The primary theme for the last two months has been strength in the economy driving long-end interest rates higher—with implications across all other markets.
Despite ever-present fears about a weakening of the economy, activity remains quite strong. The employment report on Friday was yet another very strong report—with positive revisions to prior months jobs reports for the first time in seven months.
Is the economy too strong? There was good inflation news in the employment report that average hourly earnings were below expectations. The unemployment rate was expected to drop but remained constant and signals that more people are entering the labor force—which is exactly what you want, slack in the labor force that offsets wage pressures.
Yields jumped in reaction to the employment report because there’s worry the Fed will stay higher for longer. The initial equity market reaction to the employment report was a drop, but it closed on Friday much stronger—which I think is the right reaction. All this strength in the economy without increasing inflation plays well for corporate earnings, and we will start getting the earnings reports over the next two weeks.
We have a market that’s priced at 17.5 times next year’s earnings estimates and ex-technology stocks are selling three to four points lower. Even if there is a mild recession, these are great long-term values. Stocks are almost to levels where earnings yields are above 6%, which equate to real returns going forward. There are even better long-term valuations for holders of international stocks. European stocks are selling at 10-11 times earnings.
Yes, TIPS yields and real bond returns are also higher, 2.3% to 2.4% offers more compelling returns in bonds. But remember, at 2.4% it takes exactly 30 years to double purchasing power. At 6% it only takes 12 years and at 5% it takes 14 years. Stocks are still priced for much better long-term returns and a 3% equity premium, while lower than it was for last decade, does not mean stocks are above fair value. They are now underpriced in my estimation.
The Fed is likely going to adjust higher their R-star (R*), which is now 0.5%, the neutral real rate. They’ll probably move it towards 1.5%, which translates to a 3.5% Fed funds rate at 2% inflation.
None of Friday’s data makes me think the Fed is going to hike rates on November 1. There are too many uncertainties. There is still high risk for a government shut down two weeks after the Fed meeting. Will the auto worker strikes be resolved? I still expect some weakness to come to the housing market. We now have 30-year fixed rates at 8%. Housing prices are holding but we are starting to see signs in apartment prices and rents coming down. There’s a delayed reaction in BLS shelter inflation and owner-occupied rent.
This week we will have PPI and CPI. I don’t think a one-tenth higher than expected inflation will force the Fed to hike. Maybe 0.2% to 0.3% hotter than expected inflation might cause to the Fed to hike. The long-end yields rising 50 basis points has done a lot of work for the Fed.
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Professor Jeremy Siegel is a Senior Investment Strategy Advisor to WisdomTree Investments, Inc. and WisdomTree Asset Management, Inc. This material contains the current research and opinions of Professor Siegel, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. The user of this information assumes the entire risk of any use made of the information provided herein. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of WisdomTree or any of its affiliates.
