United States — Still the Best Alternative
Payroll data suggests the U.S. is still the best alternative for global growth, but global conditions remain weak, and Europe and China continue to face significant challenges. Meanwhile, domestic earnings continue to grow, as first quarter S&P 500 earnings per share (EPS) growth tracks toward 6% excluding energy (3% growth if energy is included). Analysts expect 3.4% growth in S&P 500 operating earnings this year, according to the most recent survey from FactSet.
Last week’s payroll number for January, along with upward revisions to prior months, was far better than expected and strengthens the bull case for the U.S. economy. The total job gains over the past three months are the best in 17 years and are accompanied by solid increases in wages. Payrolls gained an average of 336,000 over the past three months, with average hourly earnings up 2.2% on a year-over-year basis through January. A solid report all around.
A deeper look at the numbers shows other important trends. First, fewer people are “dropping out” of the labor force. The percentage of people who are either actively employed or are looking for work is called the labor force participation rate. Back in 2007 it stood at 66% and has fallen steadily year-after-year right on through the recession and the first part of the recovery. There are now signs that the slide is over. For most of the last 12 to 18 months, the labor force participation rate has been holding steady at just under 63%. This is a sign that individuals are feeling better about their prospects for work.
There are actually labor shortages in some areas as employers seek qualified candidates to fill specialized positions. Accounting and information technology are examples of areas where persistent labor shortages can be seen, according to recent comments from temporary staffing firms. Among those with college educations, the unemployment rate has fallen to 2.8%, and graduates are more optimistic about their future earnings potential than any time since the recession (56% of graduates surveyed by the University of Michigan report an optimistic outlook versus only 15% who remain pessimistic).
Improvement is also seen in pay. Personal income, less inflation, is now up 3.2% over the same period last year. This is roughly consistent with the 20-year average growth rate, and there is room for further improvement given that real income growth usually averaged about 4% in prior expansions. Real hourly wages are up 1.2% through December 2014 from a year earlier. Slow-but-steady improvement in inflation-adjusted income is additive to increases in household gains from financial assets and real estate, which has helped to boost net worth as a percent of income back to near recession levels. Net worth is near 6.2 times income, compared with 6.5 times income in 2007 and 5 times income in 2009. The combination of real wage gains and increased overall wealth plays a role in the psychology of spending.
Fed Set to Hike
No longer can policymakers point to the sad state of the labor market as grounds for ever greater accommodation. The jobs report will lead most at the Federal Reserve Board (Fed) to look past the recent slippage in inflation as temporary, and should provide further justification for the start of rate normalization. The faster-than-expected drop in the jobless rate (to 5.7% last month) is supposed to push inflation higher based on models used by the Federal Reserve for setting interest rates. So far, the employment improvement has not shown up in long-run inflation expectations which, at 1.7%, remain below the Fed’s 2% inflation target. A firmer dollar, lower oil prices, and weak overseas economies are all possible reasons for the lack of pickup in inflation.
If it turns out that these factors are transitory and if inflation forecasts actually do pick up from here, it is likely that rates will soon start to move higher. A simplified rules-based model that looks at labor slack and deviations in inflation from target was advanced by Janet Yellen in 2012 before becoming Chair of the Federal Reserve. The model was recently updated by a group of Fed economists, and it suggests that the Fed should tighten policy this year. The lack of wage inflation and labor slack has been, until now, a key objection against raising interest rates. Should inflation expectations firm from here, it would be difficult for the Fed not to begin normalizing interest rates. Still, we expect the process of normalization to proceed gradually, unless employment gains and inflation accelerate meaningfully from here.
Foreign Conditions Turning? Not Yet.
There is conflicting evidence on the progress of foreign economies’ efforts to regain momentum. December’s trade data shows that U.S. demand remains strong, while foreign demand for U.S. exports is still weak. In a surprise, the trade gap widened to $46.6 billion, from $40 billion in November. Last month’s factory orders and durable goods reports were also weak. In response to weaker growth, both the Peoples’ Bank of China and the European Central Bank (ECB) are taking steps to try to turn the situation around.
China cut bank’s reserve requirements, and the ECB appears ready to initiate asset purchases of 60 billion Euros per month until September 2016. The ultimate impact of these actions are yet to be seen. Europe’s forecast inflation and the Euro-Dollar exchange rate have not changed materially, for example, but European equity markets are just beginning to turn in a slightly better relative performance in recent weeks. Purchasing manager indexes for some European economies are looking somewhat better, and China’s equity markets are up significantly in recent months. The improvements are not yet convincing enough, however, to change our outlook.
Any signs of marginal improvement in Europe could be called into question pending the outcome of negotiations between Greece’s new Syriza government and the European Union over concessions on debt and austerity. Greece faces heavy cash demands in the spring, and the ECB recently restricted Greece’s access to capital. The country’s new Prime Minister, Alexis Tsipras, must find a way to deliver on his promises to voters for austerity and debt relief, while at the same time, negotiating with international creditors over concessions.
By way of background, Greece’s public debt stands at $360 billion, or about 175% of Gross Domestic Product (GDP), making Greece Europe’s most indebted country. The lack of willingness by creditors stems from this fact and disclosures back in 2009 that the Greek deficit was four times higher than the European Union (EU) rules would allow. Years of high levels of social spending and tax evasion led to deteriorating finances, which ultimately required 240 billion Euros of International Monetary Fund (IMF) support and 100 billion Euros of write-downs to keep the country going. Still, the Greek economy has suffered badly with large scale unemployment, social unrest, and a six-year recession. Markets remain concerned about the outcome for Greece, as the cost to insure against a Greek default have more than doubled since the start of December.
China is also a potential source of concern for global investors where growth has slowed, leverage remains high, and capital outflows have increased. Increased risk in China’s financial system, from a combination of slow growth and increased leverage, led to China’s central bank’s decision to ease monetary conditions by cutting reserve requirements within the banking system. The risk here is that the cut could further increase risk in an already highly levered financial sector while trying to boost the economy. While a boost to the economy is possible near term, there is greater need for China (now among the largest of the global economies) to advance more difficult pro-growth structural reforms. China remains a wild card for the global growth story.
Earnings reports continue to deliver only modest growth. With nearly two-thirds of companies done reporting results, the growth rate in S&P 500 EPS is trending toward 3% versus last year. The growth rate is being hurt by a stronger dollar, weak foreign demand, and a falling oil price. Energy companies are seeing the biggest drop in quarterly earnings, with earnings down 21.5% versus last year. If energy were excluded from the S&P 500 growth rate, growth would rise to 6% from 3%.
Current bottom-up expectations are for earnings to rise to $121 this year from $117 last year. Projected S&P 500 EPS for 2016 is near $136. The market now trades at 16.1 times forecast earnings, which is higher than the five- and ten-year average multiples of 13.6 times and 16.9 times earnings, respectively. The higher multiple suggests that on an absolute basis, equities are slightly expensive. Relative to 10-year U.S. Treasury yields, however, this isn’t the case. Consider that the forward earnings yield for the S&P 500, based on analyst forecasted earnings, now stands at 6.2%. This is 4.25% higher than a 1.95% Treasury yield. This 425 basis point spread is very high by historic terms, suggesting equities are a better relative bet than long-term Treasuries looking down the road.
We continue to monitor a broad set of data on the global economy and valuations of various markets. The forward-looking view in recent months has been mixed, both in terms of fundamental data flow and valuations, and equity exposure has been trimmed accordingly. The United States core economic data continues to generate steady and positive performance. Europe is far less consistent and prone to greater risk given its structural issues, a recent slide into deflation, and poor track record for growth. China and several emerging market economies continue to struggle with the aftermath of a rapid buildup of debt (in some cases) and weak commodity prices. On the plus side, we recognize the fact that markets already have priced-in many of these issues. The slide in the Euro in recent months and the underperformance of Europe’s and Emerging Markets’ equity markets versus the United States in recent years suggest that valuations already incorporate a good measure of risk. Still, we would like to see tangible signs of fundamental improvement before increasing portfolio weights in these areas. We remain overweight in United States equities within the equity portion of globally allocated portfolios.