This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Brian Andrew, EVP, Chief Investment Officer.
Last Friday, we received good news in the form of a strong payroll growth number. At least temporarily. Soon after the announcement, investors began worrying about the more than 300,000 jobs created in December as a harbinger for higher interest rates in 2019.
You see, investors had begun to believe that the Federal Reserve would halt its hikes due to the prospect of more sluggish economic data as we move into the new year. Of course, a payroll number that was well above estimates doesn't fit well with that narrative. When investor sentiment turns negative, as it did in October, all news, good or bad, is viewed as bad. The reality is likely that investor sentiment had turned too negative.
The Friday jobs report from the U.S. Labor Department showed that there were 312,000 jobs created in December of 2018. This was well above the estimate of 176,000 and left the average payroll growth in 2018 around 220,000 jobs per month. In addition, the unemployment rate rose to 3.9%, a very low level, due to more people entering the labor market. In other words, as the labor market strength improves, people who are at the edges of it begin to look for jobs and are thus counted in the labor force. This led to an increased participation rate of 63.1%—still a long way from previous highs near 69%.
Equally as important as new entrants to the labor force, the data last Friday showed that wages grew at an annual pace of 3%. This higher level of income growth, coupled with lower taxes for many and cheaper gas (I noted $1.94 at the pump last weekend), should account for stronger personal consumption as we move into 2019.
As investor sentiment turned negative during the fourth quarter of 2018, everyone seemed to interpret all news as bad news. This isn't that surprising given that we reached a peak in economic data during 2018. The economy grew at more than 4% for two quarters last year, a pace that was double the 10‐year average.
Indexes that measure economic activity, such as the Institute of Supply Management's Manufacturing Index, hit a high above 61% (a number above 50 represents an expanding economy) mid‐summer last year. That was the highest posting for the index since before the 2008 financial crisis. On January 3, the December number came in at 54.1%, and the New Orders Index came in at 51.1%, down 11 points from the November reading. Yet stocks rallied on the news. These are the same stock prices that declined on every piece of economic slow‐down news we've received since October.
Perhaps investors are focused once again on the pace at which the Fed will hike interest rates in 2019 and beginning to believe that the slowing economy that put downward pressure on stock prices may also inhibit the Fed's ability to raise rates.
The rate at which economic data changes is almost impossible to predict. As a result, investors tend to read too much into one data point and then push asset prices too far in one direction or another.
It is our belief that 2019 will see a return to the long‐term average economic growth rate near 2 to 2.5%. It is also likely that we'll see a slightly slower average monthly labor force growth rate in 2019 as the participation rate climbs and wages move higher. We believe this will result in the Fed reducing the rate at which it raises rates; however, it will still raise rates.
The yield on the two‐year Treasury note is a good proxy for how bond investors believe short‐term interest rates, like the Fed Funds rate, will look in two years. The yield has dropped from near 3% during the fourth quarter of 2018 to 2.55%. In fact, today, there is less than a .02% difference between a six‐month Treasury bill and the two‐year note. This nearly half‐percent drop in two‐year yields shows that bond investors believe the Fed won't hike rates as much, if at all, in 2019.
This reflects the negativism that took over bond and stock investors alike during the fourth quarter as they repriced assets for an economy that is likely to grow at nearly half the rate it did in 2018.
Still, we believe bond investors have overdone it. And here is why. The current target for the Fed's money market interest rate is 2.25% to 2.50%. The current rate of inflation is close to 2%. That means the real rate of interest is less than .5%, which by the Fed's estimation is still stimulative to the economy. This “real rate” isn't considered tightening by the Fed until it reaches north of 1 to 1.5%.
With unemployment below 4% (considered full employment by the Fed) and wage inflation pressure still positive, the Fed will want to continue to remove the stimulus from its policy. This means continuing to hike interest rates, albeit it at a reduced pace from the last two years. The change from an expanding economic growth rate (i.e., 2 to 4%) to a declining one (back the other way) suggests that the pace of interest rate increases may subside. It doesn't likely mean they have come to an end!
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