Log inMarket Update – What is the data really telling us? 9th October 2023 from Jilly Mann
Last week saw the US release their latest non-farm payroll report (a measure of the change in US employment). This has become an increasingly observed data point for market commentators and Central Banks alike when trying to predict where markets are heading and what will happen next.
We are no different in awaiting these economic reports, but the headlines don’t tell the full picture. In this latest update, I will explain why that is and also why we remain convinced that a major inflection point in markets is imminent.
- US non-farm payroll data
- Post Covid, the world is different. Is it?
- Why does the US matter so much?
- Can history repeat itself?
- Our positioning
US non-farm payroll data
Let’s start with the US non-farm payroll data. This essentially reports on whether US employment figures are going up or down by measuring the number of new jobs added month on month. The Federal Reserve pay close attention to this particular data point, as it gives an indication of the impact interest rate rises and inflation are having on businesses and the end consumer. If employment rates go up, then the inference is that the economy is doing well and the risks of a recession are lower. Increasing employment figures also suggest that any rise in interest rates over the last 18 months hasn’t yet had an impact on the economy and so inflation is yet to be brought under control, thus meaning that more action may be required.
The principal tool that the Federal Reserve have to try and bring inflation under control is interest rates. If the hikes they have implemented thus far haven’t had a significant impact, then the concern is that the Federal Reserve will be forced to raise interest rates further. It is an unusual conundrum in that the markets are hoping for weak employment data to give reassurance that the Federal Reserve won’t feel compelled to raise rates again. Normally, positive employment data is exactly that, a positive.
The recent September US non-farm payroll data saw job numbers going up. The overall unemployment figure has remained stable, but average wage growth was lower than expected. Wage growth is a useful reference point, because if more jobs are being created at lower wages, then the people filling those roles will be hit much harder by the rise in the cost of living. It is perhaps an indication that companies are starting to feel the impact of the recent interest rate hiking cycle and have less resources available, therefore they need to offer lower wages.
Another key statistic was the revision made to the August non-farm payroll data. Every time the latest payroll data is released, revision data is also released for the previous month. The revisions rarely make the headlines, but it is an important measure and also reminds us that the Federal Reserve are having to make decisions based on data that is inaccurate on the first reading. This gives some idea of the challenges facing Central Banks when they only have blunt tools such as interest rates to play with, whilst being reliant on lagging data.
Of the 336,000 new jobs created in September, 73,000 of those were created by Government departments. Now that isn’t to say that those jobs were not real, but as I am about to explain, there is often suspicion by economists when taking data at face value. It wouldn’t be unheard of for data to be manipulated by those in power to provide a rosier perspective than perhaps it really is. With election season on the horizon in the US, a strong economy is a far easier campaign tool than an economy heading for recession.
The chart above shows the US non-payroll farm data releases from August 2022 through to August 2023. The white bars show the initial data releases and the gold bars show the revised data releases, which were announced one month after the initial release.
The chart shows that in late 2022, the US economy was still holding up better than anticipated and the revisions to the data were consistently upward. As we entered 2023, the story changed and the revisions in gold consistently show the actual numbers being revised lower than those initially reported. June 2023 is highlighted in a white box on the chart as the revision downwards was around 50%. That is a huge difference and begs the question how the initial data can be so inaccurate. Despite this, the historical inaccuracy of the data hasn’t stopped markets or commentators jumping on the September positivity bandwagon.
Keep in mind that the Federal Reserve are relying on this data and such frequent revisions both up and down, muddy the waters when they are trying to ascertain if their measures are working or not. The Federal Reserve’s next meeting to discuss the direction of interest rates, whether to hold, raise or cut, is at the end of October. They will be reliant on the September data release, which isn’t yet reflected on the chart above.
The September report may be accurate, perhaps the May and June 2023 extreme downward revisions were anomalies, but we won’t know until the October numbers are released in November. The headlines tell one story, but one has to be sceptical about using that data as a barometer of what must happen next in markets.
The following chart demonstrates how the effect of interest rate rises are not immediately apparent in unemployment data, a lag effect in essence. The Federal Reserve has currently paused interest rate rises. They warn of a higher for longer environment for interest rates, but they are waiting to see the impact of their efforts thus far in the monthly data releases before committing to a future strategy. Part of the reason for the pause is because historically, the US unemployment rate only consistently rises after the Federal Reserve pause interest rate hikes. The black line below represents interest rate movements and the green line represents the US unemployment rate.
On average, US unemployment peaks 24 months after the last interest rate rise. January 1997 was the anomaly, but the 24month lag pattern has played out in the 1970s, early 1980s, 1991, early 2000s (post the technology bubble), 2008 (during the Global Financial Crisis) and during the Covid years.
Post Covid, the world is different. Is it?
Undoubtedly markets and anyone trying to predict market direction have had a challenging 20 years. The Global Financial Crisis of 2008-09 saw unprecedented Central Bank action to restore order to financial markets and prevent even worse consequences. That unprecedented action hadn’t unravelled itself by the time of the Covid pandemic, which again saw Central Banks throw normalised responses out of the window and do whatever was necessary to support individuals and businesses through those years. The net result was an entirely distorted bond market and a consumer who bizarrely, all things considered, was often far better off than they had been before the pandemic.
The chart below shows the current state of US excess household savings. Through the early days of the pandemic, it is clear that household savings rose markedly. The white line shows the lowest levels of household incomes (the bottom 0-40% of earners), the blue line shows the next 40-80% of household income levels and the red line shows the top 20% of household income levels.
As we entered the Spring of 2021, household savings across the board had peaked beyond their pre-pandemic levels. A combination of reduced costs due to lockdown and Government support meant people had built up their Covid piggy banks, as they have come to be known. Since then, those piggy banks have been eaten into. For those households representing the bottom 80% of all income levels in the US, real household savings are now lower than before the pandemic. This is happening at a time when the US 30 year mortgage rate reached 7.49% on the 5th October, the highest level since 2000.
US mortgages work very differently to UK mortgages, they are typically taken out for much longer terms. This can be a good thing at times like these if you aren’t planning to move, but the consequence is that the housing market will grind to a halt as people won’t move for fear of having to accept unaffordable mortgage rates on new properties. A slowdown in housing sales in turn impacts economic productivity and ultimately employment statistics.
Why does the US matter so much?
We don’t have a large exposure to the US in our portfolios at the moment, but the reality is that Central Banks around the world typically mirror the Federal Reserve late in an interest rate hiking cycle. It should matter more what is happening in their own individual economies, but it is a brave Central Banker who bucks the trend and doesn’t either pause or cut when the US pauses or cuts. The US also remains the predominant global economy (25% of all world economic activity) and with China facing its own economic woes at the moment, we have to pay close attention to the situation within the US.
As of the end of last week, the US 10-year Treasury was yielding 4.79% and the UK 10 year Gilt was yielding 4.57%. Both of these yields have risen sharply since February 2023 and there is talk that the US Treasury 10-year yield may reach 5%.
Bill Gross, a respected fixed interest manager in the US was recently commenting on the movement of the US 10-year Treasury and making the point that with US inflation stubbornly stuck around the 3% mark, it wasn’t unreasonable for Treasury yields to rise and thus provide some risk-free reward to investors. At current yields, he considers the 10-year US Treasury to be good value not great value. Central Banks are targeting 2% inflation and so any data supporting a slowdown in economic activity will help bring yields down as the need to reward investors so highly will dissipate.
Whilst economic data points are contributing to the movement in fixed interest yields, there are other factors at play. More buyers are entering the fixed interest market wanting to snap up longer term yields at elevated levels whilst foreign buyers, notably China are selling down their Treasury assets.
Can history repeat itself?
Liontrust Fund Managers recently undertook some research on the UK fixed interest market and have posited three potential outcomes from where we are now.
1. Their base case requires UK inflation to fall to around 2.5% by Summer 2024, that we have no further interest rate hikes and we see a reduction to 3.25% in the 10 year Gilt yield. This outcome would mean expected returns of over 14% for a year, just from UK Gilts.
2. Their worst-case scenario, with further interest rate hikes, inflation remaining stubbornly high and minimal movement from here in the 10 year Gilt yield would still result in a positive return for Gilts, albeit a lower one.
3. Their best-case scenario of the 10 year Gilt yield falling to 2.75%, with no further rate hikes and inflation falling faster than expected could see returns from Gilts of over 17% for the year.
Of course, these are all just scenarios and they depend on variable data, but the consensus view is that whilst yields may appear out of control at the moment, Gilts and bonds remain the most attractive asset class for the pre-recessionary conditions we are facing.
The chart above shows the US 10 year Treasury Yield in black alongside the UK Treasury 10 Year Gilt Yield in pink over the last 20 years.
This is a telling chart, because the only time at which both yields went higher than they are today was in the run up to the Global Financial Crisis in 2008/09. We could buy into the thesis that this time is different due to Covid, but too many signs are pointing in the same direction for that to be true.
In 2006/07, commentators were playing down recessionary fears. Interest rate rises were underestimated and the expectation was that the economy would settle without much fanfare.
Last week saw the latest data release from the ISM (Institute of Supply Management), which reports on the US services sector. The results showed a slowdown as new orders fell to a nine month low. Non-manufacturing PMI (Purchasing Managers Index) also fell in the services industry. This measure covers around two thirds of the US economy. The hope is that these data points pick up at the end of 2023, but we heard similar messaging in the run up to the Global Financial Crisis of 2008/09.
The chart below overlays the ISM Services data from January 2007 to December 2008 (grey line) with the ISM Services data from December 2021 to mid-September 2023 (brown line) before the latest markdown
The pattern is eerily clear to see. Perhaps the drivers of this economic environment have been a little different to 2008/09 up until now, but from here, we see consumer debt rising with credit being used to maintain standards of living, pressure on employers to fund wages and maintain balance sheets, further deterioration in the housing market and a reduction in economic activity overall.
We believe that we will imminently reach the inflection point where so many economic signs reflect sufficient tightening that Central Banks will not only pause interest rate hikes, but will cut them quickly. Current Central Bank messaging is to hold out for longer and turn the screw on inflation, but we foresee too much pain for too many people to allow them that luxury. Over the last 55 years, the average time taken for the Federal Reserve to cut rates from their last hike has been 7 months. We just do not see why this time is different. Central Banks have made a habit of overestimating how long they will keep rates higher, they typically cut much sooner than they have predicted.
For portfolios, it is daunting to see bond yields keep rising. The graph below charts the US Treasury 10 Year yield in black/red, the iShares Government Overseas Bond fund in brown, the S&P 500 in green and the FTSE 100 in blue since the last Federal Reserve interest rate announcement on the 20th September 2023.
The graph shows the 10 Year Treasury Yield rising from 4.4% to 4.8%, a rise of over 8%, which is the fastest yield rise post a Federal Reserve announcement. We know that bond yield rises are not good news for bond capital values and we can see that the Overseas Bond fund is marginally down over the same time period. However, what is most noticeable is that the US and UK equity markets fell much further than the bond fund whilst yields were soaring.
Our positioning
This is precisely why we are positioned in this way. In this environment we foresee significant falls in equity markets to come. The bond market has become too stretched and when concerns over future Federal Reserve rate rises rear their head, it has been the equity markets which have shed more value than bonds. This supports our thesis that there is only so much more pain to come for bonds, but there is a lot of pain to come for equities. We believe that healthy double digit returns are just around the corner from the bond market, compared to likely double digit negative returns from equities.
With bond yields having reached their current levels, there is a chance that the US Treasury 10 year could hit 5%, but if it does, equities have far more to worry about than bonds and that inflection point will follow swiftly.
With US debt soaring over $3 trillion amidst their Government debt ceiling woes, the cost of borrowing for the US Government is unsustainable. If yields reach 5%, then the US Government, as well as the consumer, will struggle to keep funding their borrowing and if this happens, the Federal Reserve will find that the bond market has effectively done their disinflation job for them and that will prompt a rapid cycle of interest rate cuts.