The Fed's Deflation Problem?
- U.S. employment rose at a solid clip in July and wages rebounded after a surprise stall in the prior month, increasing the likelihood the Fed will raise rates in September.
- While traditionally the Fed has solely focused on the domestic economy to set interest rate policy, the specter of global deflation will weigh heavily in its decision.
- If the Fed ignores global weakness, it will all but ensure a prolonged period of global weakness and risk importing a serious deflation problem. How should you position your portfolio?
Lucia Mutikani of Reuters reports, Improving U.S. jobs market bolsters case for Fed rate hike:
U.S. employment rose at a solid clip in July and wages rebounded after a surprise stall in the prior month, signs of an improving economy that could open the door wider to a Federal Reserve interest rate hike in September.
Nonfarm payrolls increased 215,000 last month as a pickup in construction and manufacturing jobs offset further declines in the mining sector, the Labor Department said on Friday. The unemployment rate held at a seven-year low of 5.3 percent.
Payrolls data for May and June were revised to show 14,000 more jobs created than previously reported. In addition, the average workweek increased to 34.6 hours, the highest since February, from 34.5 hours in June.
"If you thought that the Fed was going to go in September, this report would suit that thematic nicely. I don't think anything has changed in that regard. I think it's another step toward the eventual lift-off," said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.
U.S. stock index futures and prices for shorter-dated U.S. Treasuries were trading lower after the data. The dollar rose to a two-month high against the yen and firmed versus the euro. The swaps market was pricing in a 52 percent chance of a September rate hike, up from 47 percent before the jobs data.
Though hiring has slowed from last year's robust pace, it remains at double the rate needed to keep up with population growth. The Fed last month upgraded its assessment of the labor market, describing it as continuing to "improve, with solid job gains and declining unemployment."
Average hourly earnings increased five cents, or 0.2 percent, last month after being flat in June. That put them 2.1 percent above the year-ago level, but well shy of the 3.5 percent growth rate economists associate with full employment.
Still, the gain supports views that a sharp slowdown in compensation growth in the second quarter and consumer spending in June were temporary. Economists had forecast nonfarm payrolls increasing 223,000 last month and the unemployment rate holding steady at 5.3 percent.
Wage growth has been disappointingly slow. But tightening labor market conditions and decisions by several state and local governments to raise their minimum wage have fueled expectations of a pickup.
In addition, a number of retailers, including Walmart, the nation's largest private employer, Target and TJX Cos have increased pay for hourly workers.
NEARING FULL EMPLOYMENT
The jobless rate is near the 5.0 percent to 5.2 percent range most Fed officials think is consistent with a steady but low level of inflation.
A broad measure of joblessness that includes people who want to work but have given up searching and those working part-time because they cannot find full-time employment fell to 10.4 percent last month, the lowest since June 2008, from 10.5 percent in June.
But the labor force participation rate, or the share of working-age Americans who are employed or at least looking for a job, held at a more than 37-1/2-year low of 62.6 percent.
The fairly healthy employment report added to robust July automobile sales and service industries data in suggesting the economy continues to gather momentum after growing at a 2.3 percent annual rate in the second quarter.
Employment gains in July were concentrated in service industries. At the same time, construction payrolls rose 6,000 thanks to a strengthening housing market, after being unchanged in June. Factory payrolls increased 15,000 as some automakers have decided to forgo a usual summer plant shutdown for retooling, after rising 2,000 in June.
More layoffs in the energy sector, which is grappling with last year's sharp decline in crude oil prices, were a drag on mining payrolls, which shed 4,000 jobs in July. The mining sector has lost 78,000 jobs since December.
Oilfield giants Schlumberger and Halliburton and many others in the oil and gas industry have announced thousands of job cuts in the past few months.The U.S. jobs numbers came in as expected, bolstering the case for the talking heads on Wall Street that the Fed is ready to go in September. At this writing, stocks are selling off as everyone is worried about another Fed taper tantrum.
I will discuss stocks a little lower. First, let me discuss Janet Yellen's global deflation problem. It is a widely held view on Wall Street that while the Fed pays attention to global developments, it ultimately sets interest rate policy based solely on what is going on in the U.S. economy. This has been the tradition and it looks like it will continue. However, I agree with those who keep warning of the Fed making a monumental mistake if indeed it raises rates too early.
Importantly, the return (more like continuation) of deflation presents a unique and very worrisome problem for the Fed. If it raises rates too early, it will exacerbate global deflation and usher in a prolonged period of sub-par growth and the possibility of a debt deflation spiral in the United States.
Before you dismiss this scenario as "impossible," take a good look at U.S. bonds (NYSEARCA:TLT). The yield on the 10-year Treasury fell on Friday following the jobs report and now stands at 2.18%. The bond market is definitely more worried about deflation than inflation. Even Bill Gross is warning that the global economy is dangerously close to deflation.
Emerging markets (NYSEARCA:EEM) have plunged 16% since their late-April highs and are now back to the level seen in June 2013, when then Fed chairman Ben Bernanke raised the prospect of a rate hike. The bursting of the China bubble and the subsequent rout in commodities is behind that selloff.
But it's not just emerging markets. Andrea Wong of Bloomberg notes that Canada is becoming a big problem for Yellen:
Federal Reserve Chair Janet Yellen said less than a month ago that she expected the dollar's drag on the American economy to dissipate. She may not have foreseen that the greenback would surge to an 11-year high against the currency of the U.S.'s biggest trading partner.
As the greenback's advance against the euro and the yen subsided, its 5 percent rally against the Canadian dollar this quarter may prove to be more detrimental to the world's biggest economy. The U.S.'s northern neighbor buys about 17 percent of America's products, more than any other nation, data compiled by Bloomberg show. And shipments already have declined after reaching a record last year (click on image below).
A firm dollar makes American goods relatively more expensive abroad, presenting a hurdle for Fed officials as they prepare to raise interest rates for the first time since 2006.
The central bank's trade-weighted dollar index is approaching the March high that prompted Yellen at the time to warn the currency is weighing on exports and inflation. The index, which includes only major currencies, gives an almost 13 percent weighting to Canada, trailing only the euro area's influence.
``Since late June, the speed in the dollar rally is probably equivalent to what we had earlier,'' said Charles St-Arnaud, senior economist at Nomura Holdings Inc. in London. ``I can hear some investors saying, `Oh yeah we're back to where we were in March when the Fed started to be worried about the dollar.'''You already know my thoughts on Canada, stick a fork in her, she's done. I've been short Canada since December 2013 and judging from the latest employment figures, the Canadian economy is going nowhere fast. In fact, Martin Roberge of Canaccord Genuity told me and Fred Lecoq he wouldn't be surprised if the Bank of Canada engages in QE next year and that in this scenario, provincial bonds will rally hard.
Martin also warned us of the US Dollar Index (DXY) and its effect on the global economy. I've been long the mighty greenback for some time and keep ignoring those who are shorting it. But I'm starting to think the consensus is too comfortable with the long U.S. dollar trade and the unwinding of the Mother of all carry trades may spook markets this fall.
It's important to understand that the strong U.S. dollar has already done a lot of the heavy lifting for the Fed. It has kept import prices low, capping inflation expectations. If it rises a lot more, it will continue to pummel commodities and bring about another crisis in emerging markets, which in turn will reinforce deflationary pressures around the world.
Interestingly, Bloomberg reports that hedge fund losses from commodities is sparking an investor exodus but not everyone is feeling the pain of rout in commodities:
Andurand Capital Management, run by Pierre Andurand, gained 3.5 percent in July, bringing his 2015 gains to 4.8 percent, according to a person familiar with the matter. The fund, which manages about $500 million, delivered a 38 percent return in 2014. The company declined to comment.You will recall Pierre Andurand provided his outlook on oil for my blog readers at the end of December, 2014. He was much more bullish on oil and global growth than I was but if you read his views in that comment of mine, he pretty much nailed it which is why his fund is up in 2015 when most other commodity funds are suffering huge losses (a true testament to Pierre Andurand's exceptional talent in trading commodities).
That brings me to my outlook on stocks. All this negativity about a September rate hike is presenting interesting opportunities. The bears are all growling, warning us that stocks are a disaster waiting to happen, but I would ignore them.
Why? There is still plenty of liquidity to drive stocks and other risk assets much, much higher. Sure, we are experiencing summer doldrums, people are increasingly nervous about what will happen this fall, but I still maintain you should be buying the dips on stocks and ignore the fear.
Having said this, pick your spots very carefully and keep focusing on the leaders. Fears of Fed tightening may boost financials (NYSEARCA:XLF) as banks and insurance companies will make money on the spread. Conversely, fears of global deflation are propping up utilities (NYSEARCA:XLU) and REITs (NYSEARCA:VNQ) as investors are betting the Fed will hold off on raising rates for a lot longer.
I'm avoiding these sectors and keep focusing my attention on tech (NASDAQ:QQQ) and especially biotech (IBB and XBI) where I use big dips to load up on companies I like going forward. Admittedly, it's been a god awful week for media and biotechs, especially many of the smaller biotechs I trade and invest in, but that is all part of the game (they are insanely volatile; click on the list below to view a few I track and trade).
Also, something else to think about. What if the Fed doesn't move in September? What if the U.S. dollar starts reversing course? What if the reflationistas are right and global growth finally picks up this fall?
Don't be surprised if you then see a snap-back rally in energy (NYSEARCA:XLE) and mining and metal shares (NYSEARCA:XME). I am paying particular attention to oil service (NYSEARCA:OIH) and drilling shares as these will move first and have been decimated in 2015 (click on image):
For now, I continue to steer clear of energy and commodity sectors but I'm keenly aware there will be violent countertrend rallies along the way and some might last for weeks (bag holders should use these rallies to shed their positions).
Still, my strategy hasn't changed despite the Septaper tantrum. I continue to buy the dips on biotech and sell the rips on energy and mining shares, believing the leaders will surge higher and the laggards will continue hitting new lows.
Below, Jim Paulsen, Wells Capital Management, provides his thoughts on the impact of Friday's jobs number on the Fed's decision to raise interest rates and its likely impact on the markets.
Also, it's been a great year for short sellers in the S&P. Which popular short could drop even more? Rich Ross of Evercore ISI and Gina Sanchez of Chantico Global discuss with CNBC's Brian Sullivan. Apart from energy and mining, I think the short of the year and week was Keurig Green Mountain (NASDAQ:GMCR).
Lastly, everyone's favorite bull during the tech bubble, Abby Joseph Cohen, president of Goldman Sachs Group Inc.'s Global Markets Institute, talks about the outlook for U.S. equities and the economy, and Goldman's investment research and strategy. Take the time to watch this Bloomberg interview here.