RSM Chief Economist Joe Brusuelas talks with MMG Editor Deborah Cohen about the second quarter of 2016. Brusuelas discusses the state of the economy, a tightening labor market and the potential impact of Britain’s “Brexit” vote.
Q: What’s your assessment of second-quarter earnings results and where we’re headed at this point in the year?
Joe Brusuelas: Earnings have come in a little bit better than has generally been expected. While earnings were expected to be negative thus far and we’re still roughly about 40 percent of the way through, earnings are looking fairly good. For middle-market firms, I expect general outperformance in contrast with the S&P 500 and the Dow Jones Industrial Average.
The overall economy has seen a very nice bounce in terms of consumer demand and housing that has bolstered the prospects of middle-market firms in those ecosystems, not to mention a fairly strong quarter of industrial production in autos and aircrafts. And with those two being the primary industrial ecosystems, we’re set to have a much better middle three months of the year than we did the first three months of the year.
Q: What about jobs growth?
J.B.: Jobs growth is interesting. We’ve reached a point in the United States (of) full employment. One should expect hiring to slow, and in fact we’ve seen that. (There’s) lots of noise this year in the jobs market in terms of monthly estimates. What’s occurred—and I think this is the best way to look at it—is you want to smooth out the averages and look at a three-, six- or 12-month moving average.
And if you look at just the plain-vanilla three-month average, we’ve averaged about 147,000 individuals hired per month, and that makes sense. In my estimation, we’re going to be slowing towards around 100,000. Full employment is an interesting phenomenon. At a certain point you’re just going to see enough hiring to meet the demands of new entrants and replacement. That will be anywhere between, say, 80,000 and 100,000 per month. So investors are going to adjust their horizons on the monthly job tallies and probably switch toward looking at how many unemployed individuals are available for job openings. I think ultimately we get to 4.5 percent this year or early next. And (employers) are going to begin looking at the composition of hiring in a much closer manner.
“I’ve talked openly about what I call the Brexit bonus, which has to do with lower interest rates, the ability of consumers to re-fi and the boost in overall purchases of housing.”
Joe Brusuelas, Chief Economist, RSM
Most middle-market firms that I talk to have a tale of two cities, essentially. The first is in smaller burgs, (they) don’t have access to the intellectual capital that we might like, so it’s difficult to find somebody to hire. The second is that it’s almost impossible right now to find individuals who have technical skills, advanced skills across finance, engineering, and mathematics, and it’s increasingly difficulty to find semi-skilled and public-facing individuals. So that’s a sign of a tight labor market. And I think it comes down to the fact that employers aren’t going to hire individuals to sit around and learn new job skills at this point in the business cycle, and not be productive. It costs money to re-train individuals. So that’s why we should expect to see hiring slow as we approach the last portion of the business cycle.
I would expect, with the critical 20 to 34-year-old cohort—the millennials—likely to see the employment to population ratio fall a bit. Now, what should provide some encouragement for small and middle-market firms, and large firms, for that matter, is we are seeing a rise in wages. If you look at the Atlanta Fed’s wage tracker, which does a good job of dealing with the demographic changes—we are going through some major demographic changes. On a year ago basis, your average worker was seeing about a 3.5 percent increase in wages, and that’s the peak in the cycle. For individuals who changed jobs, however, they’re seeing a 4.3 percent increase in pay. And of course at this point in the business cycle, if you can get a technically skilled individual, you need to act now and not wait. Pay that person a premium, get them in, they are productive.
And so when you average that out, some individuals are seeing much higher increases in wages and salaries. And so that’s why we’re fairly encouraged that the U.S. is going to be able to navigate the headwinds from the external sector, whether you’re talking about the European financial and banking problems, the lingering aftermath of the Brexit, or the real problems in Asia, specifically having to do with China.
Q: We know it’s early days, but what’s your take on how the recent U.K. decision to leave the European Union will shake out?
J.B.: Okay, with respect to the U.S. and exposure of the middle market, should we see a broad deceleration in economic activity in the U.K. following the decline in business and consumer confidence? I expect it shaves maybe a tenth or two off overall GDP in the U.S. But the middle market is fairly insulated from trade with the U.K. Most of the trade that our clients do at RSM—and we do have 100,000 clients who fit that middle-market category, (is) really with Mexico and Canada. So the impact will occur through the financial and trade channels, more the trade channel at this point, given that U.S. financial conditions remain over one standard deviation above neutral. They’re looking very strong regardless of what happens in the U.K. and Europe.
I think Brexit is more about political uncertainty, which creates investor uncertainty, and how the U.K. political authorities are going to navigate the very difficult negotiations of separating themselves economically from the European Union. That has to do with the triggering of what’s called Article 50, which is the formal mechanism through which the U.K. can withdraw from the EU. And then the knock-on effects. Are we going to see, over the next three years, say three to five countries have either de facto referendums on the euro and the EU or actual direct referendums on remaining in the currency block and the common economic area? I think those are the greater concerns over the medium and the long-term.
Q: What about Brexit’s impact on deal-makers?
J.B.: With respect to those in the financial services, private equity, and banking sectors, I think the more direct effect here is will it be a soft exit or a hard exit. A soft exit would be defined as something that occurs over three to five years, with very little change in the near term and a very carefully orchestrated exit over the medium and the long-term, with a solution to what’s called the “passporting” problems. In English that means will the 3 million individuals from the European Union that work in the U.K. be allowed to stay.
If it’s a hard exit, that means it’ll be done in 18 to 24 months without a solution to the passporting issue. And that would likely be somewhat acrimonious. At this point—and we just had the British Prime Minister Theresa May meet with Angela Merkel of Germany—it looks as if cooler heads are prevailing as they’re trying to dampen down an immediate triggering of Article 50, which would be the next round of uncertainty.
I think it’s important to look at the Brexit in a much bigger picture. Brexit was both a threshold moment and a trigger moment. The threshold moment was the fact that a country actually voted itself out of the EU, so it set the stage for other countries. Not to be flip, but the EU lost the U.K. and gets to keep Greece. That’s not a good outcome, right?
The trigger moment was that it caused investors to take another look at the viability of both the euro and the European Union, specifically having to do with the condition of its beleaguered financial system. I think among policymakers and elite financial players there’s a consensus that we’re going to need to see a $150 billion to $200 billion bailout of the European financial system, and that’s likely just a start. In particular, the real problems in Italy are such that it’s going to require action probably before the end of the year. Now for middle market players in the U.S., you tend to have to look at this in a very, very even keeled fashion. No one likes to see the U.S. dollar appreciate well above what you would call its true value because that creates competitiveness problems even here in North America.
But as you see capital flow into the United States depressing long-term yields, flowing into equities, and spilling over into private capital markets, which favors the middle market because you get alternative sources of finance, that over the near to medium term this probably is a net benefit for the U.S. And I’ve talked openly about what I call the Brexit bonus, which has to do with lower interest rates, the ability of consumers to re-fi and the boost in overall purchases of housing. And we certainly saw that in July. You can see it in the data. It’s interesting how these things work out.
(This conversation has been edited and condensed.)