Full employment economy ready to surprise investors

Tomorrow the BLS releases the monthly “Employment Situation Report”. David Rosenberg of Gluskin, Sheff and Macroeconomic Advisors said if no fiscal tightening had occurred in 2013 then the unemployment rate would be 6.0% not 7.3%. Rosenberg said monthly new job creation next year may be 280,000 instead of the recent average of 180,000. My opinion is that at this level, after subtracting 100,000 to 125,000 a month for population increase, in a year the unemployment rate would improve from 7.3% to 5.8%. At that level workers would feel more prosperous and buy more things creating a virtuous cycle where the rate of job growth would accelerate as businesses higher more people because of increased consumption. The bond market will surely react quickly and long term bonds would be hurt. Investors need independent financial advice to evaluate what will happen to the economy.

Rosenberg also mentioned for the prime age group of workers age 25-54 the employment to population ratio at 76% is now above the historical median.

My opinion is that when the GNP expands and employment opportunities increase that doesn’t necessarily mean that corporate profits will increase. The current environment has experienced record high corporate margins with minimal growth of sales, so the profit increase was due to cost cutting. When things get better for workers then employers’ cost will rise and profit margins will “mean revert” down to historical standards. Margins now are 11% and are usually 6% of sales. If wages are 55% of sales and there is a one-time wage boost of 10% that will cut margins 5 percentage points, returning them to the normal rate of 6%. The stock market already has a high 10 year PE ratio of 24 and if adjusted for unusually high profit margins the PE10 would be even higher.

In the typical five year business cycle, at the early stages wages and costs are low and sometimes decline, creating increased profits for powerful, giant companies with deep corporate moats. (A corporate moat refers to the ability to defend against competition). However, next year will see the economy moving to the hottest part of the cycle which will mean rising inflation, rising interest rates, rising wages and declining corporate profits.

The combination of rising interest rates (which will reduce margin borrower’s purchases) and shrinking profits will damage the stock market even though the unemployment picture will be better. Rising interest rates will act as a damper on real estate and make it cool down.

The coming improvement in the labor picture will fool investors in a manner similar to when the Federal Reserve first cut interest rates at the start of the 2007-2009 crash. The result was that stock investors instead of worrying about the deteriorating economy assumed that low rates would make stocks go up. So from August, 2007 when the rate cutting cycle started until Oct. 31, 2007 stocks rallied. 17 months later they fell 57% by March 6, 2009.

Investors should use independent financial advice to decide if the hidden risk of declining corporate profit margins will damage their assets.

I wrote an article “Job market has improved – will that make stocks crash?”

Investors should seek independent financial advice.

About the author

Don Martin, CFP®

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