Don't let the weak May employment number fool you as the second quarter GNP has accelerated meaningfully from a lackluster first quarter and should increase by at least 2.5%. Clearly this number should keep the Fed on hold until there is a return to over 160,000 increase in monthly employment and over a 2.2% increase in average hourly earnings
There were two other meaningful events this past week including an ECB meeting where there was no change in policy and an OPEC meeting where the oil ministers could not agree on a production freeze. Neither is surprising!
The bottom line is that global economic growth is still stuck in a rut and will remain so until there are substantive fiscal, tax and regulatory changes so sorely needed to stimulate final demand. The OECD's latest economic report pointed directly at the "rich world governments" for not taking action to revive demand and overhaul their economies. The report also said, "that monetary policy cannot revive and long-term growth by itself, and distortions are increasing." Sound familiar? Global growth is estimated at 3.0% this year and 3.3% next year.
Mario Draghi, head of the ECB, echoed the comments of the OECD report in his conference after the ECB decision on Thursday to maintain its current policy. He reiterated that there are more arrows in the quiver that the ECB could shoot if economic activity and inflation remain well below targets. Additional policy measures previously announced will commence shortly including the purchase of corporate bonds. He also noted that the OECD did increase its growth forecast of the Eurozone to 1.6% this year up from 1.4% previously and maintained its forecast for 1.7% growth next year. Both the OECD and ECB forecasts have been overly optimistic for years so don't count on them too heavily. Eurozone manufacturing growth stalled in May while consumer prices declined 0.1% from a year ago.
OPEC ended its meeting without reaching an agreement on oil production basically leaving it up to the marketplace. The simple truth is that OPEC can no longer manipulate the price of oil for a host of reasons:
1) OPEC's share of global production continues to decline;
2) OPEC has little impact on the demand for oil as its been proven that the elasticity to price change is not as important today as it was years ago;
3) alternate supplies as well as alternatives to oil are increasing; and
4) OPEC itself is not unified as there are multiple factions within it with different motivations.
Notwithstanding, after an initial decline after the OPEC decision, the price increased to over $50/barrel only to fall back after it was reported late Friday that the rig count rose last week in the United States after falling for months. Remember, that a majority of the shut in shale production becomes economic as the price of oil increases to over $50 per barrel hence our view that oil prices will range between $40-$55/ barrel. The market is sensitive more to the volatility in oil prices than the actual price itself. Consider, too, that the banks may not have to write off as many oil loans as previously thought at these price levels.
While there are a few cross currents to the rate of growth in the U.S's second quarter, the majority of the data points indicate a sharp acceleration in growth from the first quarter gain to around 2.5%.
Let's review the employment numbers: 38,000 jobs were added last month which was well below the forecasts close to 160,000 jobs; the three month average of job growth ahs fallen to 116,000 from 219,000 monthly over the last year; the Verizon strike reduced the number by approximately 35,000 jobs; average hourly earnings rose 5 cents to $25.59, up 2.5% from a year ago; the average workweek held steady at 34.4 hours; the unemployment rate dropped to 4.7% as there was a large decline in the size of the workforce and the percentage of Americans in the workforce declined to 62.6%, the lowest level for the year.
Other economic statistics reported last week included: consumer spending accelerated to a 1% gain in April while personal income increased 0.4%; the personal savings rate fell to 5.4% from 5.9% in March; core prices rose 0.2% from the prior month and are up1.6% from a year ago; consumer confidence fell to 92.6 while the consumer sentiment index rose to 95.7, an 11 month high; auto sales fell in May as there were two fewer days but was up adjusting for seasonal factors; the ISM manufacturing index rose to 52.9 in May and new orders continue strong and the Beige Book reported tight labor markets pressuring wages but that came out before the employment data.
The bottom line is that we feel that the employment number was an outlier and overall economic activity has continued to accelerate in the second quarter. Nevertheless, the Fed is stuck now and cannot/should not raise rates until the U.S economy as well as the global economies is on sounder footings.
The Federal Reserve Governors want to ratchet up the capital ratios of the largest banks once again. Same goes for the liquidity ratios for the major insurers. Think about this: monetary ease on one hand offset by higher regulated capital ratios on the other hand means limited growth in lending and overall economic activity which is why one of our core beliefs remains that the economic cycle will be extended with lower highs and higher lows with low inflation due to few excesses. Clearly this is beneficial for financial over hard assets.
Let's wrap this up: the markets reacted just as anticipated last week especially after the jobs report on Friday: concern over the economy shifted the market's view on interest rates, the timing of the next Fed hike, currencies (sell the dollar), commodity prices, profits and specific industry/stock dynamics. For instance, the financials outperformed in anticipation of higher rates only to give it back when that view shifted on Friday. We consider the financials a call on the economy as earnings continue to grow despite a relatively flat yield curve, dividends are high and going higher, the group sells at a discount to real book and to the market and when/if the Fed moves and the yield curve steepens, earnings growth will accelerate. These are the reasons why I consider financial a win/win BUT not all are equal. Look to the best managements with the best strategies for the next several years as your core investments. Financials remain close to 17% of our portfolios.
The bottom line is that we still feel that wind still is to our back in owning stocks. Only through hard research can you differentiate between the winners and losers. That is our strength and one of the reasons for our continued outperformance.
I want to comment on the market multiple. Most of the pundits feel that 17 times earnings is at the top of the range solely as it has been that way over the last 25 years. My response is that when in those years did the 10-year bond trade beneath 2% and bank liquidity ratios been so high therefore risk levels are down? The proper multiple in today's world is closer to 19-20, not 17. And S & P estimated earnings for 2016 have gone up due to better operating results and a weaker than expected dollar benefitting foreign translation of sales and earnings. The bottom line is that the market remains 6% undervalued.
I continue to see tremendous opportunities both here and abroad in specific companies recognizing and acting upon the need to change their corporate strategies to excel in a globally competitive marketplace. Change is everywhere and remains at the heart of our core beliefs.
So remember to review all the facts, step back and pause before acting, consider first the proper asset allocation and risk controls, understand mindset shifts, do in-depth, first hand research, be willing to think out of the box and..
William A. Ehrman is managing partner at Paix et Prosperite LLC.