Politicians and pundits alike have been quick to write an obituary for this economic cycle, and yet the economic data simply aren’t cooperating with a terminal diagnosis. Importantly, the labor market continues to improve, posting a record 65th consecutive month of net job gains in February. The economy has now added 13.2 million net jobs since the recovery began in 2010, bringing the unemployment rate down from a peak of 10.0% to the current level of 4.9%. Wage growth has admittedly been more difficult to come by, but average hourly earnings are nonetheless 11% higher (not annualized) over the course of this cycle. That adds up to more people with jobs, more money in pockets and more fuel for the 68% of GDP that is personal consumption.
The labor market is a critical input to the future path of monetary policy. The Federal Reserve bumped interest rates up by 25 basis points in December 2015, citing the durable recovery in jobs as a rationale for the increase. Policymakers since then have been content to sit on their hands, voting this month to leave interest rates unchanged (with one dissenting vote calling for a second increase). Time remains the Fed’s friend. Whereas the steady improvement in the labor market allows the committee to contemplate more interest rate hikes, the lack of inflationary pressure does not require it to act on that inclination with undue haste. In an environment of low energy prices and little price inflation, this luxury of leisure is likely to persist.
Any acceleration in inflation is likely to come from wage growth, which makes the labor market report a doubly important influence on Fed policy. Wage inflation is not today’s concern. Average hourly wages grew at an annual pace of 2.2% in February, down slightly from a recent peak of 2.6% last fall. This is hardly the stuff of inflationary pressure, but the laws of supply and demand imply that at some point a tighter labor market will lead to higher wages. Anecdotal testimony indicates that this may already be taking place, but it’s certainly not taking place to a degree that is likely to accelerate the Fed’s efforts to restore interest rates to more normal levels.
Regular readers of our economic analysis will recall that in addition to guiding Fed policy, the labor market has an important economic influence. As a driver of the income effect, jobs and wages are an important support of economic activity and corporate earnings as well, and on this latter point there is cause for concern.
In this seventh year of a bull market in equities, corporate earnings have stagnated. Even if we adjust the figures for the understandable pain in the energy sector, corporate earnings have flatlined since the fourth quarter of 2014. This is a natural development at a point in the economic cycle when the benefits of cost-cutting have largely been realized and margins have expanded. At this point in the cycle, the primary catalyst for earnings growth is revenue growth, and that is hard to accomplish when GDP gains are modest while the lack of inflation restrains pricing power. To make matters more challenging, after seven years of a bull market in stocks, valuations are no longer as cheap or supportive as they were earlier in the cycle. The market is by no means in bubble valuation territory, but multiples don’t offer the margin of safety1 they once did.
An acceleration in wages might provide the real and psychological effect that improves both the ability and willingness of consumers to spend money, and the psychology is likely more important than the ability. In short, whereas a rapid increase in wages would likely prompt the Fed to accelerate the pace of interest rate hikes, a modest improvement would be just what the economy and market need.
As of mid-March, the equity market has recovered nicely from January’s swoon and now trades within a few percentage points of the all-time high established in May 2015. This is, in our opinion, not a reflection of an improvement in underlying conditions, but a continuation of the price volatility that has characterized the market for the past two years. The S&P 500 has traded in a range of 1,830 to 2,130 since April 2014, and we believe this volatility will continue to define the market unless or until earnings accelerate and provide the fuel for further upside in the fundamental value of corporate America.
In the meantime, price volatility is not the enemy of the disciplined investor. Indeed, volatility creates the discount to intrinsic firm value that allows an investor to acquire shares in companies with a margin of safety, an essential element of managing portfolio risk. Emotions drive price from day to day, whereas earnings growth (and the cash flow that accompanies it) is the ultimate driver of firm values.
Developments in the labor market, therefore, have heightened consequences for both the economy and financial markets at present, as jobs and wages drive personal consumption, GDP, corporate earnings, and ultimately, the market. Stay tuned.
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1 Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.