Data deluge does little to move markets—but U.S. stocks still close at record highs

Brian Nick

Article Highlights

Quote of the week

“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 Lead Story: Plenty of jobs but no wage growth

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.
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:
  • Consumer spending jumped 1% in September, its best one-month gain since the beginning of the current economic recovery in 2009. Caveat: the surge was likely inflated by post-hurricane-related purchases.
  • Consumer confidence hit its highest level since December 2000, based on The Conference Board’s index.
  • The manufacturing index published by the Institute for Supply Management (ISM) dipped from a stratospheric 60.8 in September to a merely robust 58.7, largely because of the easing of hurricane events on supply chains. (Index readings above 50 signal expansion).
  • Meanwhile, ISM’s non-manufacturing index hit its highest level (60.1) since 2005, highlighting a strong service sector.
  • In spite of these favorable growth indicators, inflation remained well below the Federal Reserve’s 2% target. The Fed’s preferred inflation gauge, the core Personal Consumption Expenditure (PCE) Index, rose only 0.1% in October and 1.3% over the past 12 months.

On balance, given the economic backdrop, the markets are still pricing in a 100% chance of a Fed rate hike in December. We concur with that probability, believing that the Fed will remain more focused on the unemployment rate and average monthly payroll gains than on flat wages.

In other news: Tax reform—eat your spinach!

“No dessert unless you eat all your vegetables!” is a common refrain among parents. Congressional Republicans ran into a similar admonition during the week when they introduced their tax-reform plan. The mantra on this bill has long been a 20% corporate tax rate and lower marginal rates for individual taxpayers, with some offsets to help it pass budgetary muster—in effect, all pie and no broccoli. Now we’re learning that the vegetable component of this tax plan includes lower limits on the home mortgage deduction, a partial elimination of the state and local tax (SALT) deduction, and a curtailing of interest-cost deductions for corporations.

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.
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.

Below the fold: Fed Chair announcement holds no surprises

As expected, President Trump nominated Jerome Powell to replace Janet Yellen as the next Fed Chair. From the markets’ perspective, appointing Powell is as close as one could come to keeping Yellen, given that he has sat on the Fed board during her entire tenure and has never openly dissented on a single Fed decision or given a contrarian speech during that time. Most Fed watchers consider Powell to be in the center of the dovish-hawkish spectrum, which suggests he will probably continue the Fed’s gradual, data-dependent shift away from accommodative monetary policy, a transition that began in 2013. Barring any unforeseen obstacles, he’s likely to sail through Senate confirmation hearings and assume the chairmanship on February 4.

The lack of drama surrounding the Powell announcement likely explains the lack of market reaction to it. Overall, U.S. equity markets responded in measured fashion to most of the week’s individual data releases and news headlines, having already priced in certain expectations and/or paying closer attention to corporate earnings than to macro events. This didn’t stop the major indexes from reaching new record highs, however.

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.
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).
Meanwhile, fund flows into emerging-market and investment-grade corporate debt remained positive during the week, while high-yield bonds saw an outflow. Spreads overall were flat to slightly narrower across most credit markets, as risk appetites increased in sympathy with equity performance, continued benign inflation, and flat wage growth.

The Back Page: Can small caps resume their rally as the tax-reform debate gets underway?

If the performance of small caps versus large caps has been a proxy for the perception that Congress will enact tax reform, market participants don’t seem overly confident about passage of the GOP’s bill in its current form. Based on respective Russell indexes, small caps (+11.15%) have underperformed large caps (+16.93%) year to date and have lagged badly since rallying by 15.4% in the weeks following the presidential election last November.

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.
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.

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.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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