More Improvement In The Labor Market

It should now be quite obvious to all that there has been some significant improvement in the labor market over the past several months, since first-time claims for unemployment have been consistently lower than expectations. At the current rate of improvement, claims could very soon be about as low as we might expect them to get if the economy were healthy (approximately 300K per week). But of course what is still missing from the picture is a significant increase in new hiring. Businesses have done almost all the cost-cutting that they need to, but they have not yet made a serious effort to grow.

The reluctance to expand and hire more aggressively is very likely due to a number of factors commonly cited, such as increased regulatory burdens, increased healthcare costs, and uncertainty about the future level of tax rates. In other words, businesses are reluctant to hire because the cost of labor has increased substantially, and the cost of labor and overall tax burdens might increase even more in the future. This is what happens when government spending ratchets higher, as it has over the past 3-4 years; a higher level of public-sector spending relative to the economy must eventually require a higher level of taxation, and a state-managed healthcare industry must eventually become more expensive and less efficient (government bureaucrats cannot possibly run the healthcare industry better than free markets can). The slow-growth fundamentals which frustrate us all—and which boil down to government crowding out the private sector—are unlikely to change in the near term, but the outlook for spending and taxation could change significantly (for the better, I hope) as the presidential election debate kicks into high gear this summer.

PE ratios are still substantially below average and profits are at record levels, which means the market is priced to a substantial deterioration in the fundamentals and is probably resigned to some increase in future tax burdens. But with the ongoing improvement in the labor market, equity prices have little choice but to drift higher, as the chart above suggests. As I've been suggesting for years now, this market is being driven not by optimism, but by the realization that the economy has not proven to be as bad as was expected. Three years ago the market thought we would still be in a deflationary depression today, but instead we're in a slow-growth expansion, climbing walls of worry.