Stocks Rally On Strong Jobs Report

Stocks Still Range Bound

The stock market rallied sharply on Friday because of the great jobs report. The S&P 500 was up 1.08% and the Nasdaq was up 1.51%. It’s very rare to see the stock market rise and oil fall, but that’s what happened on Friday as WTI fell 3% to $65.81. The spread between WTI and Brent is at a 3 year high which is now $10. The spread is wide because American production is trapped inland. The spread is high even in medium term contracts as there isn’t an expectation that U.S. supply growth will slow or that infrastructure constraints will ease. Prices have fallen ever since Saudi Arabia and Russia discussed increasing output by 1 million to make up for the decline in production from Venezuela and the potential decline in Iranian production because of U.S. sanctions.

It will be interesting to see how oil price declines effect the economic data. Since gas prices are usually lowered slower than they are raised, the effect will be delayed until June. Remember, consumer spending growth was boosted because of spending on energy. This made GDP growth estimates soar.

Most sectors rallied as only consumer staples and utilities fell. Tech did the best as it was up 1.97%. The tech sector is actually at a record high. The FANG stocks also have a record high market cap. Facebook stock has gotten over the scandals which dogged it earlier in the year. With Apple stock’s record high, it now has a $935 billion market cap.

The chart below shows the 6 month candle chart of the S&P 500 along with the 50 day moving average. As you can see, the S&P 500 is just 4.81% below its all-time high on January 26th. I have been calling for the market to move higher as the economic growth looks solid. However, stocks have been stuck in a tight range for 3 weeks. I’m nervous because the economic data from April and May can’t get much better. If stocks can’t hit new highs on this, then what will do it? The June 12th summit with North Korea could act as a catalyst for stocks if it goes well.

Great May Jobs Report

The May jobs report brought the economic fundamentals back in focus for the stock market. The non-farm payrolls were up 223,000 from last month which beat the consensus for 190,000 jobs. It also beat the high end of the range which was 220,000 jobs. The prior month was revised down slightly from 164,000 to 159,000. The unemployment rate fell to 3.8% as you can see from the chart below. This is an 18 year low. It’s usually very bad news for equity prices when the unemployment rate is very low because it signals a recession is coming shortly. However, I don’t believe the labor market is at full employment yet.

Jobs growth of 223,000 isn’t consistent with full employment. Furthermore, the labor participation rate fell from 62.8% to 62.7%. The more important prime age labor force participation rate also fell. It went from 82% to 81.8%. This rate is actually going in the wrong direction as it peaked at 82.2% in February. I remember in February I was discussing the possibility that the labor market would reach full employment by the next year if it kept up the recent pace. There has been an influx of older workers which could suppress this rate. However, it’s now 1.6% below the last cycle peak, which implies there’s probably still room to run.

(Click on image to enlarge)

There were 18,000 manufacturing jobs added which met expectations. That’s below last month’s gain of 25,000. I’m surprised more jobs weren’t added since the sector is doing so well. The fact that it only met estimates means that the services did even better than the headline suggests. The chart below shows the historical difference between service providing job creation and goods producing job creation. As you can see, when the trailing twelve month difference falls, it usually means a recession is underway. We are at an unusual point because it has fallen outside of a recession. There has been a rebound in manufacturing jobs, so that’s better than a decline in services jobs. I am willing to discount this metric because of that point and because the labor market is still strong.

(Click on image to enlarge)

The most important part of this report remains the earnings growth rate because higher growth signals strength for the consumer, but also higher inflation which means more rate hikes. The month over month average hourly earnings growth was 0.3% which beat expectations for 0.2% growth and the prior month which had 0.1% growth. Before you get too excited about the labor market heating up, the year over year hourly earnings growth was 2.7% which met expectations. The average work week was steady at 34.5 hours. This implies the weekly earnings growth was similar to the hourly growth. That’s accurate as the weekly growth was 3% which is up from 2.86% last month. The peak of this cycle was 3.43% growth. This report certainly means the Fed should hike rates, but there’s no reason to panic and accelerate the hikes.

Fed Funds Futures & Treasury Market

The Fed funds futures market has moved in the hawkish direction in the past couple days because the Italian political crisis was averted and this report shows wage inflation could reach a cycle high in the next few months. There is now a 35.4% chance the Fed hikes at least 4 times in 2018 and only a 17.7% chance the Fed hikes rates 2 times or less in 2018.

Both the 10 year yield and the 2 year yield increased by 4 basis points. This reversal has occurred because the political stress has died down and economic growth has been strong. The 2 year yield peaking would be a signal the cycle is over, but since the Fed will be raising rates 50 more basis points this year, that’s unlikely. I see the 2 year yield rising as a given which is why I focus so much on the 10 year yield. The more the 10 year yield goes up, the longer it will take for the curve to invert.