United States

Why Is US Employment So Weak?

July 26, 2010

By Richard Berner | New York

Healthcare headwinds. US job gains so far in this expansion have been atypically weak, especially
considering the record depth of the employment downturn. Assuming that the recession ended in June 2009,
private non-farm payrolls have been flat over the past year, compared with a 2.3% gain in the first year of the
past seven recoveries. Clearly, much of that weakness is cyclical, reflecting the widely expected sub-par
rebound. In our view, however, structural culprits are also at work; of these, we think that high and rapidly
rising healthcare costs are one of the most important and certainly the most overlooked. That's long been a
key factor in our view that job gains will remain tepid for now.

But weak employment gains don't condemn the economy to 1-2% growth, because a rising workweek is a
powerful offset that spreads across the workforce. For example, although private payrolls rose by only 0.6%
in the six months ended in June, courtesy of the 18-minute rise in the workweek, private hours worked rose by
1.4%. A similar percentage increase in private payrolls would average 256,000 monthly. In addition,
temporary hires testify both to the need for labor and to the desire to avoid a commitment to healthcare
benefits. In this recovery, temp hires have jumped 19.6% from the trough versus an average of 3% in each of
the past two recoveries. While payroll gains seem likely to increase to an average of 150,000 monthly in
2H10, hours worked may rise by more as companies continue to substitute increased working hours and temps
for full-time hires until the economy is on firmer ground.

To be sure, there are other structural hiring headwinds. Among them: Mismatches between skills needed and
those available; labor immobility resulting from negative equity in housing; and uncertainty around policies in
Washington. Along with rising healthcare costs, we think all will continue boosting the workweek for now.

Working longer hours doesn't spread income directly to the unemployed, nor does it create the boost to
consumer confidence that comes from stepped-up hiring. But it does generate income that is helping to make
the recovery self-sustaining. That's evident in the strength of withheld tax payments through June, which are
up more than 4% from a year ago. And it does indicate that employers need more labor services - necessary
for an eventual improvement in the employment outlook.

Structural problems surfaced a decade ago. Healthcare costs have been high and rising for some time, and
other structural issues aren't new. So why do we think they are suddenly a big deal in suppressing hiring? We
don't. In fact, for the past decade structural factors have been behind the shift from a "high-pressure" to a
"low-pressure" economy, according to Treasury Assistant Secretary for Economic Policy Alan Krueger and
Lawrence Katz, both noted labor market experts. Krueger notes that:

From December 1989 through December 1999, the economy gained 21.7 million payroll jobs. By contrast,
from December 1999 through December 2009, the economy lost 944,000 jobs. This poor performance is not
only due to the recession at the end of the decade. Job gains in the 2000s are weak even if we exclude the
losses that occurred during the recession: Over the first eight years of the 1990s, the economy gained
almost 16 million jobs; during the first eight years of the 2000s, however, payroll employment rose by
somewhat less than 7.5 million jobs, a little less than half of the previous decade's eight-year increase.

And Lawrence Katz amply documents the structural labor market problems glaringly apparent in the wake of
the recession (with updated calculations):

Two particularly worrisome signs suggestive of longer-term structural labor market problems and persistent
costs of unemployment from this recession are the concentration of the rise in unemployment among
permanent job losers and the huge increase in long-term unemployment. Permanent job losers (job losers
not on temporary layoff) increased from 1.7% in November 2007 to a peak of 5.6% in October 2009 and
remained at 5.0% in June 2010. The number of long-term unemployed (those unemployed 27 weeks or
longer) reached over 6.75 million in March 2010, representing 45.2% of the unemployed. The long-term
unemployment rate (those unemployed 27 or more weeks as a share of the labor force) has increased from
0.9% in November 2007 to 4.4% in June 2010, well above the previous post-war peak of 2.6% in June 1983.

‘Fixed' healthcare costs hobble job gains, boost hours and temps. That still begs the question of whether
healthcare costs or other structural hurdles are the reasons for limiting hiring. In our view, healthcare costs
are critical: Thanks to the high ‘fixed' costs of health and other benefits, and of taxes on labor to pay for the
social safety net, US labor costs are out of line with other countries when adjusted for living standards. We
say ‘fixed' costs because benefit costs don't vary with hours worked; they are paid on a per-worker basis. And
healthcare benefit costs, which account for 8% of compensation, have risen by an average 6.9% annual rate
over the decade (or nearly doubling over ten years) ended in 2008 versus 4.5% for wages and salaries. As
employers seek to cut the cost of compensation, therefore, these benefit costs drive a growing wedge between
total compensation and take-home pay. Unlike in other countries where healthcare benefits are not directly
part of compensation, these rising costs likely have intensified employers' efforts to boost productivity by
cutting payrolls.

Moreover, the role of healthcare costs as a brake on hiring intensified in recession, as the fixed or rising cost
of healthcare collided with shrinking top- and bottom-line results. Just as operating leverage crushes earnings
in recession as fixed costs are spread over a smaller base, it also crushed employment as layoffs became the
only way to cut the per-worker cost of healthcare. For workers, the recession made the wedge between
compensation and wages bigger, as cost-cutting private-sector employers cut take-home pay while leaving
fixed-cost benefits intact. Thus, US relative labor costs go up versus other countries while median pay suffers.

Not simply traditional cyclical behavior. A rising workweek and stepped-up temp hiring are time-honored
leading employment indicators, so it could be that the recovery is simply tepid. But this time, the strong gains
in these two measures signal structural headwinds to full-time hiring. As noted above, both have exceeded
typical cyclical norms as health insurance costs rose. Careful statistical work confirms that relationship.

For example, Freeman and Rodgers note that the Kaiser Family Foundation found that between 2000 and
2003, employment for those at firms offering healthcare benefits fell by 2.8%, twice the decline in overall
payrolls. Sarah Reber and Laura Tyson also find support for rising health insurance cost as a deterrent to
employment growth. Katherine Baicker and Amitabh Chandra find that a 10% rise in health insurance
premiums reduces the aggregate probability of being employed by 1.6% and hours worked by 1%, and
increases the chance that a worker is employed only part-time by 1.9%.

To be sure, three other structural factors represent hiring headwinds: Mismatches between skills needed
and those available; labor immobility resulting from negative equity in housing; and uncertainty around
policies in Washington. Importantly, in an earlier note, we suggested short and long-term solutions to these
headwinds; here, we simply outline the problems.

Obstacle 1. Skills mismatch. The problem: For years, employers have complained that they don't find the
skills they need in today's workforce. Worker skills have greatly lagged technical change and tectonic shifts in
the structure of our economy. Immigration restrictions and massive dislocations in several industries in
recession have magnified that mismatch as workers who have been trained for one occupation lose their jobs.
A May 2010 Manpower research survey showed that even in recession, 14% of firms reported difficulty filling
positions due to the lack of suitable talent available in their markets; in 2006 the same survey reported that
44% of firms couldn't find the skills needed. That decline speaks to the depth of recession; it is clear that a
large portion of the long-term unemployed lack requisite skills. And even in healthcare, an oasis of job
growth, there is a growing nursing and nursing skills shortage that requires new training facilities.

Obstacle 2. Labor immobility resulting from the housing bust. America's workers have always been
footloose. Even in the Great Depression, they looked for work wherever it was. Today, however, about one
in four homeowners is trapped in their house because they owe more than the house is worth, so they can't
move to take another job - until they sell or walk away. Unlike in the Depression, when homeownership was
less prevalent, negative equity among a nation of homeowners leads to substantially lower mobility rates.
Owners suffering from negative equity are one-third less mobile according to one study. That is leading to a
wave of ‘strategic defaults', in which borrowers who can otherwise afford to pay decide to walk away.
Whether through foreclosure or default, this process is undermining the economic and social fabric of
communities and reducing job opportunities.

It's striking that the current policy debate in Washington and Wall St - focused on whether and by how much
to ramp up fiscal and monetary stimulus - has overlooked the severe problems in housing that to us pose the
biggest downside risk to our cautiously optimistic outlook. It is essential to reduce or refinance debt, writing
off bad loans while not destabilizing the financial system. Modifying existing mortgages seems appealing, but
policies aimed at mitigating foreclosures under the Home Affordable Modification Program (HAMP) for
borrowers whose homes are worth less than what they owe have not worked because they attempt to modify
mortgage payments and not the amount of debt owed; re-default rates following modification are 50-60%.
And for the 75% of homeowners with equity in their homes, the refinancing process is blocked by high
loan-to-value ratios and joblessness.

Obstacle 3. Policy uncertainty is a negative for the economy and markets. America's long-term
challenges - healthcare, budget and tax reform, financial regulatory reform, retirement saving, infrastructure,
education, energy, and climate change - are not new. Solving them is imperative, and major legislation to
address them represents important steps toward those ends - e.g., promoting increased access to healthcare
and a safer financial system. But the uncertainty around the costs of those policy changes and the uncertain
magnitude of prospective tax hikes that will be required to address our fiscal problems is weighing on business
and consumer decisions to hire, expand, buy homes and spend.

Recent work confirms this intuition, underlining how uncertainty produces negative growth shocks. Nicholas
Bloom shows how a rise in uncertainty makes it optimal for firms and consumers to hesitate, which results in a
decline in spending, hiring and activity. In effect, the rise in uncertainty increases the option value of waiting
as volatility rises. Moreover, this line of reasoning suggests that uncertainty reduces the potency of policy
stimulus. That's because the uncertainty can swamp the effects of lower interest rates, transfers or tax cuts.
In effect, uncertainty raises the threshold that must be cleared to make a business choice worthwhile, and as
uncertainty declines, the threshold falls with it. This notion squares with our long-held view that policy
traction from easier monetary policy, improving financial conditions and fiscal stimulus was lacking through
much of last year, but improved as uncertainty fell.

Market participants are used to thinking that political gridlock is good, that it prevents politicians from
interfering with the marketplace. The financial crisis clearly exposed the flaws in that reasoning with respect
to appropriate financial regulation, whose absence allowed abuses. Indeed, gridlock today is more likely to be
bad for markets, as our long-term economic problems are partly the result of past policies and can only be
solved with political action, in our view.

Implications of a rising workweek. Working longer hours doesn't spread income directly to the
unemployed, nor does it create the boost to consumer confidence that comes from stepped-up hiring. But it
does generate income that is helping to make the recovery self-sustaining. And it does indicate that employers
need more labor services - necessary for an eventual improvement in the employment outlook.

United States
Digging into Unemployment Insurance: A Primer
July 26, 2010

By Richard Berner, David Greenlaw, Ted Wieseman & David Cho | New York

Background

Initial and continuing claims for unemployment insurance (UI) are key, high-frequency US labor market
indicators. But the extension of eligibility for jobless pay and the introduction of emergency programs as the
recession deepened in 2008 have made the unemployment insurance data harder to interpret and less reliable
indicators of the state of labor markets. The expiration of benefits, the substitution of benefits under one
program for another, and the growing number of ineligible filers all add noise to the data. This primer
attempts to explain the programs, the distortions in the data and how to interpret them.

Those distortions probably intensified on May 31, when UI benefits expired for about 1.3 million recipients.
The debate over whether and how to pay for extended benefits in Congress has been resolved in favor of
extension, with retroactive benefit checks likely to go out next week. But the extension is good only through
the November mid-term election, and with unemployment receding slowly, UI policies and data will likely
remain a key focus of investors.

Overview

Approximately 10 million people in the US are currently receiving unemployment benefits, reflecting the high
level of unemployment and the extended duration of jobless spells experienced by many workers. The depth
and duration of the recession and the moderate pace of economic recovery have doubled the median duration
of unemployment compared with past severe downturns; today the median duration of unemployment stands
at 23.2 weeks, versus 12.3 in May 1983. Nearly half of all unemployed workers have been out of a job for
more than six months. As a result, many workers have long since exhausted the unemployment insurance
benefits offered under regular state programs (typically 26 weeks), prompting Congress to authorize extended
and emergency programs to supplement jobless pay.

Fast Facts

• Average weekly payout of $300

• Federal government sets broad guidelines, within which states set own rules

• Benefits are taxable

• An individual must file weekly or bi-weekly claims

• Calculation of benefits takes into account previous income and length of employment

• Regular unemployment benefits are usually limited to 26 weeks (but up to 99 weeks are now allowed due to
extensions)

• A special provision of the ARRA stimulus legislation raised weekly payments by $25

• Of the 10 million recipients of unemployment insurance, 5.3 million are currently receiving extended
benefits

Unemployment insurance provides payments to individuals who have lost their jobs through no fault of their
own, whose claims for compensation have been accepted by their state. Employers contribute to the state and
federal trust funds that ultimately distribute benefits. Typically, claimants receive benefits for 26 weeks,
although this can be extended in environments of financial distress. About half of applicant claims are
rejected nationally, but this number seems to have climbed recently, as can be seen by comparing filed claims
and initial handout figures.

Eligibility varies by state and is determined by thresholds relating to hours worked and wages earned. First
and foremost, an individual must have been employed by an actual employer (i.e., self-employed workers are
not eligible). Second, an individual's highest quarterly wage must exceed the state-determined minimum level
by 1.5 times in order to qualify for jobless benefits. States usually provide 50% of lost wages, up to the
average wage for the state.

Four Primary Unemployment Insurance Programs

Unemployment Compensation Program (UC): A joint federal-state program providing basic unemployment
benefits for up to 26 weeks. It is funded by federal and state taxes paid by employers. General federal
guidelines are drawn up by the US Department of Labor, and states formulate their own rules within these
limits. During periods of high unemployment, the federal government helps fund payouts.

Extended Benefits (EB): If high unemployment exists in a state, UC benefits can be extended through EB at
the state level for either 13 or 20 weeks. Whether a state falls into this category is a function of their IUR and
TUR. (IUR is the ratio of workers eligible for UC to those located in UC covered jobs. TUR is the ratio of
unemployed workers to all workers, and is essentially a weekly translation of BLS's monthly unemployment
rate.)

Emergency Unemployment Compensation (EUC08): EUC08 provides up to 20 weeks of benefit extension

for those who qualified for UC benefits, and up to 33 weeks of additional benefits in states with particularly
high levels of unemployment. These first two tiers of benefits are available in all states, and additional tiers
are triggered at varying state levels of IUR and TUR. This program was instituted in July 2008 by the Bush
Administration and represents the eighth time the government has created a temporary program to deal with
high unemployment in a slow economy.

Disaster Unemployment Assistance: These benefits are paid to those deemed ineligible for basic
unemployment insurance and whose unemployment can be attributed to a major disaster. The disaster
provisions drawn up by affected local governments often stipulate the form and amount of the unemployment
insurance.

There are several other programs that only apply to specific subcategories of the US labor market. Examples
include Trade Readjustment allowances (which assist those who have been affected by foreign trade and
outsourcing), unemployment compensation for federal employees, and unemployment compensation for
former military personnel.

Jobless claims are highly seasonal. For instance, claims typically surge at the beginning of each quarter when
eligibility requirements shift forward. Filings also fluctuate due to seasonal employment patterns within
particular industries such as agriculture. These seasonal occupations generate ‘repeat beneficiaries', who
consistently follow an alternating pattern of work and benefit collection; this can be seen as a public subsidy
to the firms who employ these workers. Recently, continuing claims have seen even greater seasonality,
displaying highly unreliable week-to-week movements.

Current Situation

In the current economic climate and with the unemployment rate still at 9.5%, the exhaustion of
unemployment insurance is a highly pertinent issue. We estimate that over 2.5 million unemployed Americans
had exhausted even their extended benefits prior to this week's extension.

The number of initial weekly jobless claims spiked to over 650,000 in early 2009 and has remained at elevated
levels in spite of the economic recovery. But this trend has been coupled with an increase in the claim
rejection rate as larger numbers of ineligible filers (including former Census hires) and construction workers
(who tend to file more frequently) have applied for benefits. We think this may be the result of (a) the
unusually long period of extended benefits and (b) the unusually large role that housing and construction
played in the recent recession.

In contrast, continuing claims have seen a steady decline. There is no way to tell whether this is due to the
unemployed finding jobs or to their exhausting their benefits, although current extension programs provide
additional incentives to run through regular benefits and obtain additional payouts. Thus, we believe that the
current initial and continuing jobless claims data present a distorted view of the underlying labor market
conditions.

Benefit Extensions

During times of prolonged economic duress, Congress often authorizes extensions to the standard
unemployment compensation program. In response to the recent downturn, Congress passed the Extended
Benefits (EB) and Emergency Unemployment Compensation (EUC08) programs, the latter of which was
enacted as a one-time provision of the 2008 stimulus package. Given the depth and duration of the recession,
these programs have seen many extensions, most recently until November 6, 2010.

During the recent downturn, Michigan has consistently been the state with the highest level of unemployment
and aggregate unemployment insurance payouts. Not surprisingly, this state currently has all available
emergency programs in place. Reflecting the severity of the recession, there are many unemployed persons in
other states that offer the maximum 99 weeks of benefits who have exhausted their benefits.

Debate over Pros and Cons of Unemployment Insurance

The efficacy and usefulness of unemployment insurance are subject to an ongoing debate. Opponents assert
that such benefits provide a disincentive for people to return to work and needlessly add to the country's debt.
Indeed, the dramatic extension of benefits may be one of the factors responsible for the recent rise in the
duration of unemployment. Conversely, proponents of these programs argue that unemployment insurance
stimulates consumer spending and serves as a form of countercyclical fiscal stimulus during periods of
recession.

Resolving this debate hinges on the actual impact of unemployment insurance on individuals' behavior
regarding employment, which is itself open to debate. Certainly, if the payout for being unemployed increases
sufficiently, after a certain point the recipient will be less motivated to seek a new job. However, the extent
of this ‘moral hazard' is unknown and, as The Economist points out, varies over time. During the current
downturn, the Federal Reserve Bank of San Francisco has found this effect to be negligible.
In addition, the cost of providing unemployment insurance must be weighed against the increased
consumption it enables. According to the Congressional Budget Office, for every dollar of unemployment
insurance, up to 1.9 dollars is generated in the economy. Moreover, jobless benefits (averaging $300/week)
can have a material effect on the ability of households to pay their mortgages and stave off foreclosure - a
crucial support for the still weak US housing market. On the other side of the debate, some argue that the
historically lower rate of unemployment in the US versus Europe is a result of lower unemployment insurance
payments and taxes in the US.

Impact as Fiscal Stimulus

Similar to the progressive income tax system and Medicaid, the basic unemployment insurance program
represents an automatic stabilizer that helps to cushion the effects of an economic downturn. As the economy
begins to weaken, this measure increases in magnitude and impact. The augmentation boosts the economy
and partially counteracts the overall downward macro trend. To enhance this function, extended
unemployment insurance was one of the primary components of the 2009 American Recovery and
Reinvestment Act. This fiscal stimulus bill extended the emergency unemployment compensation program,
allowed states to temporarily lower their unemployment insurance eligibility requirements, and raised weekly
payouts for various unemployment programs by $25. This expansion of UI programs and payments represents
discretionary fiscal policy.

Later this year after the latest extended benefits expire, the debate over whether to renew them yet again will
be a lightning rod for the political economy debate about the budget and fiscal policy: Some will repeat their
calls for any renewed extension to be deficit-neutral, ‘paid for' by other spending cuts, while others will
doubtless view the expiration as a fiscal drag that the uncertain economy can ill afford. That renewed debate,
which will resume after the mid-term elections, will likely be intense because it will come at the same time
that officials must decide whether to extend the Bush tax cuts on ordinary income, capital gains and
dividends.

South Africa
September Rate Cut? We Think Not
July 26, 2010

By Michael Kafe, CFA & Andrea Masia | Johannesburg

The South African Reserve Bank (SARB) left its policy repo rate unchanged at 6.5% on Thursday. This was in
line with consensus expectations but may have come as a surprise to market participants, who had pushed the
1x4 FRA strip to price in an approximate 40% probability of a 50bp cut just before the MPC meeting. We
found the overall tone of the statement to be dovish, focusing on the key issues that we highlighted in the
CEEMEA Macro Monitor earlier this week: global developments, fragility in the domestic recovery led by
weakness in the manufacturing sector, and the inflation outlook. The SARB continues to see upside risks from
high rates of administered price inflation and above-target wage settlements. We maintain our call that policy
rates have bottomed and disagree with market pricing of additional policy easing at the September MPC.
Here's why:

The Global Backdrop

First, while the governor is no doubt concerned about a possible transmission of downside risks to local
growth - especially local manufacturing production - from the uncertainties associated with global growth
weakness, it is important to note that the MPC still expects the positive trend that was seen in domestic
household consumption expenditure during 1Q10 to have been maintained in 2Q. This suggests that, despite
downside risks to GDP growth, the MPC remains relatively sanguine about the domestic consumer, and by
implication sees no valid reason to engineer further monetary laxity that risks overstimulating the consumer.
In our opinion, it would take a significant deterioration in the global outlook (compared to current conditions)
for the MPC to change its view on domestic demand conditions. As it is not our view that global growth
deteriorates significantly in the coming weeks/months (although the US will likely continue to churn out some
weak economic data, we believe that European data are likely to surprise to the upside), we do not expect the
SARB to change tack.
2Q GDP Could Surprise the SARB on the Upside

Second, it seems clear that the SARB was surprised by the 4.6%Q GDP print in 1Q10, compared to its
forecast of 3.7%Q, and it has now marked its initial GDP forecast for 2010 of 2.7% to market.
Mathematically, the revised 2.9% print that was provided in Thursday's MPC statement is emblematic of a
pure mark-to-market exercise on the back of the 0.9pp upside surprise to its 1Q10 GDP forecast. Importantly,
this implies that the SARB has not adjusted its outlook on 2Q-4Q GDP. We believe that it will have to
upgrade its annual GDP forecast again at the September MPC meeting, as the 2Q GDP outcome that will be
made available by Statistics South Africa on August 24, 2010 appears likely to come in much higher than the
SARB's forecast of 3.2%Q (our preliminary estimates point to a reading north of 4%Q). In our opinion,
therefore, it will be difficult for the MPC - if not inconsistent - to justify a more accommodative policy stance
when growth is persistently surprising it to the upside.

Downside Risk to Electricity Prices Have Dissipated

Third, the SARB revised its expected trough in CPI to 4.5%Y in 3Q10 (from 4.7%Y previously), and left the
4Q12 endpoint forecast unchanged at 5.3%Y. This was in line with our expectation (again, see the latest
CEEMEA Macro Monitor). Looking forward, however, we no are longer optimistic about a possible downside
surprise in electricity tariffs that leads to a downward shift in the inflation trajectory, giving the SARB some
scope to engineer a rate cut in September. This is because NERSA has revised its guideline increase in
electricity tariffs from 15.33% to 19% for those municipalities who had implemented a 34% increase last year
(roughly 70% of all municipalities), and 22% for those municipalities who implemented an increase of less
than 34% in 2009/10. Thanks to this upward revision to municipality electricity tariff guidelines, we no longer
see downside risks to the SARB's 20% electricity tariff assumption for this year.

What's more, a number of municipalities have made it clear to the Regulator that they are unable to implement
the newly introduced inclining block tariff structure that would have seen a meaningful decline in tariffs for
households that consume less than 350kWh of electricity per month, due to capacity constraints, such as the
absence of modernised metering systems. Effectively, this means that most consumers are likely to experience
tariff hikes, regardless of consumption patterns, and presents further upside risks to the electricity tariff
outcome that will be published in the July 2010 CPI data on August 25.

Finally, while the financial analysts surveyed in the latest inflation expectations survey foresee inflation within
the target band over the forecast horizon, the actual price setters in the real economy (i.e., business and
labour) still expect CPI to stabilise at 7.0%Y in 2010-12. This suggests upside risks to the average level of
wage settlements in 2H10 as the recovery becomes more durable.

Currency Weakness Not the Solution

With regards to the rand, the MPC expressed its commitment to further FX reserve accumulation -
presumably as a means of stemming the currency's over-valuation somewhat. We do note, however, that the
statement was at pains to acknowledge that "there is no point in having a weaker currency if the benefits are
simply eroded by inflation". We couldn't agree more. In a recent research note on South Africa's export
performance (see South Africa: Gauging Susceptibility to the Vagaries of European Growth, June 21 2010),
where we used a Vector Error Correction Model (VECM) to trace out the dynamic response of exports to a
depreciation in the ZAR, we found that any derived benefit of a weaker currency is short-lived, topping out in
the first four quarters, before eventually turning negative as inflation rises and productivity falls.

Trade Idea

To exploit the economics of an unchanged policy stance at the September 9 MPC, investors may consider
paying 2X5 FRAs at current levels of 6.30% against 3M JIBAR at 6.51% for a 20bp roll-up in the coming
seven weeks. The key risk we see to this trade is that global growth prospects deteriorate significantly, forcing
the SARB to cut rates in September.