This is what normalisation looks like


Good morning. Far-right parties in France and Germany did well in EU parliamentary elections. What will this mean for European markets? The Unhedged rule of thumb is that elections tend to have a smaller-than-expected long-term market impact, but it will be interesting to watch European sovereign debt markets today. Predictions from our continental readers are welcome: robert.armstrong@ft.com. 

The jobs report

Friday morning’s Unhedged suggested that the imminent employment report would help decide between three interpretations of the economic data that has rolled in over the past month or so. Have the soft recent numbers suggested a worrisome slowdown, post-pandemic normalisation, or a statistical blip within an economy that is still too hot to be consistent with inflation falling back to 2%?

In the event, the job numbers — 272,000 jobs added in May — were well warmer than expected, making the “worrisome slowdown” interpretation very hard to maintain:

Column chart of US jobs added showing Trendspotting

It is notable how the addition of one data point can change the way we see a whole series. Before the May numbers landed, it was easy to make out a slowing trend in the employment figures since December of 2023. Toss out the March number as an anomaly, and you could have seen a downward staircase in the data, if you were so inclined. Add the higher May number, and suddenly it looks like we have been locked in a consistent sideways trend since at least January of 2023, adding about 250,000 jobs every month. The trend for the five years before the pandemic was 200,000 a month. Similarly, wages grew .4 per cent in May, or almost 5 per cent annually. That is bang in line with the average growth of the last two months, and almost twice their pre-pandemic average.

Does that suggest that the labour market is not cooling at all and is instead stuck at a level inconsistent with a Fed rate cut? It’s a close call, but I think not.

Commentators who have declared the jobs report “mixed” have pointed to the fact that the unemployment rate (which comes from a different survey than the jobs numbers) rose from 3.9 per cent to 4 per cent, and was just 3.7 per cent back in January. This doesn’t seem like such a big deal to me, given that 4 per cent is still quite a low number. In addition, Preston Mui of Employ America notes that the increase in the unemployment rate appears mostly down to employed people transitioning out of the workforce, which shrinks the denominator, and people outside of the workforce transitioning to unemployment (students leaving school and seeking work?) which increases the numerator. Neither seems to me to say a huge amount about recent changes in the economy, and more about seasonal and longer-term demographic shifts.

But there are other reasons to see normalisation in the job market. One is also pointed out by Mui, who notes that wage growth in services industries, the largest part of the economy and the one the Fed says it is watching most closely, is declining steadily: 

This is consistent with the fact that the employment portion of the ISM services industry survey is in contraction. The job openings and quits data (which, I should note, some people don’t trust) has fallen back to pre-pandemic normality, as we discussed last week. Temporary employment continues to decline. The rate of hiring is falling. Job creation may be more or less steady, but the jobs market continues to cool, gently.

Margins, maths and valuations

Last week’s comment on the link between high margins and high valuations provoked a lot of comment from readers. Many of them pointed out that there were sound analytical reasons that high margin businesses tend to receive high valuations. Businesses that have a high intellectual property content in what they sell tend to have high gross margins and high returns. High return businesses can grow faster, return more capital to shareholders, or both. This justifies a higher price/earnings (P/E) valuation.

Maarten Smit of APG summed up as follow in an email, pointing out several papers on the topic: 

For two firms with the same earnings, growth, and discount rate, the firm with higher profitability needs less capital for reinvestment and hence has more free cash left over for shareholders . . . firms with higher profitability have a higher warranted P/E multiple (and this difference increases with higher growth rates) as long as profitability is higher than the discount rate.

The relevant equation is basically a rearrangement of the dividend discount model:  

P/E = (1/discount rate — growth rate )*((return on investment — growth rate)/return on investment) 

With this one can build a simple illustrative matrix of P/Es ratios, assuming (in this case) an 8 per cent discount rate:

This is all very straightforward, finance-101 stuff. It remains only to point out that margins are not always a very good proxy for returns on investment — it’s the different between profits/sales and profits/capital. Drug distributors such as McKesson and Cardinal Health, for example, have tiny margins and very high returns on capital, in part because they have low or negative working capital. Is Amazon’s retail business another example of high returns and low margins? It is hard to say, because Amazon does not provide separate balance sheets for its different business segments. But, like the distributors, the company has very low working capital.

Peter Osborn of Flexiion wrote to make an interesting point I’d never considered. It is that low margin businesses tend to be an operationally complex, detail oriented grind, which leaves managers without the time or resources for innovation that boosts long-term growth: 

Low gross margin business tend to be all about managing a blizzard of detail and having robust and controlled operations. Ideas and innovation do not fit easily, except in the domain of strategy, and are for the long term. Some time ago I chatted to the CEO of a major food producer . . . he said “I have to be utterly focused on detail, because I never get one problem, I only ever get a million problems.”

Whereas high gross margin business are essentially ideas factories . . . Ideas and innovation are all important and drive the business with necessarily short cycles between inception and implementation

Consequently, low margin businesses are very difficult, slow, and expensive to adapt to change.

One good read

English journalists are taking over America.

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