The Aussie jobs report blew me away this week, with unemployment falling to 3.4%. In the UK, despite Brexit, inflation, war and political shambles, the unemployment rate remains at 3.6%. Jobs were lost in the September quarter, but the rate is still very low.
In the US, the unemployment rate is at 3.7%. We made the case a few weeks ago that housing is likely to go through a freeze and that probably means big job losses in construction, particularly in the US.
But even if that does eventuate, the jobs market is still very hot in these economies and will have to deteriorate very quickly for a flow on effect on interest rate expectations.
I’m finding it very difficult to see how we move away from ultra-strong job markets, quickly. Things are too hot for a sudden shift, unless we get an unexpected event. Amazon cut 10,000 jobs, but they still employ almost 650,000 people. Let’s keep that in context.
The thing is, strong jobs are very bullish for investment. It’s true that a strong jobs market puts pressure on wages and inflation. But it’s much more desirable to have a strong jobs market with moderate to high inflation than a weak jobs market with low inflation. The worst combination is weak jobs with high inflation, that’s the situation Europe finds itself in at the moment. A big mess.
Strong jobs might mean rates settle at current levels
One of the things we might need to consider is that strong jobs mean current interest rates become the new reality and the ultra-low days are over. I know that jobs are a lagging indicator and that eventually job losses will climb as rate rises hurt. But searching for a pivot point might be the wrong focus.
Bond markets are now expecting US Fed Funds rate to peak at 4.9% in 6 months and then to remain above 4% until Q1 2024. It’s the “remain above 4%” part that is the big mindset shift for me in recent this week as I continue to look through and analyse the employment trend.
US 5-year bond yields are back to levels they were at post 2001/2002. They only came down because of the 2008 financial crisis and the extreme slump in 2020 which wasn’t a true recession but a global pandemic. The 3-4% range could be the new normal, that’s what bond markets are suggesting anyways.
Implications of new rate levels
Living in Australia gives me an interesting vantage point because we don’t view everything through the US or European prism. We generally have a wider world view. The US is unique because rising rates don’t necessarily impact all borrowers. The US has a higher percentage of fixed rate home borrowers, who generally fix for longer periods of time.
Many other countries are different, such as the UK, Australia and Canada where mortgages have a larger variable component. Central banks in these economies will be mindful of that difference when setting rates. They can’t just look to the US and follow the course. The UK feels like it’s suffering from a European war, a post pandemic fiscal mess and also the fallout from Brexit which probably still hasn’t been fully felt and could take more time to play out.
Australia is probably better placed to ride out higher rates because its underlying economy is very China focused. China will eventually open it and when it does, we will see bulk, agricultural and service export benefits. Aussie dollar vs Canadian dollar is on my watch-list as a trade irrespective of US policy changes.
Implication on asset allocation & stock earnings
The biggest implication of rates remaining at current levels will be on asset allocation, portfolio investing and the way we think about stock earnings. A new 3-4% risk free rate, even slightly higher in the US, means that we now need to think about allocating more money to cash, less to speculative junk and more to cash flow generation sectors.
It’s false to dismiss stocks as expensive purely based on interest rate rises because stocks are exposed to earnings and those earnings will benefit from record levels of employment. The discount rate is higher because the economy is stronger. Let’s not forget that.
It’s back to sensible investments. The crazy 50x price to earnings ratio stuff won’t swim in the new environment, but 15-20x earnings isn’t necessarily expensive if earnings can grow at 7-8% per annum.
Market commentary and analysis from Peter Esho, economist and co-founder at Wealthi
