The S&P 500 Index is up 22.8% this year and trading near all-time highs, but among lawmakers’ shenanigans, looming Fed policy decisions, and noisy global economic data, it ain’t easy being an investor these days. We’re subject to all kinds of whiplash. Last week was a case in point. October jobs data were stronger than expected, which should have been nothing but good news. Still, stocks barely budged and Treasuries sold off on revived fears that the Fed would begin tapering its large scale asset purchase program—perhaps as soon as December.
Nobody knows when the Fed will actually start tapering (the consensus is still for a March start), but whether it’s one, three or five months from now, eventually they’ll decide that the data finally warrant bringing asset purchases to an end (an interest rate hike, of course, is likely still years away). The problem for investors at this moment, with valuations near their long term averages and domestic equity indices at near record levels, is whether to celebrate or cringe when the economic data are positive. Does an improving economy and consequent taper prolong the current rally or bring it to a pause?
To prevent ourselves from being whipsawed by the economic releases or fiscal or monetary policy machinations we have maintained four main adages that have kept us on the right side of the market rally. 1) Markets don’t trade on the absolutes of good and bad but on whether things are getting better or worse. 2) Be aware of (or profit from) the herd’s mentality. 3) Don’t fight the Fed. 4) Hating the government is not an investment strategy. For all of the public sector’s attempts to derail the recovery, the private sector continues to improve, albeit at a frustratingly slow pace. Notwithstanding the inflows into equities over the past few weeks, the herd still remains generally cautious.
Friday’s move in Treasury rates serves as a reminder that investors should consider replacing more interest rate sensitive assets with securities that tend to outperform in an improving global economic environment. The 10-year Treasury yield has risen more than 100 basis points since its May low, having peaked near 3% in September at the height of the “taper tantrum.” Perhaps if we see additional positive economic data, markets will once again drive yields toward 3%, which could translate into weakness (at least in the short term) for yield-sensitive asset classes. Last go round, these included core bonds and telecom and utility stocks. That having been said, other asset classes that are more directly exposed to a strengthening economy did quite well including U.S. dividend growth stocks and senior loans.
There’s certainly no pressure for the Fed to act because of inflation; prices and wages are barely rising. But with the central bank’s balance sheet now at $3.65 trillion, a new chief on the way in and a consistent message that the timing of a taper would be “data driven,” we should assume tapering is on its way and be prepared for some volatility in interest rate sensitive assets.
Stronger than Expected October Employment
October non-farm payrolls beat virtually all expectations, with the economy adding 204,000 net jobs despite the drama in Washington. Private payrolls grew by 212,000, a pretty decent showing, with leisure and hospitality, professional and business services, retail, manufacturing, and construction gaining the most, in that order. The furlough of many government employees introduced some noise into the report, with those workers apparently being counted as unemployed in the report’s household survey, but employed in the establishment survey-thus slightly pushing up the reported unemployment rate (another example of why I tend to discount this over-emphasized data point). Future reports will probably revise away that discrepancy, however. Overall, the labor market continues to show modest strength, with the economy adding about 2.3 million jobs over the last year. While that’s barely enough to surpass population growth, and many of those jobs are low-wage positions, the fall of 2013 is shaping up to have been better for job seekers than many thought it would be.
Last week also brought new data on consumer incomes and spending for September. The former was stronger than expected, growing at 0.5% month over month. The latter slowed from 0.3% to 0.2%, and if consumer confidence surveys since the shutdown are anything to go on, spending—representing about 70% of GDP—has probably remained fairly soft. Though consumers may be saving more, rising employment and cheaper gasoline (which has fallen below $3.00/gallon in some areas) should give them greater spending power going forward. The question, particularly as the holiday shopping season nears, is whether they’ll feel confident enough to open their wallets. Whether they do will bear on corporate revenue growth, which continues to trail that of earnings.
Elsewhere in the economy, August and September factory orders, which were combined into a single report following the shutdown, pointed to weaker conditions in manufacturing. The reported weakness contradicts other evidence we’ve seen, including strong October readings two weeks ago for the Chicago Purchasing Managers’ Index and the Institute for Supply Management’s (ISM) Manufacturing Index. If the picture is muddied for manufacturing, however, the much bigger services sector seems to be doing quite well. Data released last week showed the ISM’s Non-manufacturing Index climb to 55.4 in October from 54.4 the previous month, with measures of business activity and employment picking up strength and new orders remaining robust.
Although the economy continues to expand at a modest pace, we have yet to see companies’ “animal spirits” emerge in force sufficient to drive hiring and capital spending higher. Demand for loans remains flat even as lending standards ease, and part of companies’ hesitancy (like consumers’) probably has to do with uncertainty from policymakers. While Washington still must grapple with contentious regulatory, spending and taxation questions, I don’t expect another government shutdown or extreme brinksmanship over the debt ceiling this winter, and the force of fiscal headwinds should moderate next year. Though confidence has taken a bruising in the past couple of years, the potential for stronger growth in the quarters ahead is certainly there.
ECB Responds to Disinflation Fears
If uncertainty is high in the U.S., it’s even higher in Europe. Last week’s European Central Bank (ECB) decision to lower benchmark interest rates is a testament to that uncertainty. Despite the recent emergence of “green shoots” in the Eurozone, very weak October consumer inflation—the weakest in almost two years—raised fears that the currency bloc could be backsliding economically, potentially even toward Japanese-style deflation. Last week’s rate cut was long overdue, and prospects are slim that the ECB would embark on a program of massive quantitative easing, as the U.S. and Japan have. In fact, Frankfurt has allowed its balance sheet to shrink as money lent under the LTRO program repays. The most likely outcome is more muddling through: enough action to prevent a meltdown, but not enough to really kick-start the growth Europe so desperately needs. If there’s a silver lining, however, it’s that the latest bout of worries (not to mention a downgrade of France’s credit rating) has eased some of the recent upward pressure on the euro, which had been working against export-oriented European firms.
China Plots out Reforms
No discussion of whiplash and uncertainty would be complete without China, which this weekend begins its Third Plenum, a four-day meeting at which the government aims to map out economic and political policy for the next five years. To try to reorient China’s investment and export led economy toward a more sustainable, consumption-driven model, the government has already taken a few measures, such as cutting taxes for small firms. The Third Plenum will try to add substantially to such efforts by introducing programs to deregulate industry; opening the Chinese economy; liberalizing the financial system, reforming regulations on land ownership and the household registration (“hukou”) system; reforming inefficient state owned enterprises; introducing property taxes; reforming pensions; and making municipal finance more transparent. That sounds like a tall order, and it is. Such sweeping changes will not come overnight, but much rides on the government’s willingness and ability to enact them. Deregulating industry, for example, would likely pave the way for stronger growth and a greater ability to absorb millions of well-educated Chinese who don’t want to work in factories. Reforming property taxes and municipal finance are ways to help rationalize the Chinese property market, while social security and hukou reform can help China manage the process of urbanization and income inequality more effectively.
As I’ve written previously, China is at a crucial stage of its development as it approaches the “Lewis turning point,” when supplies of cheap labor diminish, growth slows and developing further becomes more and more difficult. The country’s demographics don’t help; the Chinese workforce is rapidly aging. Whether China can overcome its challenges could be among the most important economic stories of the coming decade or more. The Chinese government seems to recognize some of its most important challenges and seems committed to overcoming them. For the sake of the global economy, we should hope they succeed.
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