Falling Unemployment Doesn’t Mean Rising Wages
It is good to be writing this without any hospital visits having taken place, and with my daughter, Sadie, back in school and joyfully getting every square inch of her pink cast signed by all of her loving friends. I appreciate all of you who reached out to see how she was, and both of her parents are happy to see her on the mend and out of pain.
The market showed signs of being out of pain early last week as well, as the huge volatility of the previous couple weeks subsided a bit and market participants appeared to go into a holding pattern awaiting whatever catalyst would be next (Mon and Tue). That all changed Wednesday but surprisingly a lot of things did quite well in the face of a 300-point down day. I never discount the possibility of Janet Yellen wearing a certain necklace one day which would cause some market genius to say, “Wow, that necklace means they’re raising rates!” (or something along those lines), but more or less I expect the next bout of volatility will come as first quarter earnings results begin hitting the wire in mid-April. The earnings season that will go roughly from the second week of April through the third week of May will be an interesting one as it may test my “divergence” thesis … What is my “divergence” thesis, you ask? Read on and find out. Off we go …
My top points of the week, noted with an asterisk (*)
- I expect a wide dispersion of results across individual companies in this coming quarter’s earnings results. Rather than a monolithic “good” quarter (or the opposite), I think you will see a lot of different results from individual companies based on their own operational execution, etc.
- There will be a lot of talk in the coming weeks and months about the impact of a stronger dollar on corporate America, and that talk will be mostly silly.
- The bond market is off to a good start this year across nearly all sectors.
- When we look at the positive effects in an economy of low interest rates, we also must look at the risks being created (in terms of misallocated capital and distorted optics)
- Falling unemployment has not led to rising wage growth. This has been very atypical of normal economic recoveries.
* Hey – what is your “divergence” thesis?
I strongly suspect that there will NOT be a theme this earnings quarter of “most companies beat their numbers” or “most companies failed to meet their numbers.” Rather, I think you will see many companies “diverge” from one another – even more so than is normally the case. I believe we are entering a period where individual company results will be far more reliant on execution, individual company landscape, specific competitive advantages (or disadvantages), and management performance, as opposed to reliant on a uniform macro environment. Of course, once you get all of these “divergent” results added up together, you do end up with a sort of aggregate result, but my point is that I am expected a wide dispersion of results across that “aggregate.”
What is the actionable takeaway from this thesis?
Two things: (1) As a general rule, it always behooves one to find companies that are executing and performing and surprising markets; this is especially true in this environment; (2) Attempting to trade around the mood of earnings season will be particularly dangerous as you may find the markets celebrating a batch of results one day and moaning a batch of results the next. It is incumbent on me and my team to monitor company results for real directional news – real cash flow results – real business ramifications – but the day to day divergence in quarterly results need not tempt anyone to misbehave.
* What is another forecast you want to make about this quarterly earnings season starting in a couple weeks?
You will hear ad nauseum under-performing companies talking about “the pressure of foreign currency exchange” impacting their results (which is another way of saying the strengthening U.S. dollar). More than that, you will REALLY hear it ad nauseum from the PRESS. It is a nothing-story but it is a narrative the media has decided to run with, and I would expect it to be more visible and audible in the weeks ahead.
I take it you do not think that hype is going to be justified?
No, I do not. Companies have known of a declining Euro and declining Yen and (by default) rising dollar for quite some time. Companies have the ability to raise prices to pass on the effects of currency when they are large multi-national exporters. There is no evidence of sustained fundamental material impact from something like this in the ongoing execution of a company, so one quarter’s math effects from currency is really quite silly. And besides, it cuts both ways. When is the last time the press ran a story saying, “XYZ really hit the ball out of the park, led by a declining currency”? It doesn’t happen, because that would make no sense. If a currency going one way is no basis for a positive result (and it surely is not) then a currency going the other way is no basis for a negative result either. It’s all noise. And financial media loves noise!
* How has the bond market performed so far this year?
Recognizing that as I’m writing we still have a few days to go until Q1 officially wraps up, it has been a mostly very positive result for fixed income thus far this year. The one exception is on the global bond side, where certainly the U.S. denominated bonds would have done better than most non-U.S. denominated bonds have done. Treasuries of an intermediate duration are up over 1% on the year, high yield is up over 2%, as are investment grade corporates. Munis have done quite well too, especially in the longer end of the curve (meaning, the further out the maturity, the better performance has been). Floating Rate is also up nearly 2%. It has been a solid start to the year for credit and duration oriented strategies. The Fed holds a lot of cards in how this is sustained for the rest of the year (1).
* Do you think these low interest rates are doing anything for the economy?
Of course they are! Never take my criticism of any part of Fed policy to mean that I do not believe they are not trying to do something constructive, or that nothing constructive is being done. The problem I have is that I believe excessively low interest rates for an excessively long period of time does some economic good for some economic actors in a certain period of time, while inviting poor investment and distorted economic behaviors on the other hand. Companies issued $48 BILLION of debt in the first week of March, the second most EVER in a single week (2). Nearly $250 billion of new corporate debt has been issued already this year (in fairness, some of this is likely replacing old debt). Would corporate America be taking on this kind of debt if not for a Fed policy inviting them (begging them?) to do so? I suspect not. Is some debt good and necessary and healthy and normal? Of course! My only point is that we must not just look at the short term positives that this monetary paradigm creates (new capital expenditures as a result of cheap financing) but also must look at the bigger picture (what future project will not happen as a result of the debt service, et cetera).
Speaking of low rates, any further analysis of the Fed’s statements a couple weeks ago about the interest rate environment ahead?
It is very clear in looking at the assumptions of the actual voting participants in the FOMC (Federal Open Market Committee) – the group that really sets policy here – that more people are projecting a lower rate for a longer period of time than was the case at the last meeting. They are projecting a “range” for the Fed Funds rate (the short term interest rate they actually control) as opposed to a hard rate, meaning when they move it may be a “band” (i.e. 25 to 50 basis point target, as opposed to a hard rate target of 50 basis point; the net effect of which is greater latitude in keeping rates down). Their rhetoric all centered around GDP growth being not as robust as planned, inflation being less than desired (a central bank expressing disappointment in a lack of inflation – wow), and as I mentioned last week, there was implied reference to the effect of a rising U.S. dollar.
* What is the single, number one challenge in the jobs data that mostly has looked better and better?
There is nothing more confounding to economists than the fact that unemployment has fallen from over 10% to just over 5%, and yet wages have not risen at all. Falling unemployment is supposed to mean rising wages for all the obvious reasons (with more employment, employees have more leverage whereas when there is high unemployment, employers have more leverage). This has not happened in this cycle, and I actually do not believe it should be a head-scratching moment. Either, one has to scratch their head (how could wages not be going up as unemployment declines?), or one has to conclude that the quality of the employment that has brought the jobless rate from 10% to 5% is less than we aspire for in terms of overall economic health. This is one of the reasons I believe the Fed is afraid to claim victory, and it is another reason that skeptics about this economic recovery are justified to feel that this has been muted and rather subpar. The job market is on fire when there are so many jobs out there and so few workers needing jobs to fill them that wages rise. We have not seen that.
So I can interpret your above paragraph correctly, does this mean you do not see the state of the labor market as improving?
No, it does not mean that. The labor market has improved. There are less people unemployed – this is both very good, and also indisputable empirically. But there has not been a normalcy to this job market improvement. The explosion of Disability claims, the high under-employment rate, the collapsing labor participation rate, and the lack of wage growth all indicate to me that while things are better, they are not great (in terms of American employment). I believe this is structural, not cyclical, and therefore lacking in any simple solutions.
Apart from job market skepticism, how does the economy look overall and what are your thoughts on corporate earnings?
Negative economic surprises this quarter were at their worst since 2009, and year-over-year profits may be lower, not higher (we shall see). GDP estimates are down. Bond yields are low (and this ALWAYS trumps everything else). Cash holdings are very high. And yet equity prices are pretty good. What gives? I would suggest that (a) We may very well be due for ongoing volatility, and this volatility would include some corrections along the way. The market is right now treating a lot of the news like it is delayed good news coming, not impaired good news. Time will tell, and volatility will be elevated. But I also would suggest that (b) Much of what is driving equity prices right now is simple asset allocation. Globally, the U.S. has been the leader in risk asset attractiveness, and stock earnings yield trump paltry bond yields, enabling U.S. stock prices to keep their bids. Headwinds persist, volatility is elevated, and investors absolutely must know that there will not be an easy ride in the months and quarters ahead. Earnings will end up dictating where markets go. They always do.
Are you following oil prices closely?
I certainly am, and there are a number of reasons for this. But I am not following them because I am trying to exploit their short term movements. I believe oil prices are going to go higher, and I believe they very well could go lower before they do. How’s that for a bold prediction? But what I care about is the differential between WTI and Brent Crude oil, for that differential is what impacts much of the refiner space, the storage pipelines, and the supply/demand dynamics. I have a diversified energy complex in my client portfolios, mostly centered around income-producing pipelines. There is modest exposure to a production name for some clients, and modest exposure in the oil services sector. But the greatest care we have is not one of oil prices but oil volumes, and this is manifested through our exposure to midstream energy investments.
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QUOTE OF THE WEEK
“All of the great leaders have had one characteristic in common: the willingness to confront unequivocally the major anxiety of the people in their time. This is the essence of leadership.”
– John Kenneth Galbraith
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I need to leave it there for the week. I am excited to bring you a summary of March and the whole first quarter next week. Next week’s commentary is going to delve deeply into much of what makes up the core of our investing philosophy at The Bahnsen Group. I am excited to write it and excited for you to read it. In the meantime, enjoy your weekends, may your college basketball dreams come true, and may this gorgeous time of year be taken in for all it is worth.