And then there were none … no more reasons for the Federal Reserve (Fed) to tighten monetary policy, that is.
For the longest time, the primary argument for the Fed to tighten has been the strength-of-the-labor-market argument. The U.S. Labor Dept.’s September payroll report demolished that argument quite forcefully: Not only is the U.S. economy not delivering on price stability, the employment outlook is faltering. As a result, arguments for the Fed to tighten policy based on either of its mandates-employment and price stability-now look quite shaky.
First, on the employment report itself, not only was the headline number below expectations, previous months were also revised downward. The weakness was even more pronounced in private employment, the U.S. economy’s workhorse. While the unemployment rate remained steady, it was only due to the labor force participation rate dropping by 0.2%. Furthermore, average hourly earnings were flat, much weaker than expected. Enough said on that front.
Based on the September report and accompanying revisions, it is quite clear that the U.S. economy did not accelerate in the third quarter of 2015, as we were expecting. Instead, it actually slowed and is now tracking at a sub-2% rate.
In other words, the U.S. growth rate remains modest at best and the Phillips curve-which would suggest that rising employment leads to higher wage inflation-is no longer relevant for all practical purposes. Thus, the primary drivers for the Fed to tighten policy have now fallen by the wayside.
Pressures to Tighten May Have Peaked
In a previous blog prior to the release of the September employment report, I noted that a potential Fed tightening would not occur until 2016 at the earliest. Based on the data flow, despite numerous Fed members’ assertions to the contrary, I see no reason to change that view.
While it is too early to say with any certainty, there is a case to be made that the economic and market turmoil we saw in the third quarter of 2015 may have closed the Fed’s window of opportunity to tighten policy until sometime next year. All along, secular issues provided no justification for a potential Fed move this year, but the cyclical pressures were building.
In my view, the third quarter of 2015 may prove to be the peak of those cyclical pressures, and growth may taper down to a level that will make talk of Fed tightening, or tightening by any global central bank, moot. Again, it’s a little early to assert that just yet, but we are certainly moving in that direction quite rapidly, especially in emerging markets and even in Europe to some extent.
Impact on Asset Prices
Coming into 2015, I had a positive view on risk assets. That view was based primarily on my expectations that growth would be modest and the Fed would not tighten. While interest rates have remained low, the least volatile of all market metrics, risk assets, have had a tough go. The potential for Fed tightening and an ill-advised, ham fisted market intervention in China were the primary drivers. For risk assets to do well, I believe both of these drivers have to be neutralized.
Chinese policy makers seem to have learned their lesson and are now on an aggressive path to add more fiscal and monetary stimulus. That is certainly a positive.
More important, however, based on the September employment data, I think there is reason to be hopeful as the market’s anticipation of Fed tightening is slowly being priced out. If earnings reports and the data flow confirm our benign view, modest valuations and an overall negative sentiment in the market have the potential to propel markets higher.
Beyond the equity markets, the performance of the credit markets-which have given up the ghost of late-has been even more disappointing. If the turnaround in the markets is to have legs, the credit markets must participate. Unfortunately, credit markets are not budging at the moment. Investment-grade credit spreads, for example, are still at their three-year highs. As a result, I am hopeful but watching credit spreads more intently than I usually do.
While I can explain the negative sentiment in the credit markets due to the weakness of the energy, mining and materials sectors, lately the weakness has spread far and wide. For the overall market direction to change, I think the sentiment in the credit markets has to change. The still healthy volume of issuance in the investment-grade markets gives me a reason to be hopeful that this negative sentiment will improve as investors increasingly see the likelihood of a rate hike in 2015 fade.
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