Why the Market's Downturn Shouldn't be a Mystery
The pileup of stocks in the first two weeks of 2015 has furrowed a lot of brows but it should not be much of a mystery. Fund managers are selling stuff that had worked last year, like utilities and consumer discretionary, and turned their attention to groups that had been abandoned and could be bid up amid an improving economy, such as home builders and real estate. Chips and biotech are going along for the ride higher too because they are still cheap.
On Friday, after an initial surge higher, shares traded lower in response to a mixed December jobs report. Payrolls jumped by 252,000, which was slightly better than expected. But the unemployment rate narrowed to 5.6 percent, a tenth more than expected and reflective of a job market that is tightening quickly.
I happened to be in a room at the time the jobs report was announced alongside two big–time macro traders from different hedge funds, who were attending the funeral of our mutual friend in New Jersey, and it was fascinating to hear them debate the meaning of the data.
I was impressed at how deeply they seemed to care about each data point and its implications for their unique world view. The most accessible thing I heard was one of them say was that “if you only do one thing with the monthly jobs report, it’s this: Fade whatever move happens first.” (Fade is trader–speak for “trade against.”) That certainly worked on Friday, as the initial move higher was quickly obliterated as stocks did a swan-dive from midday through the close.
While the labor market tightening underway is good news for working Americans (with business surveys pointing to a shortage of qualified workers) it is bad news, at least short term, for the market. Yes, markets can be so mean sometimes. Not only does the tighter labor data keep the pressure on the Federal Reserve to end its 0 percent interest-rate policy but it jeopardizes corporate profitability as well.
You see at 5.6 percent the unemployment rate is near the Fed’s 5.2-5.5 percent estimate of long-run unemployment. It’s also very near the Congressional Budget Office’s estimate of the “non-accelerating inflation rate of unemployment” — also known as the natural rate of unemployment — at 5.5 percent.
Wages are being held back, at the moment, by the significant number of Americans that have left the workforce. The labor participation rate is down to late 1980s levels while the employment–to–population ratio is at 1984 levels.
At the current pace, the unemployment rate will drop to 5 percent by this summer — which would represent the level the Fed expected at the end of 2016. And according to Deutsche Bank, the unemployment rate is on track to end the year at 4.7 percent or lower as the pool of long–term unemployed people dries up.
That means meaningful wage inflation should start materializing soon, something that could crimp corporate earnings as labor costs rise.
The chart above shows how the number of long-term unemployed is dropping fast, down by nearly 1.2 million workers over the last four quarters.
If this continues, Fed officials would have little excuse to delay lift-off for short-term interest rates for the first time since 2006. It is this realization that sent stocks swooning on Friday.
“Some will argue that the Fed will want to wait to see wage growth rising before it raises rates,” analysts with Capital Economics said in a note. “But our sense is that it won’t feel it needs to hold off that long and will be willing instead to trust the usual relationship between unemployment and inflation. If this is case, we may see rates rise as soon as March if the activity data continue to improve, since the unemployment rate is rapidly approaching the Fed’s estimate of its natural level.”
The end of the greatest experiment in monetary policy is not likely going to be a smooth, easy transition. Credit Suisse, in a note to its clients, warned that the effect on markets of even a small rate hike “may well exceed that of a more routine rate hike” given how large a role the Fed has played since the recession. It’s basically like taking away a subsidy to investors: expected, yes, but still crazy–making.
Yet the history of Fed rate hike campaigns suggests that after some initial weakness, stocks should resume their climb. That’s what happened in the late 1990s and in the mid–2000s.
With all that said, we cannot dismiss the potential for an ongoing drop in oil prices to keep a lid on inflation enough to allow the Fed to stay on hold. A research note by Bank of America Merrill Lynch warned that oil prices will need to head below $35 a barrel in the short–term to cause U.S. shale oil producers to cut production. If that happens, the Fed could hold back on rate increases until 2016, which would be quite market friendly.
Best wishes,
Jon Markman
