January employment report & Q4 GDP are solid, but Fed likely on hold until there is clarity on fiscal policy
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The employment situation in the U.S. remained on solid footing to start 2017. U.S. employers added 227,000 new jobs to the economy and this was well ahead of the 175,000 consensus estimate. More people entered the labor force last month so the unemployment rate ticked up from 4.7% to 4.8%. The November report was revised lower by 40,000 jobs while the December revision was +1,000. While the headline numbers were positive, the the drop back in annual wage growth was another reason to think the Fed will hold off raising interest rates until June. Average hourly earnings rose only 0.1% in January and they were revised lower by 0.2% in the December report. Wages have grown 2.5% Y/Y.
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Overall, with PCE inflaton stuck below 2% and considerable uncertainty over Trump’s fiscal policies, we believe that the Fed will remain on hold until at least its June meeting. There is certainly the potential for higher inflation over the course of 2017 and this could force the Fed to become more aggressive with monetary tightening. More aggressive action from the Fed could spook markets across the globe.
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Economic growth slowed in the U.S. during Q4, but a lot of the weakness was atrributed to soybean exports which spiked in Q3 and fell sharply in Q4. The initial estimate of Q4 GDP growth was 1.9% and this is down from 3.5% in the prior quarter. It is important to note that after a very weak first half of 2016, when GDP growth averaged only 1.1% annualised, there was a significant acceleration to an average of 2.7% in the second half. Trade subtracted 1.7% from Q4 growth while consumption growth slowed from 3% in Q3 to 2.5% in Q4. Business investment grew 2.4% during the quarter and this is positive because it has been a headwind over the past 18 months. The U.S. economy grew a disappointing 1.6% in 2016, but most economists expect GDP growth to accelerate to the 2.5-2.7% level in 2017 based on the prospect of tax reform, repatriation, infrastructure spending and reduced regulation.
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Manufacturing continued its strong rebound into the new year with the ISM Manufacturing Index jumping to 56.0 in January from 54.5 in the prior month. This reading was above the 55.0 estimate and there was broad based gains across the major sub-indices. The biggest improvement was in the employment index, which rose to 56.1, from 52.8 in December, and there were other strong results from production and new orders. Manufacturing has picked up globally, but the U.S. continues to benefit from the fading drag from the strong dollar. After a strong year of growth, construction spending ended 2016 on a weak note (0.2% decline). Construction spending grew 4.5% Y/Y in 2016 with a 5.2% gain in residential spending. Public construction spending was the real weak spot in December, posting a 1.7% decline.
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Activity in the U.S. service sector expanded for the 85th consecutive month, albeit at a slightly slower pace than in December. The ISM Non-Manufacturing Index fell from 56.6 in December to 56.5 in January, and this was below the 57.0 expectation. Employment, prices paid and the backlog of orders gained ground last month, but production, new orders and inventories all fell.
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Consumer sentiment fell back to earth last month after the post-election surge higher. The index fell from 98.5 in January to 95.7 in February, but it remains at a very high level based on historical standards with only five higher readings in the past decade. The expectations sub-index decline drove the drop in confidence, but over time, stronger consumer confidence hasled to an acceleration in consumer spending.
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Through about 75% of the fourth quarter earnings season, the aggregate earnings growth rate for the S&P 500 has been 5% with 67% of companies beating expectations. Earnings were projected to grow 3.1% at the start of the quarter and better-than-expected earnings have been broad based across eight of eleven sectors. 2017 forecasts have already begun to come down as the analyst community now expects about 10% earnings growth in 2017 and this is down from 12% at the end of 2016. As we progress through the year, the headwind from energy earnings should turn into a big tailwind. Earnings are forecast to grow 12% in 2018. Earnings in the small cap focused Russell 2000 are projected to grow 25% in 2017. Small caps posted strong gains in 2016, but they remain in fair value territory on a historic basis relative to large caps.
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For the first time since 2008, the eurozone registered faster economic growth than the U.S. Eurozone GDP grew 0.5% in the final quarter of 2016 and this brought full year 2016 growth to 1.8%. In addition, higher energy prices resulted in a spike in inflation from 1.1% in December to 1.8% in January. Unemployment in the eurozone also ticked lower last month to 9.6%, the lowest level since May 2009 and down from 10.5% a year ago. Energy has driven the rise in inflation, but core inflation still remains stubbornly low and expectations are for the ECB to continue its bond buying program at least until the end of 2017. We do not expect the ECB to tighten monetary policy any time soon, but perhaps they will take their foot off the gas if economic conditions continue to improve.
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Below is a chart of total returns for an international benchmark which consist of earnings growth, dividends, currency movement and change in valuation. Since 2000, returns from the MSCI Emerging Markets Index have been driven by earnings growth and dividends. EM earnings have been falling since 2011, but they have bottomed and are expected to grow nearly 15% over the next twelve months. The long-term outperformance of emerging markets over the U.S. and EAFE indices has occurred because of the higher level of earnings growth. The backdrop for emerging markets is positive going forward when considering the combination of accelerating economic and earnings growth. This of course assumes there are no surprises from the Fed.
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