MV: A Strong US Jobs Report Confuses the Interest Rate Picture
The US jobs report released on Friday was strong across the board and certainly took us by surprise. We had thought that announced job losses in the energy sector and by multi-nationals suffering from a strong US Dollar would have begun to show up in the official data, but that did not occur. There can be a lag between actual layoff announcements and them being captured in the official data and so it will be a matter of time. We should fully expect the next few employment reports to be less robust.
With average hourly earnings reversing December’s setback, average weekly hours worked remaining at its highest since the financial crisis and the participation rate rising, the details of the report were very reasonable, although we would note that earnings are still not growing as strongly as should be expected at this stage in the cycle.
This jobs report has altered market expectations for rate rises from the Fed with many now expecting the Fed to raise rates in the early summer. Clearly a lot that can happen between now and the Summer and, as we have seen so often over the last few years, the Fed will not want to be too hasty in raising rates if economic data deteriorates and/or the equity market falls.
We said a couple of weeks ago that we were worried about the US economy in the first half of the year (before the windfall from lower energy prices could really kick in), and we showed the leading indicator qualities of corporate earnings and business investment in predicting changes in economic growth. Little has changed on this front. Business investment will fall as the impact from dramatically reduced spending from the energy sector and lower inventory build is seen (n.b. inventories saw a massive build in the 4Q GDP report adding 0.8% to the 2.6% number, and so inventories will be a drag on near term growth). Furthermore, both energy sector profits and a strong US Dollar will significantly impact earnings.
If our view on economic growth in the first half is correct, then the Fed won’t raise rates. We are basing our forecast on both indicators that have leading qualities rather than lagging qualities in terms of their predictive value. We are also trying to incorporate qualitative evidence from the fallout from the energy sector bust and the impact of the strong US Dollar. We also believe that inflation will not be a problem in the first half of the year. Of course, we could be wrong and the US economy could be totally unaffected by the issues that we worry about. If so, the Fed will feel compelled to start raising rates soon. However, even if we are only half right, the Fed will have every excuse not to raise rates in the Summer, and the only reason they would do so is to get some rate rises in place so that they have some ammunition if there were to be a downturn in 2016/17.
Back to the employment picture for a moment. We have shown in the chart below year on year jobs growth and GDP growth. With the number of US employed growing at more than 2% year on year, we would expect real GDP to be growing at or above 4%. Certainly the last time jobs growth was sustainably above 2%, in the late 1990s, this was the case. So it appears that the jobs market is healthier than the real economy; a classic case of poor productivity, and this could be crucial in the quarters ahead for the equity market.
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For companies to increase output, they either need to invest in new plant and equipment or they need to hire more workers – they need to employ more capital or more labour. It is clear that in the post 2009 cycle, the quoted non-energy sector has not been interested in ramping up capex and have instead been employing more workers to meet increased demand. Without any meaningful wage growth, this has allowed profit margins (helped by aggressive accounting techniques and low interest rates) to expand to record high levels, as shown in the chart below courtesy of Andrew Smithers.
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In the last weekly report, we wrote about corporate excess and how executives are hugely incentivised to work at boosting share prices, and part of this is utilising any measure they can to boost earnings. An obvious ploy has been to borrow money to buy back shares which boosts both the share price and earnings per share. If needed, companies will cut jobs (see IBM, Proctor and Gamble and American Express for example across different industries outside the energy sector) and hold back on capex to boost earnings. We wonder whether we are close to some sort of tipping point whereby profit margins must come down as productivity declines because of years of under investment. This should cause future earnings to miss still elevated Wall Street expectations. Alternatively, to keep long-term margins high, companies need to invest now which is of course a headwind for short term earnings. Alternatively, workers simply need to increase output and not be paid extra.
Simply put, the US has reached the point at which both consumers and the corporate sector can no longer both be beneficiaries. If the corporate sector wins, and the share that goes to labour loses, how can this be good for sustainable economic growth? If the share of labour rises, then corporate profit margins revert to the mean, and how can this be good for the stock market?
Our view is that the economy will struggle more in the first half than many expect, and this will likely put pressure on corporate earnings. As a result, more job losses will be seen as executives respond and this will impact on the consumer. Of course, the benefit from lower energy prices will help a lot, and the real question on this front is whether consumers choose to spend this windfall or save it. With the household savings rate at a historically low level, this could go either way.
In terms of the stock market, everyone knows that the US market is fundamentally expensive. However, the economy and corporate profits have kept growing and central bank largesse has been the main driver of returns. If the economy and corporate profits come under pressure and the Fed are seen as being at the start of a rate rising cycle, then we believe that the best of the post 2009 returns have been seen, and the potential for a meaningful correction is higher than many think. In the event of a market correction, we will see just have brave the Fed will be in raising rates.
Just one more comment on whether the Fed will raise rates sooner than we expect. Virtually every other central bank is either easing or perceived as being dovish. If the Fed maintains is desire to raise rates, then the US Dollar could make more gains having risen by nearly 20% in the second half of last year. A strong Dollar always leads to a crisis somewhere, with emerging markets the usual candidate. However, a strong Dollar is likely to lead to weaker than expected growth in the US as well. Negative rates on trillions of dollars of paper in Europe and Japan is distorting the allocation of capital, and if ECB QE helps the Dollar overshoot on the upside, we think it will ultimately lead to a global crisis not just an emerging market crisis.
