The employment data continues to be one of the stronger data points on the US economy. Today’s non-farm payroll figure showed the US economy added 292,000 new jobs in December which was well ahead of market expectations of +200,000 jobs. The two month net revision of +50,000 jobs was also strong. The unemployment rate was unchanged from the previous month at 5% and the participation rate edged up to 62.6% from the previous month’s reading of 62.5%. Average hourly earnings rose 2.5% yoy up from the prior month’s reading of 2.3% yoy and average weekly hours worked were unchanged from November at 34.5.
Ahead of these figures and following the weak US ISM manufacturing figure (the weakest reading in six years) and a set of somewhat dovish Fed minutes the market was not looking for another hike in rates this month and expectations for a March hike had eased. The strength of the US dollar and weakness in the manufacturing sector remains a headwind to US growth and suggests, in line with the Fed commentary, that any further increases will be gradual and dependent on the economy not weakening further from here.
The median estimate from the Fed is for 4 more rate hikes this year to give a target range of 1.25-1.5% by the end of 2016. We are more pessimistic on the outlook for growth and expect a Fed Funds rate of 1% at the end of the year at most. Never before has the Fed started a tightening cycle with the ISM below 50 (the average of the past three is 57.2) which suggests to us that rate increases will be very modest. Added to this is the issue of inflation as the Fed has hiked on the basis that it is ‘reasonably confident’ inflation will return to 2% and slack is reducing in the economy rather than on any strong pick-up in the inflation data itself; core PCE is still only 1.3%. However, as the Fed minutes pointed out for a number of members the decision was a “close call” with inflation data being a critical factor to monitor going forward. Our valuation models show ten-year US Treasuries are trading cheap at current levels and this is still the case when we model inflation at 2% and an increase in short-rates.
We expect the Fed will remain ahead of the curve and the yield curve to flatten which favours positioning at the long end on a duration weighted basis. Given an uncertain growth outlook we prefer higher quality credits, especially value credits, where there is a ‘margin of safety’ (actual spread versus rating implied spread). Differentiation across credit markets will be an increasingly important theme in 2016 as tougher operating environments continue to put weaker credits under pressure. ‘Wealthy nations’ as strong credits should outperform debtors; de-risking is negative for debtor nations as capital flows back to creditor nations. Individual credits, particularly those lacking sovereign support, with weakening balance sheets will be more vulnerable to downgrades.