Wall Streeters disagree about when the Fed will start to tighten (September?, December?) but most agree that once it gets started the pace of tightening will be exceeeeeeedingly gradual. An overleveraged US in a weak world economy supposedly requires easy money for the foreseeable future.
But I predict . . .
. . . Wall Street will be singing a different tune 18 months from now. Word on the Street will be that the Fed has to tighten faster than people thought back in 2015. For a simple reason: the economy is adding ~210,000 jobs per month but only needs around 100,000 to keep up with population growth. So the unemployment rate is falling 90-100 bps per year. Over the last 12 months the jobless rate fell -0.8% (6.1% to 5.3%); this metric averaged -0.9% over the past six months. At this pace, the unemployment rate will be 3.9% by the end of 2016.
How low is 3.9%? Of the 546 months since the start of 1970, just six months were below 4% and the lowest figure was 3.8%. Even Larry “Secular Stagnation” Summers would agree a near–zero Fed funds rate is too low when unemployment is at record lows. Inflation is already approaching the Fed’s 2% target; the core CPI is rising 1.8% yr/yr. As wage metrics such as the Employment Cost Index accelerate and the debate shifts to how high rates must go to restrain job growth, investors will belatedly recognize the Fed is way behind the curve.
Four Reasons to Expect Rate Psychology to Change
Official Group Think. Central bankers in Europe, Japan, China and emerging markets (Madame Lagarde) are trying to nurture weak economies by pressuring the bankers of close-to-full-employment economies (the US and UK) to keep rates low. Lagarde explicitly instructed the Fed not to tighten until 2016. Yellen and Carney seem to be looking for reasons to maintain easy money. Yellen is a dove who loves to talk about the “slack” in the labor market, but in all her speeches and Congressional testimony I have never heard her address the simple fact that—as the Congressional Budget Office detailed—Obamacare will keep millions of people out of the labor force and increase part-time employment. Thus, much of Yellen’s “slack” is an optical delusion. Another problem, sadly, is that public schools are turning out semi-literate graduates who are not qualified for most jobs.
Bond Bears Have Cried “Wolf” for So Long that investors are complacent, oblivious of basic relationships involving inflation. Very early one morning I watched an eye-opening exchange on Bloomberg TV-Europe between a grizzled rates strategist who thought central bankers needed to tighten and a much younger FX strategist. “Weak UK productivity growth puts pressure on the Bank of England to tighten” said the bearish veteran, but the FX strategist denied low productivity growth was inflationary – it merely increased demand for low-wage workers. The veteran was incredulous; “Don’t you know that weak productivity growth means faster increases in unit labor costs?”
Deflationary Side-shows Obscure the Big Picture Shenanigans in Greece and Chinese equities divert attention from a tightening labor market. So do weak gold and oil prices. Neither Greece nor China’s stock market matter much to the U.S. economy, and by 2016 the year/year change in oil prices will be flattish, as comparisons get easier.
Radio Daze I distrust official statistics, which are revised heavily and often rendered useless by structural change. If they were a trustworthy guide to the future the Fed, with its 10 million economists and unlimited access to proprietary information, would not have failed to predict the last three recessions. (Bernanke assured Congress in the spring of 2007 “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”)
Conversely, I like anecdotal evidence such as radio commercials. Numerous ads for pets.com and drkoop.com pretty much rang the bell at the top of the tech mania in late1999; ditto all those ads for second mortgages in 2007 and gold funds in the summer of 2011.
So I think it is highly significant that Verizon—a big, solid employer that presumably offers good benefits—is advertising on New York City radio stations to recruit workers. And don’t forget that 26 states have lower unemployment rates than New York—in many cases, much lower. Earth to Dr. Yellen: Verizon would not be doing this if there were still plenty of “slack” in the labor market.
Investment Implications
Although much more bearish for bonds than stocks, rising short rates will keep a lid on PE ratios, which are already lofty for this point in the cycle, when profit margins are elevated and future earnings growth will be moderate. What would make stocks plunge is if investors sensed that rising rates could tip the U.S. economy into recession. I also wonder whether big losses in bond ETFs could spook investors and hurt consumer spending.
Addenda
Two important items in the FT:
James Grant cites a study showing that an increasing number of companies are encouraging analysts to focus on “pro forma” EPS that excludes option expense, as opposed to GAAP earnings. Pro forma EPS is not all bad—it excludes exceptional gains as well as losses—but excluding option expense is ridiculous. My takeaway: where is the SEC on this issue? They were all over it in 2003, when everyone had sworn off tech stocks, but now that we have new mini-bubbles in some tech stocks and biotechs the SEC is nowhere to be seen. That’s the problem with regulators: like investors, they have short memories.
Dominic Rossi of Fidelity cites a big study based on Fido’s internal database of 2700 firms showing that – contrary to popular lore – capital spending is very healthy in most industries and substantially exceeds depreciation. This is consistent with my May 27 post showing that a WSJ article attacking hefty dividends and buy-backs was based on a crude misinterpretation of the charts that accompanied the article. The notion that dividends and buy-backs are starving capex is a fairy tale—but a dangerous one, because Hillary Clinton believes it.
Copyright Thomas Doerflinger 2015. All Rights Reserved.
