The employment report presented no surprises.

Inflationary pressures are increasing slowing but earnings are growing nicely. Which proves to be more important will determine the future direction of stock prices.

Stocks fell sharply yesterday coincident with a sharp two-day spike in bond yields although losses were cut by the end of the day as traders hesitated in front of today’s big employment report.

The employment report itself was mixed.  The nominal number for employment growth was 134,000, well below consensus forecasts. But the upward revisions for July and August totaled 80,000.  If you add that to the 134,000, the number would be quite good.  In addition, Hurricane Florence might have affected the number somewhat.

The number within the employment report that everyone was watching given the sharp rise in bond yields over the past week, was the average hourly wage.  That number rose $0.08 month-over-month or 2.8% year-over-year.  That annual increase was a slight tick down from the 2.9% last month.  The immediate response in the bond markets was a very slight one basis point increase in both the 2 and 10 year Treasury bonds.  Stocks reacted well immediately in the futures market but then turned negative.

We appear to be at a bit of a crossroads in financial markets. The bull market for bonds that began in the early 1980s is now over.  It ended two years ago when the 10-year Treasury hit 1.35%  Virtually no one expects that rate to be seen again for a long time, maybe not within the lifetime of any one of us.  Bond cycles tend to be long, measured in decades.  It takes a very long time for inflationary pressures to build and it takes a long time for them to fully dissipate.  In the late 1940s and early 1950s, long term bond yields centered around 2.5%.  After the 1968 election, when President Nixon selected Arthur Burns to head the Federal Reserve, they set out to fight inflation that was approaching 4%.  Many of us have memories of the late 1970s when rates soared to double digit levels.  But no one has any reason to be thinking that way today.   Wage pressures build slowly.   Companies that have lacked pricing power for so long don’t suddenly feel brazen. There is still the Internet that gives all of us price discovery.  Today, we can find the best price very easily.

With that said, we have a different overlay this time around.  For many years since the Great Recession, central banks have been flooding the world with cheap money, something we all labeled quantitative easing or simply QE.  Now that economies are almost fully recovered, a decade later, it is time for them to return to normal. The U.S. has led. We are now raising rates and the Fed is reducing the size of its balance sheet by about $50 billion per month.  Soon Europe and eventually Japan will follow.  China may be a bit later because it needs easy money to offset the pain of tariffs but it too will eventually come around.   More money chasing the same assets means higher values for financial assets.  How much of the rise in asset prices (i.e. stocks and bonds) related to QE and how much was due simply to better economics is something no one can answer definitively.  Both were factors. To that there is little argument.

Now we face a time when the economy is humming, maybe even accelerating.  But the reversal of QE will be a bit of a headwind.  Whether the tailwind of economic growth is stronger than the reversal of QE remains an open question.  To date it hasn’t hurt much because only the U.S. has been raising rates and selling central bank assets. But as others join in and as interest rates approach and even surpass the rate of inflation (meaning borrowing is no longer “free”) we will begin to see the impact more.

In 2008 and early 2009, one of the buzz phrases at the time was “green shoots”.  Everyone was looking for signs that the economy was improving.   First we saw stabilization in the Treasury market. Then the monthly job losses started to shrink. They still declined, but the numbers weren’t quite as bad.  Finally, higher risk classes stabilized. By early 2009, junk bond yields started to decline.  By March, the stock market hit bottom.

Today, the risks relate to the withdrawal of QE and the possibility of higher inflation.  The problem isn’t economic growth. Those numbers are excellent. U.S. growth of 4% seen in the second quarter may not be sustainable but growth of 3% or better is likely for some time.   No one is getting fired, consumer confidence is at a high, and small business owners are optimistic.

But there are signs of concern on the inflation front.  Wages are increasing and the pace is picking up slowly.  Capacity utilization has crossed 79%.  When it crosses 80%, that is a tell that pricing power is beginning to return to the seller.  As central banks withdraw QE, interest rates will normalize.  We saw a quick bump in the 10-year Treasury from 2.4% around year end 2017 to over 2.8% during the February-March correction.  Then rates stayed flat until just a few weeks ago.  Suddenly they are over 3.2%.  In some ways, this shows that even bond markets, in the very short term, can be surprisingly illiquid.  These spikes require some realignment in values of other asset classes.   An increase of just 20 basis points in long term rates may equate to a decline of about a percentage point in the market’s price-earnings ratio.  That doesn’t sound like much but a one P/E decline would represent a correction approaching 7%.

Thus, we have cross currents facing us today, a somewhat bumpy upward sloping yield curve, a combination of slightly higher inflation expectations diminished QE, versus a strong uptrend in earnings.  We all know the earnings tailwind will dissipate a bit as we go into 2019 because the tax rates year-over-year will stabilize.  But we all know that and it is priced in.

The most logical conclusion is that our economy remains strong and that earnings continue to grow at a slightly better than normal pace.  But earnings are only part of the equation that dictates asset prices.  It is also logical that P/Es next year decline as interest rates rise.  The intersection will determine whether the rally extends for another year or not.  After two big years, a sideways year wouldn’t be an unexpected outcome.   In such a year, one might expect more volatility. But none of this suggests that anyone should rush out and change asset allocations.  Asset allocations should be set to each individual’s needs and risk profile.  Only in extreme circumstances should market conditions dictate a change.  A strong economy and the prospect of a relatively flat market don’t seem to be such a circumstance.  As one gets older, the asset mix often changes to reduce risk regardless of the market outlook.  No reason for that to change either.

There has been a lot of talk as the 2-10 year Treasury yield curve flattened, that a recession was approaching. Over the past couple of weeks, the curve has steepened and recession talk has subsided.   The simply thing to say is that until it inverts, we shouldn’t worry about a recession.   Let’s not put the cart before the horse.  What we should be looking at is a growing economy with better earnings, some increase in inflation, and a bunch of mid-course adjustments.  That might mean that returns over the next year or two won’t match those of the past couple of years but, over the long term, we remain on a very acceptable flight path.

One should always be diligent looking for storms ahead.  But every cloud isn’t a rainmaker and an occasional rain shower is the key to life.  Stay calm and stay true to your asset allocation.


Today, Kate Winslet is 43.


James M. Meyer, CFA 610-260-2220


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