Why 2% jobs growth will lead to higher PEs and rising interest rates

Just about everything these days points to a continuation of steady, unremarkable 2-3% economic growth, and today's jobs report did nothing to change this. The equity market is moving higher not because the economy is doing better than expected or corporate profits are likely to surprise on the upside, but because in the absence of a recession, owning just about anything but cash makes sense. We're now in a market that is being driven by expanding multiples (PE ratios), and the Fed is encouraging this by keeping short-term interest rates at levels that are consistent with a recession. This can't go on much longer, but that's not a reason to worry.

The private sector is creating about 200K jobs a month, and it has been doing that for almost four years now. It's quite boring.

Private sector jobs are growing at roughly a 2% annual pace. Since productivity averages about 1% a year over the long haul—over the past two years it has only been about 0.5%—this pace of job growth should give us 2-3% overall growth. We're not going to see anything better than that unless and until jobs growth picks up, and that, in turn, is not likely to happen unless and until policies in Washington become more growth-friendly (e.g., reduced tax and regulatory burdens). This won't happen anytime soon, but the November elections may create fertile ground for positive change.

The private sector has fully recovered (finally), and private sector jobs now comfortably exceed their pre-recession high. Government jobs fell about 3% from 2009 through 2013, but have since stabilized; this provided a modest benefit to the economy, since government's influence on the economy was somewhat reduced.

There is no part-time employment problem. Part-time employment is doing the same thing it has in almost every growth cycle in modern times: it's steadily declining relative to the size of the workforce. Plus, there has been no increase in part-time employment for the past five years.

PE ratios are now moving above their long-term average. The growth of corporate profits has slowed—earnings per share are up at only a 2.4% annualized rate in the past three months—even as PE multiples have increased. Investors are willing to pay more for a dollar of earnings because the earnings yield on equities (now about 5.5%) is significantly better than the yield on cash, and the risk of a recession is very low (negative real yields on cash plus a steep yield curve all but rule out a recession).

A growing body of evidence points to a steady-as-she-goes, slow-growth environment that persists.  It's boring, but it's better than a lot of uncertainty. Not surprisingly, the Vix index is now at a post-recession low, which confirms that the market is fairly certain that there's not much excitement out there.

I don't think we're in "bubble" territory yet, but I worry that the Fed's rationale for keeping cash yields close to zero is deteriorating rapidly: multiples are rising and that means confidence is increasing. The banking system's willingness to hold a mountain of excess reserves is almost certainly declining, and possibly at a rate that exceeds the Fed's tapering pace. The Fed might well have to increase rates sooner than expected or else risk a disequilibrium situation (i.e., a bubble and/or rising inflation). A Fed surprise could prove unsettling to the market, since it would push interest rates up across the yield curve, but it shouldn't lead to a big or lasting decline in equity prices, since in the long run it would be the right thing for the Fed to do.