Everyone likes jobs. No politician would ever run on a platform of creating fewer jobs or use the slogan “I will put America out of work again.” Markets are more ambivalent. Government bonds tend to sell off on strong employment numbers because they are safe assets. Investors hold them in part to protect against weakness in the economy, so good news is bad news. Stocks can’t seem to figure out how they feel. Sometimes they rally on strong jobs numbers; other times they seem to prefer smaller payrolls. On the company level, job cuts can be rationalized as cost discipline, but in aggregate bad jobs numbers mean weaker economic growth and that should hurt risky assets like equities. 1 1 Close It’s not like you would look at a Bureau of Labor Statistics report showing no job growth and say “wow this is a great month for corporate cost discipline, I’m going to buy the S&P 500.” It seems pretty clear.
There are two concepts behind the view that job gains are bad for stocks. First is that the Fed will react to a strong labor market with tighter monetary policy. 2 2 Close Or less loose monetary policy. Second is that employment is a lagging indicator, meaning that a strong employment report only says that economy had done well in the past. When the stock market sells off it is saying that a strong employment report doesn’t give us any new information about the direction of the economy. It’s those silly Fed economists who are going to overreact by hiking rates and maybe cause a recession in the future. Markets can be such know-it-alls.
The Fed has a dual mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” 3 3 Close Isn’t that three things? Doesn’t dual mean two? People always forget about moderate long-term interest rates and just talk about inflation and employment. There is nothing in the Congressional guidance that says the Fed has to hike rates if employment is too strong – if anything, “maximum” implies an asymmetric reaction function. However, there is an economic theory known as the Phillips Curve, which posits an inverse relationship between unemployment and inflation. 4 4 Close The meaning of the Phillips Curve has evolved over time. Now it is used to mean any relationship between employment and inflation. The logic behind the Phillips Curve is that low unemployment will lead firms to increase pay to compete for workers. Wages are often the largest component of costs, so companies will be forced to charge more to customers. It is a very intuitive concept, and for a while the data supported it. But then the relationship broke down in the 1970s when many countries experienced high unemployment and high inflation. Some economists have blamed Phillips Curve thinking for fostering the policy environment which led to that unwelcome combination. While the Phillips Curve may have been discredited, many economists maintained a belief in some loose relationship between unemployment and inflation, and it influenced Fed policy.
In recent years, economic data has challenged even this loose relationship: unemployment has been low, yet inflation has remained tame. The remaining Phillips Curve apologists (and you know who you are) have posited that maybe the curve is flat or non-linear. In other words, unemployment won’t affect inflation until it goes below a certain critical level, then suddenly inflation will explode higher. It’s difficult to know whether this inflation cliff exists, but unemployment has fallen so much without a reaction that people are rightly skeptical. It is also possible that there is some other variable that is overwhelming the employment/inflation relationship, and as soon as that variable reverses, the Phillips Curve will reassert itself. 5 5 Close For a while, people had posited that high productivity was overwhelming the relationship, but productivity growth has been low for a while. Perhaps technology and/or foreign competition are lowering prices, so domestic wage costs are less relevant to prices.
The Powell Fed seems to be moving away from the Phillips Curve. In a speech last October, Powell said that even though he doesn’t think the Phillips Curve is “dead,” it will not “exact revenge.” 6 6 Close Powell, Jerome H. (2018). "Monetary Policy and Risk Management at a Time of Low Inflation and Low Unemployment," speech delivered at the "Revolution or Evolution? Reexamining Economic Paradigms" 60th Annual Meeting of the National Association for Business Economics, held in Boston, MA, October 2, 2018. Instead he argued that employment is one of many factors that explain inflation, but that as long as inflation expectations are low the relationship will not be strong. In the meantime, the Fed doesn’t seem worried about the employment numbers. The Fed has stopped hiking rates and probably won’t restart unless inflation starts to rise. This means markets may treat the Phillips Curve as if it were dead.
It is also worth looking at whether employment actually is a lagging indicator. There is support for this view in both the data and the economics. During several of the past recessions the unemployment rate stayed low well after many of the other variables had turned. Because of the high costs of employee turnover, some firms can be slow to let people go during downturns. But there also is a case that employment can be a leading indicator if viewed properly. Workers who are paid more will spend more. Firms are unlikely to keep hiring people if they think demand for their products will be bad in the future. In a closer examination of the data, we’ve found that changes in hiring trends are either concurrent or leading indicators for the economy and perhaps markets.
Last week the Bureau of Labor Statistics released a very strong employment report. While the January release is affected by seasonal factors and subject to revision, equity markets rose on Friday. Through much of the second half of last year, market participants were concerned about slowing growth and the prospect of a recession at some point in the future. The jobs number is a small sign that the economy is doing okay and maybe that those fears are overdone. With the Fed more focused on inflation data, equity markets view this favorably. For now, stock investors can agree with everyone else that more jobs are a good thing. 7 7 Close Markets need to find other reasons to sell-off, like I don’t know … trade. Government bond investors may still need some convincing. 8 8 Close If you wanted to try, you could make a similar argument. The Fed is a big driver of bond returns, so if they are less interested in employment data, the effect on bonds of strong employment should be weaker. However, strong growth is still bad for bonds.
U.S. CPI (Wednesday)
Despite a tightening labor market and firm consumer expenditure, core inflation (which excludes the impact of food and energy prices) has remained subdued in recent years at levels consistent with the Fed’s 2% target. Growing confidence that upside risks to inflation are limited has given the central bank additional flexibility. In its January statement, the Fed reiterated its positive view of the U.S. economy but announced that “in light of global economic and financial developments and muted inflation pressures, the Committee will be patient” with respect to future policy changes. If inflation does begin to pick up at some point, the Fed may face more difficult tradeoffs between supporting growth and containing price pressures. Upside surprises to CPI data could therefore lead to weakness in equity markets and might flatten the slope of the yield curve.
Potential Brexit Votes in U.K. Parliament (Thursday)
The Withdrawal Agreement negotiated by Prime Minister Theresa May suffered a resounding defeat in the U.K. parliament in January, leaving the country without a legal roadmap for its fast-approaching departure from the European Union. Prime Minister May is now attempting to secure legally-binding concessions from the E.U. on the contentious “Irish Backstop” provisions of the agreement, and she has set February 13th as a deadline to either present a modified deal or provide guidance on the way forward. Parliament will then have a chance on Thursday, February 14th to vote on or propose amendments to these plans. Depending on how much progress is made in the next few days, Prime Minister May might need to formally request that the E.U. push out the timing of Brexit beyond the current scheduled date of March 29th. While this would avoid the near-term risk of a disruptive “No Deal” Brexit, it would also extend the current environment of uncertainty, which appears to be weighing on business confidence.
China Trade Data (Thursday)
Chinese imports and exports deteriorated meaningfully in December, prompting concern in markets about an abrupt slowdown in growth. Weakness in trade activity may have reflected slower domestic and global growth as well as the impact of the current trade dispute between the U.S. and China. Front-loading of shipments ahead of feared tariff increases likely pulled some activity forward earlier in 2018, and it is possible that the soft December figures represented payback after a “truce” between Presidents Trump and Xi delayed any further tariff increases for the next few months. The release of the January trade data could also be difficult to directly interpret. Chinese trade data is often volatile during the first few months of the year, as the Lunar New Year holiday makes seasonal adjustments difficult as the date changes each year. Trade is a large component of China’s economy and further downside momentum is likely to be viewed as negative for market sentiment, while an upside surprise could relieve some concerns around the outlook for Chinese and global growth.