Stocks fell on Friday after a hugely surprising January employment report showed that more than 500,000 new jobs were created in December. Moreover, adjustments to prior months indicated that the available workforce was almost 1 million workers larger than previously thought, largely due to higher immigration. That pushed the unemployment rate to a low 3.4%, last seen in 1969. Despite the surge in jobs, wage rate increases continued to moderate, although they held at well over 4%. The sum, and the reason the market went down, is that the U.S. economy is still too hot given that the Fed’s goal is to moderate growth, slow the pace of job increases, and lower inflation. The report increased the odds that last week’s 25-basis point increase in the Fed Funds rate won’t be the last. The odds of another increase in March are now close to 90%.
With that said, longer-term Treasury yields stayed within a narrow range all week, including Friday after the employment report was released. For the past four weeks, rates have remained in a tight range. They were not the cause for the sharp stock market rally so far this year.
Last week was the busiest for earnings. If I had to put a grade on the earnings reports, I would give it a C+. The plus is due to the fact that most companies reported near expectations. The C is because the reported results were pretty punk. Nowhere was that more obvious than when many of the big tech companies reported last week. Expectations going into earnings season were low. Managements, as they almost always do, did an effective job moderating expectations going into the quarter, to the point where the bar had been set low. No one likes surprises, especially to the downside, but the reality is that earnings growth rates are receding to the point where they have turned negative. According to FactSet, earnings so far are down over 5%, the first down quarter since the height of the Covid pandemic in 2020. Moreover, there are no signs of recovery anytime soon. In the tech sector, many of the market leaders not only had down earnings, their secular growth rates have receded in some cases to single-digit levels. Amazon’s cloud service growth rate has been cut in half in less than a year, while its Internet retailing business struggles to grow faster than the economy. Internet retailing is no longer taking significant share from traditional stores. The shift toward digital advertising is also moderating as that business sector shows greater signs of maturing. For Facebook’s ad revenues to grow, it will have to take share from TikTok, rather than NBC or The New York Times. In fact, in the fourth quarter of last year, 65% of the Times’ ad revenue was digital. Amazon and Facebook, the disruptors, are now getting disrupted. That doesn’t mean they won’t continue to grow, but to grow in the future, both must pivot, adjust costs, and find new revenue sources.
Back to the overall market, if changes in long-term interest rates aren’t propelling stocks higher, and earnings are now in decline, why has the stock market been so robust in January?
1. Prior selling had been overdone. Meta Platforms# may not have deserved to sell close to $400 per share, but below $100 it was an outright bargain. December tax selling by retail investors was the greatest seen in years. As the pressure lifted, stocks rebounded.
2. Markets look ahead. Inflation is falling. It is falling toward the Fed’s 2% goal. When it gets there is a matter for discussion, but when the Fed wants to tighten and slow the economy, it wins the battle every time.
3. The odds of a recession have changed. In early January, almost 80% of economists predicted a recession this year. As data shows the persistence of the American economy, the odds of a soft landing have increased. It is remarkable that more than 500,000 net new jobs can be created in a month, while the pace of wage increases slowed.
4. The linkage between the unemployment rate and inflation may not be as tight as the Fed believes. The Taylor rule, an economic correlation that ties the two together, is a favorite indicator watched by the Fed, but in a real-world setting, the facts suggest much less correlation than perceived. Granted, there is a logical connection between the two, and Friday’s jobs report suggests demand for workers is surging. The number of jobs available is close to 11 million today, almost two jobs for every unemployed worker, but there seems to be a disconnect somewhere. As the economy slows, the urgency to fill open positions fades. Signing bonuses and retention bonuses are so 2021, not today. Unemployed workers are taking longer to secure new positions. There is clearly more balance to the labor market today than there was just a year ago. Even unions are struggling. While they have begun to make gains at companies like Apple# and Amazon#, the percentage of union workers at private for-profit companies is at a multi-decade low.
5. The risk of being left behind. When markets rally as sharply as they did in January, the opportunity cost of staying in cash hurts. Investors start to chase momentum. Institutions that measure performance against the S&P 500 get only a fraction of 1% holding cash versus the 6%+ advance registered by the S&P 500.
Perhaps Friday’s reaction to the jobs report, and investors’ less than enthusiastic reception to earnings Thursday evening from Apple#, Amazon, and Alphabet#, will slow the advance for now. The fuel for the January rally may be dissipating. There are few big company earnings reports left. Despite lower inflation, 10-year bond yields have stabilized, at least for the moment. The Fed may well pause its pattern of interest rate increases after March, but the prospects of an early retreat after that are less. What motivation does the Fed have to lower rates in an economy adding hundreds of thousands of jobs every month? Forget corporate profits. The single most important indicator in the U.S. politically and economically is the unemployment rate. If over 96% of the work force is employed, and inflation is receding, there are few reasons to complain about Fed policy.
Thus, the real news last week wasn’t that the Fed might pause soon. It’s that there is no reason to expect moderation of policy until there are clear signs of recession, starting with any hints that the unemployment rate is rising to something over 4%.
In the 1970s, the mistakes in monetary policy weren’t that the Fed was too tight. It was that it loosened its grip too soon and too fast. Chairman Powell has said repeatedly that he has no urgency to lower rates until it is clear that inflation is not only falling toward his 2% target but that when the Fed slowly releases pressure, inflation will stay within a targeted range. The 2-year Treasury yield today is about 4.1%. If the FOMC increases the Fed Funds rate to 4.75-5.00% in March, that suggests that within two years, there will be significant moderation to a rate well below 4%. That might happen. Clearly the so-called neutral rate is below 4%. No one knows exactly what it is other than it is above the long-term pace of inflation, something currently predicted to be about 2.3-2.4% by TIPS spread.
The bottom line is that the tailwinds of January may be dissipating. No real boost ahead from earnings or interest rate declines. As we mention so often, valuation is extended. P/Es, based on future earnings forecasts, are well above historic norms. There are few bargains remaining. Momentum chasers have wiped them out. For momentum to continue, there must be an external force. Instead, we have a slowing but resilient economy with moderating but still high inflation. Money is now tight. Money supply is falling. The Fed doesn’t have to do anything more to win not only the battle, but the war. Any mistake from here will be to moderate policy too quickly and let inflation reignite. Chairman Powell says that won’t happen on his watch. Maybe investors should pay attention.
Today, Axl Rose is 61. Tom Brokaw turns 83. One of the sex symbols of the 1950’s, Mamie Van Doren, turns 92.
James M. Meyer, CFA 610-260-2220