Friday, June 6, 2014

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.


steve said...

as I've said umpteen bazillion times, 99% of investors (yes, that means you) should buy VFINX or like kind and go away-forever. you CANNOT time the stock market. no one has ever done it over the long run and no one ever will. pe's be damned!

Anonymous said...

I've done something similar by buying IWV, and intend to gradually accumulate it and just let it sit there. I consider it a decades-long investment.

Benjamin Cole said...

Great blogging.

BTW, John Cochrane recently argued in favor of the Fed keeping its large balance sheet and using higher interesr on reserves to keep inflation in check.

RichmondG30 said...

So we now have the same number of people working as we did in 2009. That's good news provided the population did not grow. Uh oh, nevermind...

Benjamin Cole said...

Not sure about the higher interest rates in the future.

The Fed has set a ceiling at 2 percent (officially a target, but in reality a ceiling).

The means the Fed starts cranking down anytime we see inflation in the 1.5 percent area.

Japan never saw higher interest rates after 1992, despite eye-popping federal deficits. And (thank goodness) we are not doing the huge deficits.

Given enormous pools of global capital, that may means chronic surfeits on investable funds, and thus lower interest rates.

As for higher PEs, maybe so. If PEs get too high, of course, you set up for a fall. Running a company to make money is inherently a risky business (and people doing so should be admired).

But,five years is an eternity in the life of any company. High PEs are tricky.

I keep thinking we need to go back to the stock market in days of yore, in which people bought stocks for dividends.

It would make today.

Scott Grannis said...

Drawing deflation parallels between Japan and the U.S. is very difficult. There is one huge monetary difference: the yen appreciated against every currency in the world for decades, while the dollar plumbed all-time lows against most other currencies.

Global capital is always virtually unlimited in size (create a new business like Uber and it almost instantly is worth $12 billion--creating capital out of thin air), so it makes no sense to say that interest rates are low because there is a surplus of capital. Interest rates on high quality debt are low because there is a shortage of appealing alternatives. Lower the tax rate on capital and lower regulatory burdens and there would instantly be a lot more appealing alternatives.

William said...

I am attuned to perceiving the psychological attitudes expressed by comments on this and a few other blogs. Today "steve" and 'Unknown" have expressed a couple of beliefs: 1) commitment US based Index Funds and 2) confidence in a Buy and Hold "for decades" approach.

I would just note that these beliefs are in marked contrast to the frequent predictions of an approaching "crash", "double dip", "recession", etc. made repeatedly by posters on this blog throughout 2009, 2010, 2011 and early 2012.

The psychological tide has turned. Now we can await the next phase of over-confidence ("irrational exuberance")to be expressed.

steve said...

seriously doubt rates will rise appreciably anytime soon for reasons scott himself has outlined. slow fairly predictable growth and contained inflation. if they haven't risen by now, why would they anytine soon?

William said...

Brian Wesbury has an interesting video (5/30) on the First Trust website in which he discusses economic statistics for the three months FEB, MAR and APR (after the weather related slowdowns of DEC and JAN):

* the four week moving average of unemployment claims was down to 311,500, lowest since 2007;

* real consumer consumption was up 4.2% at an annualized rate;

* real personal income was up 3.6% at an annualized rate;

* commercial and industrial loans are growing at 17% annualized;

* M2 Money Supply now growing 7.5 to 8% annualized up from 6.5%.

More here:,-economy-ok

William said...

Jim Paulson also sites a litany of unexpectedly good economic news over at WellsCap website:

"However, ....the economic momentum index has risen smartly since early April. The array of economic reports which
have surpassed expectations in recent months include a new
low in unemployment insurance claims,... recent
healthy gains in both personal income and spending, consumer
confidence reaching and hovering about a six-year high,
impressive retail sales results since year-end, better capital
goods and shipment reports, small biz confidence recently
rising to its highest level since 2007, a substantial recovery in
household net worth to a new record high above $80 trillion,
solid ISM manufacturing and service sector readings, the fastest growth in bank loans of the entire recovery, back-to-back household total annual
debt gains in the last two quarters for the first time in the
recovery, and new housing starts rose above one million again
for the first time this year in April!

We think the U.S. economy, after flat-lining in the first quarter due mostly to extremely bad weather, is likely rising between a 4% to 5% pace in the current quarter. Moreover, we expect U.S. real GDP growth to sustain above a 3% pace on average
in the balance of this year and believe such a performance will
be enough to improve sentiment surrounding the
stock market.

McKibbinUSA said...
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