Weekly Markets Commentary — July 10, 2017

David Joy – Chief Market Strategist, Ameriprise Financial

Lack of wage growth and inflation could give the Fed pause

The U.S. economy generated 222,000 new non-farm jobs in June, well above the expected 175,000. It was the best showing in four months. The report also included a 47,000-job upward revision to the prior two-month total. While the unemployment rate rose to 4.4 percent from 4.3 percent in May, it was accompanied by a modest increase in the participation rate. However, the report also continued to confound expectations of rising wages this late in the cycle. For the month, average hourly wages rose just 0.2 percent, and just 2.5 percent on a trailing twelve-month basis. The combination of solid job growth and little inflationary pressure should be supportive of risk assets.

Following the report on Friday, equities rose modestly and the spread between two and ten-year Treasuries steepened fractionally. That spread has now steepened by a total of 21 basis points from a twelve-month low of 77 basis points on June 27, when European Central Bank president Draghi alluded to the eventual wind down of its own quantitative easing program, which has helped suppress U.S. yields.

June jobs proves to be frustrating for the Fed

The June jobs report is also likely to be somewhat of a source of frustration for the Federal Reserve, which has expressed its faith in the belief that wage growth will inevitably rise as the slack in the labor market tightens, taking inflation higher in the process. And while no policy action is anticipated at the Fed’s next meeting in two weeks, the doves on the Federal Open Markets Committee (FOMC) will no doubt press their case for a pause in the pace of rate hikes.

The lack of wage pressure may now make it more likely that the Fed waits until December to consider its next rate hike, but may also make it more likely that it initiates the runoff of its balance sheet at its September meeting. The next report on consumer prices comes on Friday, and is expected to once again be on the soft side. Fed chair Yellen appears before Congress this week and is expected to reinforce the Fed’s abiding belief in the Phillips curve.

Also, last week, the ISM manufacturing index rose to a three-year high in June, well above expectations. That was followed by another strong report on the service sector. Overall, second quarter economic activity seems to have rebounded from the soft first quarter. The Atlanta Fed GDPNow forecast, updated prior to the jobs report, anticipates growth at an annualized pace of 2.7 percent in the quarter. In contrast, the New York Fed Nowcast model anticipates growth of just 2.0 percent, unimpacted by the June jobs report, as the number of jobs created raised the forecast by 0.1 percent and the rise in the unemployment rate lowered it by the same amount. June reports on retail sales, industrial production and consumer sentiment are scheduled for this Friday.

Q2 earnings season gets underway and the Senate heads back to work

Second quarter earnings season is about to get underway, with the initial focus on bank earnings beginning on Friday. Factset estimates growth of 6.6 percent in the quarter compared to last year, led by energy, technology and financials. Earnings grew by 14 percent in the first quarter. Full-year growth is estimated at 9.8 percent. Contributing to the earnings backdrop is the weaker dollar. Expectations at the start of the year called for a stronger dollar due to the so-called reflation trade. As those expectations have faded, so has the relative strength of the dollar.

The DXY dollar index began the year at 102. It ended the second quarter at 96, enhancing the relative attractiveness of U.S. exports. The weaker dollar also amplifies returns from foreign investments for dollar-based investors.  For example, year-to-date through the second quarter, the MSCI emerging markets local currency index is higher by 13.8 percent, while the emerging markets dollar based index is higher by 17.2 percent. The MSCI EAFE international index is higher by 5.7 percent in local currency terms, but 11.8 percent in dollars.

The Senate is back to work on Monday and it appears that a lot of work remains if a healthcare reform bill is going to pass. Three weeks remain before the August recess, so the time for a successful compromise is short. The implications for tax reform are significant, so along with earnings season, the lazy days of July will also be filled with a certain degree of anxiety.