3 Key asset classes that are mispriced
Oil is in the basement, the dollar is in the attic and the bond market’s sleeping in. In short, the house of financial assets is a house of confusion. While the passage of time and a steady flow of new data should restore some order, this progress could yet be halted or even reversed by significant geopolitical distractions. However, for investors, it is both important to understand the market’s mispricing of key asset classes and logical to invest on the assumption that the gravitational forces of macroeconomics and supply and demand will gradually bring markets to heel.
On the bond market, the January jobs report confirmed the strong momentum of the U.S. economy. Booming growth in payroll jobs was, of course, the headline, with the U.S. economy producing 1 million net new jobs in the three months ending in January and over 3.1 million in 2014, the best year for US job growth this century. However, equally important was better news on wages. The average hourly earnings of production and non-supervisory workers rose 0.3% in January and is now up 2.0% year over year, a much stronger reading than the 1.6% year-over-year gain initially reported for December (which was revised up to a 1.9% year-over-year increase). Wage growth should accelerate further in the months ahead as a tighter jobs market forces more employers to grant wage concessions.
More jobs with rising wages should keep the Federal Reserve on track to begin to raise interest rates in June. Indeed, the only domestic fig leaf for a more dovish stance is the increase in labor force participation seen in this January report. This is improving with a 1.1% gain in labor force over the past year, more than the previous five years combined.
However, it is crucial to recognize that this is a temporary effect. Consumer confidence has suddenly rebounded to its strongest levels since the peak of the last expansion, in part because of perceptions of a tighter labor market. This may have encouraged some who had given up on a job search to reengage. However, once all those who possibly could be motivated to look for a job have reentered the labor force, the growth of the labor force should revert to its pre-2014 demographically driven trend of less than 0.5% per year.
If the labor force does so, then the unemployment rate, which ticked up to 5.7% in January, could still fall below 5.0% by the end of this year and head towards 4.0% by the end of 2016. While this may not be accompanied by rising prices in the short run as cheap oil suppresses inflation, the Federal Reserve correctly recognizes that the deflationary impact of cheap oil is a very temporary phenomenon, and so will likely continue to prepare for a long-overdue monetary normalization. Meanwhile, although the 10-year Treasury yield has backed up from its lowest levels of the year, the continued existence of yields below 2% remains completely at odds with a strengthening economy and a Federal Reserve, which by its own projections, expects to raise short-term rates four times this year.
Oil prices are also being watched closely as surging short-term supply interacts with long-term fundamentals. For the moment the former seems to be having a bigger impact. However the reality is that while the world is currently producing excess oil, both production and consumption trends are calibrated to oil selling at over $100 a barrel. A sudden drop in prices to half that level will inevitably affect supply and demand. As just two examples of this, in January the share of U.S. light vehicle sales accounted for by relatively gas-guzzling light trucks reached 55.8%, its highest level since June of 2005, while employment in oil and gas drilling, which has boomed in recent years, fell by almost 1% in the month of January alone.
Just as oil should rise from the basement over time, the U.S dollar may descend from the attic. On a trade-weighted basis, the dollar is now at its highest level since 2003 and up about 14% from its average level of 2014. However, it is worth noting that in the year ended in September 2014, the U.S. ran a significant current account deficit of 2.3% of GDP while Europe, Japan and Emerging Markets as a block, all ran trade surpluses. In particular, the Euro Zone ran a surplus of roughly 2.4% of GDP. Fundamentally, these radically different trade positions should boost the Euro and depress the dollar over time.
In the short run, the U.S. is experiencing stronger economic growth than other developed nations and has the prospect of near-term monetary tightening. However, within the next two years the U.S. will likely run out of the capacity to grow at an above-trend rate, with capital flows potentially moving abroad to take advantage of better growth opportunities. This should, in time, force a dollar retreat to below current levels.
For investors, this is, or should be, very confusing. Domestic economic fundamentals are, for the moment, being swamped by short-term market forces and it should be noted that all of them are contributing to low long-term interest rates.
In addition, these trends are also hurting corporate earnings. With just over 90% of the market cap of the S&P 500 now reporting earnings for the fourth quarter, current trends suggest that S&P 500 operating earnings will be down by about 6%, or approximately $1.70, year-over-year. However, these earnings have been reduced by more than $1 due to telecom pension charges related to very low interest rates. In addition, the impact of lower oil prices on energy company earnings and the impact of a higher dollar on foreign earnings have had similarly depressing effects.
In the long run, economic fundamentals should reassert themselves, boosting both earnings and interest rates. Because of this, while the equity market is not as cheap as it has been in recent years, both current valuations and economic fundamentals suggest an overweight to stocks relative to bonds may still make sense in the context of a long-term diversified portfolio.