5-Minute Huddle: Just OK

January 13, 2020

By Justin Pawl, CFA, CAIA

In this week’s edition:

  • Last Week Today. A quick rundown of market-moving news.
  • Jobs. Employment growth is slowing, but it doesn’t mean the economic expansion is over.
  • Rising Tide. Liquidity trumps macroeconomic, geopolitical, and valuation concerns.

Last Week Today. In a week fraught with potentially adverse outcomes, markets proved resilient. The S&P 500 gained +1%, but technology and growth stocks kicked it into another gear, notching a nearly +2% gain for the week. On the international front, Japanese equities led the way advancing by +2.3%, and China jumped +1.6%. European stocks were laggards for the week but still rose +0.2%. Tepid economic data in the U.S. resulted in a flatter yield curve (short-term interest rates rose more than long-term rates), as investors’ muted concerns about inflation are putting downward pressure on long-term interest rates. Precious metals continue to benefit from heightened geopolitical risk. Still, the previous week’s Iran-engendered jump in oil prices reversed as tempers cooled, pushing WTI Crude down by 6.4% to under $60 a barrel.

For detailed weekly, MTD, and YTD financial market performance, please click on the table below.

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Jobs. With a nod to AT&T’s current marketing campaign, the jobs report released on Friday was “Just OK.” In December, nonfarm payrolls increased by 145,000, reflecting a modest miss vs. the upbeat consensus estimate of 160,000. Average hourly earnings also fell short of expectations, rising 2.9% year-over-year (vs. estimates of 3.1%). Although fewer jobs were added than expected, the unemployment rate held steady at cycle lows of 3.5% (if you carry out the decimal places, the unemployment rate actually fell from 3.536% to 3.496%). Also, the U-6 unemployment rate – a broader measure of unemployment, which includes discouraged and underutilized workers – declined by 0.1% to an all-time low of 6.7%.

Still healthy overall, it’s becoming increasingly clear that the pace of hiring is beginning to sync with the 2.0%’ ish “Good, but not great” sustainable growth potential of the U.S. economy. It’s worth remembering that the 2010 decade began on the heels of the Great Recession and the unemployment rate near 10%. The high starting point for unemployment combined with a decade of economic expansion, devoid of a recessionary setback, generated a historically strong job market, and a consistently declining unemployment rate.

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Source: LPL Research

However, as the table above hints at, and the chart below details, job growth peaked mid-decade and has been slowing since.

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Source: Bloomberg L.P. and Covenant Investment Research

A deceleration in the pace of hiring should be expected more than ten years into this economic expansion, but it doesn’t necessarily portend an impending recession. Part of the slowdown is related to a lack of available workers. Due to declining fertility rates, reduced international migration, and retiring Baby Boomers, the labor force is growing more slowly than in previous decades. Indeed, today there are more than 7 million job openings, but only 5.8 million officially unemployed people.  Moreover, for those that think the December report of 145,000 jobs was disappointing, they may want to recalibrate their expectations going forward.  The Congressional Budget Office forecasts a sharp decline in employment growth in the coming years, as modestly slower economic growth and an increasing number of retirees depress average monthly job gains to 39,000 from 2020 – 2023.

Bottom Line: Unlike the AT&T commercials, in this case “Just OK”, is in fact “OK”. The best employment growth is behind us, but a slowing pace of hiring is a natural outcome for an economy operating slightly above its long-term sustainable growth rate. So long as hiring doesn’t fall off a cliff and aggregate wages continue to rise, consumers should remain in a constructive position to help keep the expansion intact.

Rising Tide. Over the last several months, major central banks fell into line again, simultaneously pumping liquidity into the markets, reducing market volatility and supporting the prices of risk assets. The episode with Iran over the last couple of weeks is an excellent example of the volatility dampening effect of liquidity. Despite the potential for a major military conflict in the Middle East, equity markets barely blinked as investors raced to “buy the dip” when stock prices fell modestly overnight after Iran “completed” its retaliation against the U.S. for killing their lead terrorist.

In the U.S., the Fed abruptly halted its balance sheet reduction program last September when overnight repurchase lending rates between banks spiked (aka, “repo madness”). Since then, the Fed has purchased $400+ billion in U.S. Treasuries, reversing more than half of the previous balance sheet reduction measures. In Europe, the ECB resumed its Quantitative Easing program in November, committing to €20 billion in monthly asset purchases for “as long as necessary” to bring inflation up to their 2% annual target. Meanwhile, China’s central bank (the PBOC) is taking a multi-pronged approach to liquidity enhancement. On January 1st, the PBOC reduced the Reserve Requirement Ratio for the 8th time since 2018, releasing about $115 billion of additional lending capacity in their economy. The PBOC also instructed lenders to use the Loan Prime Rate as the interest rate benchmark, resulting in a 0.2% reduction in the cost of borrowing as compared to the old benchmark. In addition to the above measures, China’s crackdown on shadow lending has subsided, which should generate additional credit growth this year.

The band is back together. The Fed’s balance sheet growth is the most pronounced (the red line in the chart below), but the size of the ECB (blue) and PBOC’s (yellow) balance sheets have hooked up as well. The net result is that central bank liquidity is trumping macroeconomic, geopolitical, and valuation concerns. Synchronized loose monetary policies won’t completely eliminate market volatility. But so long as the central banks flood markets with cash and credit, the rising tide of liquidity will create a favorable backdrop for risky assets.

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Be well,

Justin