Employment, Wages, Inflation and Portfolio Positioning: Is the Federal Reserve Ready to Act?
The most common questions we’ve received over the past few weeks have been whether or not the Federal Reserve will raise interest rates in June and how that will impact our client portfolios. While the answer to the first question is a resounding “maybe,” the answer to the second question is far more certain: our client portfolios are well positioned when/if the Fed decides to tighten monetary policy. We outline below the main factors influencing the rate hike decision, along with the most likely outcome for our strategies.

Nonfarm payrolls are driving the economy forward, with February posting a 295K gain, handily beating the consensus estimate of 235K. The unemployment rate edged down to 5.5%, which is the top of the range for full employment according to the Federal Reserve. The low participation rate of 62.8% indicates that the falling unemployment rate is partially due to fewer people in the workforce.

Over the last year, the U.S. economy, on average, has produced 266K jobs a month, which invites the questions: where are the jobs coming from, is the job growth helping the long-term unemployed and is there any spillover from falling oil prices?  The largest month-over-month driver of job growth in February came from the food services and drinking places sectors, which added 59K jobs combined. These sectors tend to be lower-paying in nature. The long-term unemployment rate is stuck at stubbornly high levels, with a third of the total category unemployed for more than 27 weeks. The long-term unemployment rate is something the Federal Reserve continues to monitor closely. Lastly, the impact of falling oil price on jobs, so far, seems to be muted, with the mining sector and ancillary activities falling only 9K. Mining was the only sector showing a decline in February. Last week, RBS provided a compelling set of charts showing a flattening Phillips curve in advanced economies. A flatter Phillips indicates that job growth is currently less influential at spurring wage growth than in the past. So while job creation is good for the overall economy, is it enough a create wage inflation?

Based on the most recent FOMC statement along with public comments from Fed Governors, it is clear that wages are an important component of the Fed’s decision on raising rates. The lack of wage growth has been a clear disappointment, and contrasts with the strong job creation numbers over the past 18 months. On Friday, we learned that average hourly earnings grew just 0.1% month/month, and only 2.0% year/year in February. Both of these figures are in nominal terms and represent almost zero wage growth in real terms. The lack of wage growth indicates continued slack in the labor market, where employers are adding jobs, but don’t feel the need to raise compensation. This gives the Fed room to remain longer at the zero-bound.      

Whether a country’s central bank is explicitly targeting 2% or otherwise, most developed economies are not achieving their inflation objectives, according to recent data. Last week the United States reported price increases of 1.3% year/year as measured by the Federal Reserve’s preferred inflation metric, Personal Consumption Expenditures. In the nineteen-country Euro currency bloc, prices fell 0.3% year-over-year, and economists expect prices to remain flat in 2015. Japan has a similar problem. “Core” prices increased just 0.4% year/year, and a broader measure of inflation showed only a 0.2% annual price increase. Japan is more optimistic than the Euro bloc and expects inflation to continue rising in 2015. Chinese inflation recently fell to its lowest level in five years, just 0.8% year/year, down from 1.5% reported in December.

Two factors persist across the globe. First, with near uniformity, measures of inflation were dampened by a significant drop in the price of oil. Secondly, global central banks have stepped up measures to combat the specter of deflation. The Federal Reserve has pledged “patience” in its approach to raising interest rates despite solid job growth and decent economic growth. Mario Draghi, the European Central Bank president, announced a program of Quantitative Easing, money-printing and bond-buying, which will hopefully spur inflation. In Japan, Shinzo Abe’s measures, dubbed “Abenomics,” which include doubling the monetary base, appear to be working. However, a looming sales tax increase, only recently pushed into 2017, could materially affect consumer action, as we saw when Japanense authorities implemented a sales tax increase last year. Finally, Chinese authorities reduced interest rates in an effort to spur business activity, and more stimulative measures may follow. 

Our sense is that, even in the presence of extraordinary action by global central banks, consumers appear more ready to save than spend. Most recent figures in the U.S. show consumer saving has increased another half percentage point to 5.5%, which is below the average of 5.9% over the past thirty years, and may indicate further saving is possible. Our duration positioning will likely remain neutral until the prospects for inflation materially improve.
SNW Positioning
Interest rate increases don’t have to mean losses for bond investors. Shorter-maturity bonds are less sensitive to rising interest rates than longer bonds. In fact, over the long term, higher rates are good because maturing bonds can be reinvested at higher yields, which increases the cash flow generation in portfolios. We have a significant number of bonds maturing in the next 12 months that can be used for reinvestment.

Furthermore, a rate hike from the Fed may only affect short-term interest rates. The long end of the yield curve is driven mainly by inflation, which, as we mentioned above, remains subdued. Flows from overseas investors also drive longer-term bond yields. We’ve written about how the relative attractiveness of U.S. bonds versus those from major developed economies like Japan and European sovereigns (think Germany) is driving flows into the U.S. and putting a cap on rates. This relative value relationship remains in place, with Japanese Government Bonds at 0.38% and German 10yr Bund yields at 0.37%. Through February, all of our strategies have positive net returns for the year, and while we can’t promise that this will always be the case over the short-term, our goal of long-term principal preservation and prudent yield maximization remains our top priority when making investment decisions.  
Sources: Bloomberg, The Economist, SNWAM Research, RBS, WSJ