Can U.S. Services Growth Outweigh High Oil Prices?

The political uprising in Libya that has pushed oil above $100 understandably has dominated the headlines lately. But amid all the concern about oil and instability in the Middle East, investors shouldn't lose sight of the improving economic fundamentals in the U.S.'s manufacturing sector and, equally significantly, in its services sector.

Services, which account for 65% to 70% of the country's GDP, expanded for the 15th consecutive month in February, according to the Institute for Supply Management's survey. That month, the institute's nonmanufacturing index rose to 59.7, its highest level in about five years, from 59.4 in January. Readings above 50 signal an expansion; below 50, a contraction.

And every key component in the services index is pointing to continued growth.

The new-orders component -- a gauge of future business demand -- did dip to 64.4 in February from 64.9 in January, but the number still indicates that demand is increasing. What's more, new orders are increasing faster than inventories. The inventories measurement rose to 55.5 in February from 49 in January, which suggests that commercial activity is likely to keep services firms -- such as software and technology companies -- busy.

Services-Sector Jobs on the Rise

All of that increased activity has created a need for more service employees. The ISM survey's services employment index rose to 55.6 in February from 54.5 in January, marking its six straight monthly rise.

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ADP's (ADP) February private payroll report confirmed that hiring trend, finding that 202,000 services sector jobs were added last month. The ADP survey also estimates that employment in the services sector has increased by 779,000 since September 2010, or roughly 129,800 new jobs per month.

In an emailed research note to clients, IHS Global Insight's Chief U.S Financial Economist Brian Bethune says he expects good news on the job-market front. "These recent consecutive gains in the ISM employment gauges point in the direction of a fairly significant improvement in the labor market," Bethune wrote.

All this activity presents policymakers -- particularly U.S. Federal Reserve officials -- with perhaps their most challenging question since the acute stage of the financial crisis in the fall of 2008 and winter of 2009: Does the economy have enough demand in it to grow without monetary stimulus?

One Stat That Could End the Recovery

On the one hand, most economic fundamentals are positive. Led by export demand, the manufacturing sector is humming and services-sector activity is growing at a good clip. Also, initial jobless claims have declined, job growth has improved in the past five months and consumers -- more confident that the period of large job layoffs is over -- have started spending a little more. Meanwhile, lean corporations well positioned for economic growth continue to register adequate-to-good quarterly earnings growth.

On the other hand, one variable largely beyond the control of U.S. policymakers could negate almost all of that positive momentum, and that's the price of oil. Oil, which traded up 0.34% to $104,75 per barrel Wednesday, has grown more than 40% in five months. And prices posted at U.S. gas stations' entrances are rising almost as fast as an altimeter in an F-16 fighter jet.

Rising oil prices slow the U.S. economy by decreasing consumers' disposable income and by increasing businesses' operating costs. They also can increase inflation, as fuel costs raise the cost of making petroleum-based goods, of transporting goods and of travel.

True, the U.S. economy has grown more fuel efficient, making it less vulnerable to high oil prices now than it was during previous oil shocks in 1973-74 and 1979-80. But economists generally agree that sustained prices of more than $120 per barrel would slow the economy substantially, while prices over $150 would tip the economy back into a recession.

Right now, the bulk of the economic data -- including manufacturing, services, employment, consumer spending -- points to a self-sustaining expansion up ahead, and probably a winding down of the Fed's QE2 stimulus later this year. But investors can rest assured that the Fed also is keeping an eye on oil prices and will take them into account.