November 3, 2017
“If you don't eat yer meat, you can't have any pudding! How can you have any pudding if you don't eat yer meat?”― Pink Floyd, “Another Brick in the Wall, Pt. 2.”
The U.S. economy generated 261,000 jobs in October, a robust number but below forecasts of well over 300,000. Payrolls for the prior two months were revised upward by 90,000. Meanwhile, the national unemployment rate ticked down from 4.2% to 4.1%, its lowest level since December 2000, although this drop was driven partly by a plunge in the labor force participation (LFP) rate. With 765,000 fewer people in the workforce last month—a decline attributable in large measure to retirements—the LFP rate erased the modest gains it had made since December 2015.
More worrisome was a literal halt in wage growth, which came in at 0% month-over-month, versus expectations of 0.2%. Sluggish wages reflect a tilt in job creation toward lower-paying jobs, evidenced by an unemployment rate of only 5.7% among people without a high school degree—a 25-year low. Meanwhile, there are fewer workers willing and able to fill the millions of low-wage openings. Because the U.S. economy is creating around double the number of jobs it needs to keep up with population growth, and unemployed workers are becoming scarcer every month, it’s only a matter of time before wage inflation arrives.
Brian Nick, Chief Investment Strategist, TIAA Investments
Beyond the labor markets, U.S. economic data has been almost uniformly positive of late. In the past week we saw a slew of strong data releases, coming on the heels of the healthy 3% third-quarter GDP estimate the previous week. Among the reports:
We’d place the probability of any tax bill becoming law before the 2018 midterm elections at around 50%. Assuming something does pass, it’ll more likely be a slimmed-down tax cut than something closely resembling the current House bill and its elimination of popular deductions. By definition, getting rid of these deductions is unpopular, and House representatives have to answer to voters next year.
Some of these proposals are going over like a lead balloon among both Democrats and certain House Republicans. The trouble is, Congress needs to eliminate close to $4 trillion in deductions to get the tax cuts they seek, while keeping the bill under its $1.5 trillion allotted price tag.
In fixed-income markets, yields fell despite positive U.S. economic news. The yield on the bellwether 10-year Treasury note fell 8 basis points (0.08%), ending the week at 2.34%. (Yield and price move in opposite directions.) Bond investors took the Powell announcement in stride and began to digest the many proposed changes in the tax-reform bill. At this stage, it is simply too early to put too much emphasis on any one aspect of the proposal, beyond the general theme of lower corporate and individual tax rates. As revisions and refinements to the bill occur, we would expect to see reactions from specific fixed-income sectors most affected by the changes, as well as some volatility should uncertainty about the bill’s prospects linger well into 2018 (which is our expectation).
For the week, the S&P 500 Index was up 0.26%, closing at 2,587.84. Technology stocks were among the leaders, while homebuilders declined on a proposal in the tax-reform bill that would limit the deductibility of mortgage interest for higher-priced homes. Outside of the U.S., Europe’s STOXX 600 Index gained 0.78% in U.S. dollars, bolstered by continued strong economic readings for the region.
As optimism about lower corporate tax rates waned throughout much of 2017, so did relative enthusiasm for small-cap shares. Although they bounced in August (outperforming large caps slightly) once it became evident that Gary Cohn, President Trump’s top tax-reform advisor, would remain in the administration to help usher a bill to passage, the Russell 2000 Index has trailed the broader market over the past month amid the bill’s delayed release and lingering doubts about its ultimate enactment.
The reduction of the corporate tax rate to 20% would benefit smaller corporations the most. Notably, the median effective tax rate of 31.9% for companies listed in the small-cap Russell 2000 Index is high compared to the 28% for firms in the S&P 500. The prospect of a larger tax cut for smaller-cap companies helps explain their post-election rally.
On November 2, the day the House released its tax bill, both small-cap and large-cap stocks closed essentially flat—the latest expression of market skepticism that such a complex piece of legislation will be signed into law without major revisions.
© 2017 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA), 730 Third Avenue, New York, NY 10017