No Upward, No Onward?
“If you don’t know where you are going, any road will get you there.”
While the Fed decision to hold rates was anticipated, it was the reasons given that sent markets lower on Thursday and Friday. The FOMC statement inclusion of a new warning that “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further pressure on inflation near term” was a dovish shift, but a clear picture of reality. This fortified bearish arguments of a US economic slowdown spiraling into recession, lower corporate earnings, and potential global deflation. Slower growth in China is in its fifth year and by all accounts, the transition to a consumer-based economy is on schedule. However, the shift away from bricks and mortar has lowered commodity demand. As a result, short positioning in mainstream commodities is at historically high levels. With sentiment on global growth negative, the bears seized on the idea that this revelation by the Fed implies the situation is much worse and the Fed knows something not reflected in market prices. Such thinking borders on the ridiculous and takes on a life of its own when investment psychology is negative. We see nothing unusual in the FOMC decision recognizing that the year-over-year core rate of inflation is 1.6%, below the 2.0% precondition for a rate increase, may fall in the near term. It seems more reasonable that Chairman Yellen and the Board do not want to risk making this “highly symbolic” move to normalization without follow through.
The preoccupation with short-term movements in the markets has brought about a reincarnation of technicians and market timers. They have been drawn into the deteriorating global growth story which has monopolized the financial media since mid-summer. Only one problem, the US economy keeps growing. Dire reports of $20 oil, wholesale recessions in Emerging Markets, and the hard landing in China dictate day-to-day market swings. Contrary to what bears are forecasting; US stocks with 50% or more international revenue exposure and those with 100% domestic revenues have traded about the same since mid-August through mid-September. Stocks with 50%+ international revenues declined on average 8.0%, meanwhile, 100% domestic revenue companies were down 8.2%. Russell 1000 averaged a decline of 7.9% during this comparable period.
There will be low inflation in the US for years, not only from low energy and industrial commodity prices, but from rapid technological innovation and a changing labor market. Higher wages and salaries have been absent even though the level of employment is at its natural rate. This anomaly has been cited by the Fed and economists as temporary, but as yet there is no sign of an uptick. A recent study conducted by Liberty Street Economics provides data into current labor market conditions. Since unemployment rose to 10% in October 2009, the rate has declined steadily to the current level of 5.1% and is expected to fall below 5.0% by year-end. Jobs by unemployed persons have added to a net 11.3 million workers to total private payrolls. Given the magnitude of the decline in the unemployment rate and the number of new jobs added, wage and salary growth has been virtually nonexistent. Our interpretation of the Table below is that being unemployed is a significant handicap when compared to job seekers that are currently working. At employment, the unemployed, on average, receive an hourly wage 18.5% below their previous pay. The employed worker pay outstripped the returning worker by raising, on average, his earnings 6.9% over his previous job. Additionally, only 13.2% of the job-to-job workers did not receive benefits, compared with 37.3% for reentering workers.
What does this mean? Firstly, the depth of the Great Recession limited job mobility and although there were incremental pay increases,turnover was much lower. On the other hand, those returning after being unemployed, many with long-term unemployment, were more willing to settle for lower wages. In fact, data from the Study show that 40% of these workers are actively looking again compared with 23% of those who have not been out of the workforce. With so many reentrants on the employment rolls at lower overall costs (wages and benefits) to employers there seems little likelihood of any near-term wage/push inflation.
The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. Earnings should begin more favorable comparisons as 2016 approaches and stocks, currently 16x estimated forward 12-month earnings, are not expensive. Markets remain vulnerable as investors and traders reassess China and Emerging Markets, falling oil prices, a stronger dollar, and fluctuating interest rates. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.