economic data are still
64
150
based on the manufacturing sector. (What a business opportunity
60
for someone who wants to measure service-sector activity!)
75
Market participants need to keep one eye on the stream of
56
manufacturing data and another on the realities of the world
0
around them. In that real world, more people are buying or selling
52
a house, pocketing a substantial investment gain, and using the
-75
48
proceeds for more travel and leisure, for moving to another
(preferably less expensive) part of the country, or for starting a
-150
44
business. The deregulation of our capital markets has made much
of this possible, and as a result wealth keeps on rising. As we
40
-225
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97
98
99
00
01
02
03
04
05
mentioned in an issue late last year, the Federal Reserve flow of
Sources: ISM, BLS /Haver
07/08/05
funds data showed that 2 million more millionaires were created
between 2002 and 2004. Much of this is
due to the appreciation of real estate
holdings. So while the national savings
All Employees: Nondurable Goods Manufacturing
rate declines, the value of owner-occupied
Difference - Period to Period SA, Thous
real estate appreciates. This is a store of
40
40
wealth that has been making its way into
the real economy as baby boomers
20
20
liquidate primary residences and more
money is freed up to be spent on other
0
0
things, creating all kinds of service-sector
jobs in places where they never existed
-20
-20
before. As we mentioned in that same
issue, there will be 10 million new jobs
-40
-40
created in this decade: 2 million in
construction, 2 million in financial
-60
-60
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
services, 2 million in professional and
Source: Bureau of Labor Statistics /Haver Analytics
07/08/05
business services, 2 million in education
and health services, and 2 million in leisure and hospitality. We
are well on our way to this amount of job creation. According to
Households: Assets: Total Owner-occupied Real Estate
B i l . $
the establishment survey, 3.4 million new jobs were created
Personal Saving Rate
between June 2001 and June 2005 alone.
SAAR, %
20000
16
It’s no wonder Wall Street keeps getting it wrong: With so much
misplaced emphasis on manufacturing data, one is bound to get
16000
12
the forecast for GDP growth wrong along with the direction of the
markets. We would be extremely careful about overemphasizing
12000
8
manufacturing data or listening to the doom and gloomers on
slowing economic growth, more Fed tightening, and inflationary
8000
4
pressures. We continue to forecast 4% growth for 2005, 2.7%
CPI, a 4%–4.5% ten-year note, and a peak in the federal funds
4000
0
rate at 3.5%. Those who believe that the economy is collapsing
and predict 2% real GDP growth and a 3.5% ten-year note by the
0
-4
75
80
85
90
95
00
05
end of this year need to take stock of the real-world economy, not
Sources: FRB, BEA /Haver
07/09/05
just manufacturing statistics.

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This week we were confronted with inflation statistics, industrial
production, and the trade balance. We look for inflation to remain
CPI-U: All Items
% Change - Year to Year SA, 1982-84=100
quiescent. The overall CPI should show continued deceleration
4 . 0
4 . 0
from its peak of 3.5%. Since higher oil prices are not making their
way in a generalized fashion into goods prices, we don’t expect
3 . 5
3 . 5
higher inflation pressures to spook the Fed into more tightening.
Once the market realizes this, it could be disappointed. Industrial
3 . 0
3 . 0
production may surprise on the upside as ISM manufacturing did,
and the trade balance is likely to continue to be large.
2 . 5
2 . 5
The recent terrorist attack in London prompted the press to ask us
2 . 0
2 . 0
to comment on the extent to which such an event will further
1 . 5
1 . 5
weaken European growth. With growth already weakening there,
we see this as just another reason it may continue to moderate in
1 . 0
1 . 0
the months ahead. Since the Italian economy is already in
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
Source: Bureau of Labor Statistics /Haver Analytics
07/09/05
recession, more European central bank easing may be in store.
As for the US stock market, we stand by our original forecast made at the beginning of this year
and presented at the annual forecast luncheon of the New York Society of Security Analysts. The
S&P 500 will likely post only single-digit gains once again in 2005. For those anxious to get better
returns, it would be wise to find a superb financial adviser who knows how to pick stocks. This
may sound old-fashioned, but it is the tried and true method of investing.





















Kathleen Camilli
Camilli Economics, LLC
917-363-3609
kcamilli@camillieconomics.com
www.camillieconomics.com




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