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May’s disappointing jobs report doesn’t spoil the equity party

Brian Nick, Chief Investment Strategist, TIAA Investments


June 2, 2017

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Quote of the week

“If you don’t like how the table is set, turn over the table.” — Frank Underwood, from the series “House of Cards”

The Lead Story: Signs of laboring from the U.S. labor market

May’s employment data showed a softening jobs market. Payroll growth totaled 138,000 compared to the consensus forecast of 182,000.  Downward revisions to March and April brought the total “miss” to 110,000 fewer jobs than expected. The unemployment rate continued to fall, to 4.3%, from 4.4% in April, largely due to a drop in the labor force participation rate.  On the bright side, the so-called “underemployment rate” ticked down to 8.4% from 8.6%, a sign that more of those who want to work are able to find jobs.

Brian Nick, Chief Investment Strategist, TIAA Investments

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Article Highlights

The long-term downward move in the size of the labor force relative to the population is demographically driven as baby boomers reach retirement age. The momentum of this decline had been temporarily arrested by stronger economic growth, pulling more people into the labor force. Absent higher wages, however, it may be difficult to attract a significant number of discouraged or “marginally attached” potential workers back into the jobs market.

The weakness in this report is probably not alarming enough to prevent the Fed from hiking interest rates at its upcoming meeting on June 14. The low unemployment rate—demographics aside—and the near-record number of job openings still point to a labor market that is tight and getting tighter. The lack of strong underlying  wage pressure (wages rose just 2.5% year-over-year) will reassure the Fed that its slow pace of rate increases remains appropriate. 

Today’s data and the market’s reaction to it lend credence to our long-standing thesis that the relative growth rates between the U.S. and the rest of the developed world are converging, given the advanced stage of the U.S. economic expansion and the improvement in Europe. Any further weakness in U.S. data will drive equity investors even more toward foreign markets, which they have already been doing in droves this year, according to flow data from the Investment Company Institute.

In other news: This Treasury and equity rally have got us thinking

After flatlining at 2.21% for three straight days in a week shortened by the Memorial Day holiday, the yield on the bellwether 10-year U.S. Treasury fell immediately following the employment report’s release on June 2. (Yield and price move in opposite directions.) It ended the week at 2.16%, a seven-month low. Greater-than-expected first-time unemployment claims, along with the May payrolls data, have provided  the fixed-income market with a sense that the Fed’s tightening timetable could be slower than previously forecast.

A continued lack of wage pressure—even  as the unemployment rate hits new cycle lows—has also contributed to the decline in yields. Additionally, it now appears that the Trump administration will have to wait until 2018 to pass fiscal stimulus or tax reforms. This pause has deflated nearly all of the reflation trade momentum that had sent Treasury yields higher post-election. 

Returns for non-Treasury “spread sectors” were broadly positive for the week through June 1. These asset classes have performed well this year, although the pace of spread tightening has slowed.  

It’s interesting to note the continued divergence in mood between the bond and stock market. While the former has been sending more cautionary signals—as evidenced by falling yields —the latter has been quite jubilant. While both markets seem to have incorporated the reflation reversal, stocks appear to be hanging on to stronger earnings to support them in the months ahead.

Of course, should wages finally begin to rise given the scarcity of labor, Treasury yields should recover, hurting bond prices. In that case, equities could still outperform, fueled by increased consumer spending.  Alternatively, if lower Treasury yields turn out to accurately portent weaker U.S. growth, equities may find they’ve run slightly too far, too fast.

But  for now, the stock market party rolls on, with the S&P up another 0.9% for the week en route to establishing several all-time highs. Europe’s broad STOXX 600 Index also enjoyed a solid week, advancing 1.1% in U.S. dollar terms.  The German DAX index hit an all-time high on June 2 as well.

Current updates to the week’s market results are available here.

Below the fold: Consumer spending heats up, while inflation cools

In addition to May’s job report, the U.S. economic data docket was heavy with closely scrutinized gauges of the economy’s health. Among the week’s key releases:

  • In the latest sign that the divergence between “hard” and “soft” data is narrowing, consumer spending climbed 0.4% in April—marking its biggest gain since December. Personal income also jumped 0.4%, doubling March’s showing. Meanwhile, after zooming to a 16-year high in March, the Conference Board’s index of consumer confidence has now fallen for two consecutive months.
  • Inflation, as measured by the Fed’s preferred inflation barometer (the PCE index), rose 0.2% in April, leaving prices just 1.7% higher than they were a year ago. The “core” PCE index, which excludes food and energy costs, also increased 0.2% in April and is up only 1.5% over the past 12 months. By accelerating 0.9% in March, home prices lifted their year-over increase to 5.9%, a three-year best, according to the S&P/Case Shiller 20-City Composite Index.
  • By accelerating 0.9% in March, home prices lifted their year-over-year gain to 5.9%, a three-year best, according to the S&P/Case Shiller 20-City Composite Index.
  • U.S. manufacturing activity quickened slightly in April, to 54.9, according to the index published by the Institute for Supply Management. (Readings over 50 indicate expansion.)
  • Overseas, Eurozone manufacturing activity hit a six-year high, with Markit’s final Purchasing Managers’ Index for May registering 57.0. Growth in output and new orders underpinned the region’s strongest job creation in the survey’s 20-year history.

Back page: The flattening yield curve—a recovery with legs:

The slope of the U.S. yield curve—the spread between the 10-year Treasury note and the 3-month Treasury bill—is frequently used as a gauge of economic/financial market conditions. An inverted curve, where short-term rates are higher than long-term rates, indicates diminished expectations for growth and can be a harbinger for recession. Flat yield curves are more ambiguous, however, occurring in both recoveries and downturns. 

The curve has flattened in recent years as short-term rates have risen alongside the federal funds target rate, which the Fed began raising in December 2015. Meanwhile, the persistently low 10-year Treasury yield has reflected lingering post-financial-crisis pessimism and low global rates. After surging above 200 basis points (bps), or 2.0%, subsequent to the U.S. election, the curve has fallen back to just 118 bps, well below its 25-year average of 182 bps.

It’s not unusual for the curve to remain relatively flat for long periods. Over the last 35 years, it has tended to bounce between 0%-2% during mid-cycle phases lasting from 2-7 years. The spread has turned negative just three times (since the early 1980s); after doing so, the economy has gone into recession within 12-18 months.

The Fed appears confident in the recovery and will likely raise rates twice more in 2017. At the Fed’s current pace, it would take at least two more years to see the yield curve turn negative, assuming the 10-year remains at today’s yield. We believe long-term rates are headed moderately higher (at least) in the near-term, which would postpone any inversion even further. So even if the Fed hikes consecutively toward normalization, the yield curve signals that this recovery has legs.