Friday’s employment report showed a 257,000 increase in January non-farm payrolls. This news was followed by a spike in Treasury yields up to 1.96%, a 4% plunge in utility stocks, a 5% plunge in precious metals shares, and took the S&P 500 within a fraction of a percent of December’s record high, before a late-day retreat. These frantic market movements smack of an investment climate dominated by one-dimensional “theme” based behavior –Â where asset prices have been amped up on yield-seeking speculation, but where the most marginal change in the outlook can trigger a race for the hills or a pile-on, depending on whether the asset has features that are consistent with that theme. On Friday, the knee-jerk reaction was that stronger employment will prompt the Federal Reserve to raise interest rates sooner, creating a scramble to get out of yield-sensitive Treasury bonds and utilities, to buy dollars, and to sell foreign currencies and gold. Of course, in equilibrium, there must be someone on the other side of those trades, so prices moved to the extent needed to find that match.
Even after last week’s volatility, we continue to observe dispersion in market internals, a recent widening of credit spreads, and other features of market action that – at least for now – convey a subtle but measurable shift toward risk-aversion among investors, in an environment where risk premiums remain razor thin.
It is in this context that I want to go back to our opening comment from last week (seeMarket Action Suggests Abrupt Slowing in Global Economic Activity):
“The combination of widening credit spreads, deteriorating market internals, plunging commodity prices, and collapsing yields on Treasury debt continues to be most consistent with an abrupt slowing in global economic activity. Generally speaking, joint market action like this provides the earliest signal of potential economic strains, followed by the new orders and production components of regional purchasing managers indices and Fed surveys, followed by real sales, followed by real production, followed by real income, followed by new claims for unemployment, and confirmed much later by payroll employment. Stronger conclusions, particularly about the U.S. economy, will require more evidence, but from a global perspective, these pressures are already quite evident.”
Notice that payroll employment is last in the sequence of economically informative indicators. Simply, payroll employment is well known to be a significantly lagging indicator, reflecting the climate of economic activity that broadly existed several months earlier (the unemployment rate actually lags even more). The reason is inherent in how people are hired and fired. The point in time that a business decides to add or remove an employee is well-aligned with the actual business climate at that time, but the full process requires interviews, employment contracts, and negotiation of starting dates, or conversely, several weeks of termination notice, and additional lags in reporting the employment change. So what we saw last week in the employment figures tells us a lot about how the economy was doing in the September-October period. Indeed, more timely measures such as the new orders (including order backlog) and production measures of regional purchasing managers indices and Fed surveys are consistent with strong economic activity at that time. But those measures have also turned abruptly lower in recent weeks, following the initial deterioration that was evident in market internals and credit spreads.
In my view, the Federal Reserve may find it difficult, from the standpoint of economic activity, to justify raising interest rates even a few months from now – though I still believe that the Fed should immediately discontinue reinvesting the proceeds of assets as they mature, for reasons I detailed last week. Given the prospect that the Fed might defer hiking rates (via increases in the amount of interest it pays to banks on idle excess reserves), the very first reaction of many investors is that this would be bullish for stocks. It’s here where we need to be careful about what history, and even the experience of the past several years, has actually taught.
First and foremost, the response of the equity markets to Federal Reserve easing (and much other news) is conditional on the risk-tolerance of investors at the time, which we infer from observable market action such as internals and credit spreads, among other factors. Quantitative easing “works” by creating default-free liquidity in an environment where that liquidity is viewed by investors as an inferior asset. That is, if investors are risk-seeking, as inferred from the uniformity of market action across securities, sectors and asset classes of all risk profiles, then yes – Fed easing will tend to support further advances in stock prices regardless of the level of valuation. On the other hand, once investors have shifted toward risk-aversion, overvalued markets become vulnerable to abrupt free-falls and crashes, and monetary easing is not materially supportive for stocks because default-free liquidity is desirable.
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