23 November 2019
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A big downside risk for markets

David Bassanese
4 December 2015

By David Bassanese

Last Friday’s solid United States payrolls report means it’s now virtually certain the Federal Reserve will lift interest rates next week.  Judging by Wall Street’s reaction to the employment report, however, markets seem well prepared for the Fed’s inevitable “lift off.”  That said, markets are likely to remain nervous for some time and investors should approach the next few months with a good deal of caution. 

First, the good news.  US employment rose by 211,000 in November, or slightly more than the market expectation for a 200,000 gain. The unemployment rate held steady at 5%.  What was even more reassuring, however, is that private sector average hourly earnings rose a more subdued 0.2% in the month after October’s outsized gain of 0.4%.  As seen in the chart below, annual growth in earnings slipped back to 2.3% from 2.5% - which is still somewhat higher than the average of the past few years.

Forget China and emerging markets. To my mind the biggest downside risk for markets as we head into 2016 is the possibility that the US labour market is already pushing up against full employment and wages growth leaps higher. If so, all the Fed talk about being “gradual” in raising interest rates will go out the window. 

So far at least, however, Fed chairperson Janet Yellen doesn’t see it that way. In a speech last week, she viewed the recent lift in wages as “welcome” news, as it means it will be more likely that the Fed succeeds in pushing inflation up closer to its 2% long-term target.  I think the Fed should be careful in what it wishes for: once the wage inflation genie gets out, it may be hard to stuff it back in the bottle without a notable slowing in economic growth.

Wall Street, meanwhile, saw more reason to cheer the positive employment news than fear it, with the S&P 500 Index rallying almost 2 per cent.  As seen in the chart below, however, the market has nonetheless largely been in a sideways range for much of the past year, after struggling to break to new highs on several occasions.  The 200 day moving average in prices has also flattened out and prices are struggling to stay above this key trend indicator.  Against this vulnerable technical backdrop, it’s not clear to me the prospect of Fed tightening is going to be the catalyst that pushed this market onto new highs anytime soon.


Fundamentally, although forward earnings for companies in the S&P 500 index continue to rise (unlike the case among Australia’s top companies due largely to the weakness in mining sector profits),  the market is starting to feel valuation constrained notwithstanding still relatively low interest rates. At 16 times forward earnings, the PE ratio remains above its longer-run average of 14.5 and toward the top end of its range over the past decade.  Some also question the quality of the earnings being achieved, as buybacks and re-leveraging seem to be driving growth in earnings per share more than top-line revenue growth.

All up, while I don’t see a catalyst for a major slump in US equity prices (baring a potential break-out in wages), it’s hard to see how or why the market can rally strongly over the next few months.  I fear we may see more messy sideways action in the market that has already priced in a lot of good news and needs to take a breather to allow more value to be restored into the market.    

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