Last week’s employment report raised the odds of a December rate hike considerably and the consensus at this point seems to be that it is a done deal. The employment report was pretty good with the unemployment rate down to 5%, 271,000 jobs added and a pay hike to boot. Year over year average hourly earnings are now up 2.4%, nicely outpacing inflation for a change. Janet Yellen and the other Phillips Curve acolytes will see that as evidence of full employment, of a tightening labor market that will lead to higher inflation. There isn’t much in the way of actual evidence to support that idea but Yellen seems intent on justifying her life’s work by running monetary policy based on the ideas of some defunct economist.
As I outline in my Bi-Weekly Economic Review, the actual economic data released recently has not been all that good. Markets are moving mostly based on Fed rhetoric and expectations of the rate hike. It is almost as if the market is coming to believe that higher interest rates will cause better growth rather than the other way around. I suppose that is possible just as it is possible that the recent rise in wages has nothing to do with the rising minimum wage and the debate surrounding it. And there is a certain attractiveness to economic theories that are so counterintuitive if for no other reason than they often turn out to be right. But I have my doubts. There is simply too much debt piled on the global economy for higher interest rates to be anything but a net negative, at least in the short term.
In any case, I don’t think December is a done deal, far from it. There’s a lot of data between now and then, including another employment report, and the anticipation of the rate hike is already tightening financial conditions just as it did the last time it seemed like a hike was a sure thing. Interest rates aren’t waiting for the Fed to act; bond markets are busy pricing in the rate hike right now. Currency traders aren’t waiting for the Fed; the dollar is about to challenge the spring highs with all that implies for emerging markets and their dollar denominated debts. The rising dollar will also keep pressure on commodity prices and the struggling shale industry.
While the focus in the corporate bond market has been on those shale companies and the debts they probably can’t pay at current oil prices, balance sheets in general are not as healthy as they were after several years of borrowing to buy back stock and pay dividends. S&P corporate debt downgrades have outnumbered upgrades this year for the first time since 2009 and they aren’t all energy companies. It has happened a bit under the radar but leverage has risen considerably since 2010 and defaults are already rising – although still quite low historically.
Corporate credit spreads have improved over the last month but the trend is still pretty obviously toward wider. Treasuries have sold off over the last few weeks with the 10 year yield recently hitting a 3 month high but high yield bonds have continued to underperform except in the very short term. Despite parts of the market anticipating better growth, high yield and high grade corporate bonds are already in a downtrend. That contrasts with the last cycle when corporate bonds continued to perform well until mid 2008 when credit concerns started to mount. Or maybe it doesn’t contrast at all; perhaps we’re closer to recession than anyone realizes.
Stocks also belie this belief that the Fed finally has it right, that growth is finally accelerating and the real recovery is finally underway. Yes, stocks have rallied nicely the last few weeks and have nearly recovered from their August swoon. But all that has done so far is to bring stocks back to where they were in mid-August just before the sell off. While it is certainly possible that we will yet make new highs, I think it is important that momentum is not confirming the move higher except, again, in the very short term. Long term momentum indicators still show a market in the process of topping.
That shouldn’t really be that surprising considering what is going on with earnings. With so much hoopla surrounding the Fed it has almost been lost in the shuffle but earnings this quarter have not been very good overall. If you look at “operating earnings” – earnings before all the bad stuff that is allegedly one time but rarely is – over 70% of companies are beating estimates although the beat rate for revenue is quite a bit lower. However, reported earnings paint a different picture with less than half the companies beating estimates. This kind of divergence happens every cycle as we get near the end of the expansion. It speaks to the quality of the earnings and the creativity of CFOs at the end of an expansion.
Companies this cycle have loaded up on debt to buy back stock and keep earnings per share rising. That and other means of cost cutting were necessary because revenue growth has been hard to come by. Particularly hard hit recently have been the US multinational companies, hit by the double whammy of a rapidly rising dollar. The strong dollar lures capital back from emerging markets which hurts local economic growth and therefore sales growth for the multinationals. In addition, what earnings remain convert into fewer dollars. It is also hard to raise prices in emerging market economies that are already struggling and hedging is difficult and costly.
The anticipation of the beginning of the long awaited Fed tightening cycle is creating conditions that will make it difficult for the Fed to follow through. The market waits for no man or woman, not even Janet Yellen. Interest rates have already been hiked, the dollar is already rising and financial conditions are already tightening. In a world drowning in dollar debts, higher interest rates and a rising dollar are not good news. The odds of a rate hike may have risen with the employment report but it’s one report and unemployment is a lagging indicator. Maybe the economy really is accelerating and the employment report is the beginning of a trend. I sure hope so but I wouldn’t go all in the rate hike bet just yet.
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