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Strong earnings help U.S. and European equities

Brian Nick, Chief Investment Strategist, TIAA Investments


August 4, 2017

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Quote of the week

"Economics is extremely useful as a form of employment for economists.” – John Kenneth Galbraith

The Lead Story: A (mostly) thumbs-up July jobs report

The U.S. labor market generated 209,000 jobs in July, easily outstripping forecasts. Additionally,  the unemployment rate dipped by 0.1% to 4.3%, matching a 16-year low, and the labor force participation rate ticked up by 0.1% as most people who entered (or reentered) the job market immediately found jobs. The slight rise in the number of manufacturing payrolls could signal that the weaker dollar—which makes U.S. products more competitive overseas—has finally begun to act as a tailwind.

Average hourly earnings rose just 0.3% for the month (+2.5% over the past year), a tepid pace that nonetheless should lift core inflation closer to the Federal Reserve’s 2% target.

Brian Nick, Chief Investment Strategist, TIAA Investments

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Article Highlights

All told, July’s showing is solid but not game changing. Looking longer term, we’re pondering how long the current “Goldilocks” economy (combining steady growth and low inflation) will last. If we’re correct that some labor market slack remains, then wage growth and overall inflation could stay at current low levels for an extended period of time. In contrast, less slack could trigger stronger wage gains, leading to higher inflation and a faster pace of Fed rate hikes.

In other news: “I want to be loved.”

That’s what blues great Muddy Waters once sang and what the S&P 500 Index might be feeling as this bull market continues to be one of the most unloved ever. Despite having already returned nearly 12% year to date through August 4, investors have pulled some $11 billion out of U.S. equity funds since January 1, while adding more than $210 billion to taxable fixed-income vehicles. 

Meanwhile, the market-friendly second-quarter earnings season entered its final stages. Earnings have topped expectations by 5%, while sales have come in largely on target. Thanks to rebounding energy prices, companies in the Energy sector have enjoyed enormous year-on-year profit growth. Excluding Energy, large-cap companies grew earnings at an 8%-10% annual clip, led by Technology and Financials, two of our preferred sectors. 

Profits have been even better in the Eurozone, rising 11% year-on-year (excluding Energy). We expect the region to exhibit modestly stronger earnings expansion in the medium term given the recent uptick in economic growth. Against this encouraging backdrop, Europe’s STOXX 600 Index jumped 1.2 % in U.S. dollar terms for the week, outpacing the S&P 500, which eked out a 0.2% gain. 

In U.S. fixed-income markets, investment-grade bonds moved in sympathy with equities, returning 0.4% for the week through August 3 and lifting their year-to-date return to a healthy 5%. Treasuries rallied for most of the week on the back of sluggish economic data before giving back gains following the release of July’s job numbers. As a result, the yield on the 10-year U.S. Treasury note, which moves in the opposite direction of its price, finished the week little changed at 2.27%.

Below the fold: Consumer spending, personal income, and service-sector growth slow in June

June’s disappointing consumer spending (+0.1%) and personal income (flat) results again reminded us of Muddy Waters, who once lamented that “you can’t spend what you ain’t got.” Nonetheless, the robust U.S. labor market reinforces the case for better consumer spending in the coming months. 

In the meantime, the PCE price index, the Fed’s preferred inflation barometer, was unchanged in June and has risen just 1.4% compared to a year ago. The “core” PCE price index, which excludes food and energy costs, increased only 0.1% last month and 1.5% in the past year.

Moreover, service-sector activity in the economy slipped last month to 53.8, an 11-month low, according to ISM’s non-manufacturing index. (Readings above 50 indicate expansion.) Manufacturing activity held up better, however, with the ISM index registering 56.3. And U.S. factory orders leaped 3% after consecutive one-month declines.    

Across the Atlantic, Eurozone GDP jumped 2.1% (year over year) in the second quarter, its fastest pace of growth in six years. Also, the region’s economy started the third quarter in good form: Markit’s Composite Purchasing Managers’ Index hit 55.7 in July.

Back page: Why aren’t more American men working?

The U.S. labor-force participation rate among working-age (16-65) men has steadily fallen, from nearly 87% in 1947 to 69% today. According to the Organization for Economic Development (OECD), of the world’s 23 largest economies, only Italy has suffered a more severe drop during the same period.  

For prime-age (25-54) working American men, the downward trend in labor-force participation began in the 1960s, accelerated after the global financial crisis of 2007-2009, and has improved only mildly in the past two years. With today’s economy at or near full employment, this is clearly no longer a cyclical problem. So why have so many men failed to return to the labor force? According to a number of studies, many factors are likely “at work” to keep men on the sidelines—including longer stints in school, rising incarceration rates, and substance abuse.

We see this issue as a structural shift in the workforce. As technology has displaced labor across a wide variety of industries, higher-paying manufacturing jobs have become scarce. Meanwhile, job creation in lower-wage service-sector positions, particularly in health care, has strengthened.  

At the same time, the social welfare net has expanded in the form of rising levels of unemployment insurance, disability claims, and Medicaid enrollments. This could also explain some of the sustained drop in labor force participation. One point is clear: losing such a large chunk of men during their prime earning years hinders the nation’s productivity and reduces its long-term potential growth rate. The longer they remain unemployed and their skill sets diminish, the greater the negative economic impact.