.
Marcuard's Market update by GaveKal Dragonomics
Rightly or wrongly, the US payrolls have for years been the biggest market-moving event in the monthly news cycle. The market action on Friday was a reminder of their totemic power. We have repeatedly noted the mesmerising effect of the monthly payrolls, not just on Wall Street but even more on markets outside the US.
We have offered two explanations for this outsized influence of the payrolls and by extension have argued that the cyclical bounce in equities (and also the dollar) from 2009 onwards has matured into a structural bull market. The first reason is simply that fear of a double-dip US recession, or more recently of “secular stagnation”, has been the main counter-argument against the structural bull market—and every unexpected dip in the payrolls provided some statistical ammunition for the bears to keep these fears alive.
The second reason—and the one that probably accounts for the paradox of US payrolls affecting Europe and emerging markets even more powerfully than Wall Street—is the role of US monetary and fiscal policies as a model for the rest of the world. Whenever payrolls disappointed, the cry went up that the US economy was still in trouble, despite unprecedented budget deficits, $3trln of balance sheet expansion and five years of zero interest rate policies—so what hope could there be of similar policies working in the rest of the world? Whenever each of these “soft patches” in payrolls was followed by an acceleration to 200,000, investors in the rest of the world concluded that the US policies were working after all—and therefore that similar policies of monetary and fiscal stimulus would ultimately be applied in other regions with broadly similarly effects, albeit with a lag.
As the US recovery has become increasingly self-sustaining and recession prophets have been corralled into a small messianic cult, the message from the monthly payrolls about the cyclical conjuncture has become less important than the policy message. But this policy message is different from what most analysts claim. Friday’s rebound in payrolls told us nothing important about when the Federal Reserve will start moving or how fast it will hike. This is partly because of the elements of softness in the figures, such as the labour force participation rate and stagnant wage growth, but more importantly because of the evolution of the demand management philosophy, especially since Janet Yellen’s ascension. The Fed’s dovish management team has been clear that it wants to maintain ultra-stimulative monetary policy until something near full employment is restored (which means boosting the participation rate by at least one or two percentage points from its present 35-year low of 62.7%) and return US GDP to its long-term growth path, closing an output gap of several percentage points still remaining after the Great Recession.
Yellen will therefore keep shifting the definitions of “maximum employment” and “price stability”, regardless of hawkish dissent from a minority of the FOMC. Yellen and the Fed management will go on moving the monetary goal-posts unless and until they are stopped by some external force—an upsurge of inflation, a bond market panic or a Tea Party president. Since no such force majeure is likely in the next year or two, it is a waste of time and money to speculate on significant changes in US monetary policy—unless you happen to be a speculator in Eurodollars whose definition of “significant” includes a one-month shift in market expectations of the first Fed rate hike, which is all that happened last week. Assuming that US monetary policy is more or less pre-determined, Friday’s payrolls should have limited significance not only for US equities and bonds but also for emerging markets, especially in comparison with local dramas such as the Hong Kong protests and Brazil’s election.
What then is the really significant message from last week’s payrolls? It is not about US policy, but about monetary and fiscal policy in Europe. If the US economy keeps visibly improving, while Europe stagnates and lurches from crisis to crisis, the pressure on European policymakers will become overwhelming to follow some variant of US-style monetary stimulus and to soften fiscal austerity into US-style benign neglect of budget deficits. In the three weeks before the European Commission has to deliver its verdict on the French and Italian budgets, these governments and the European Central Bank will probably propose to Angela Merkel some kind of “grand bargain” that would combine more aggressive monetary action with more leeway on fiscal policy with some modest steps on structural reform.
The US will add to the pressure on Germany at the Washington G7 meeting this week. But far more important than any political pressure will be the demonstration effect of US economic performance on European public opinion and business sentiment. If the US continues to power ahead of the euro zone, Germany’s resistance to US-style policies will become politically unsustainable. Even the dollar’s rise against the euro will paradoxically give Europe more licence to follow US-style monetary and fiscal policies, because of the traditional German view that a strong currency is always and everywhere a product of good economic policies. And given the present over-sold conditions, any signs of more decisive policy action in Europe would probably trigger a decent rebound by the euro, albeit in a downward trend that still has a way to run. The upshot for investors is that last Friday’s payrolls were actually more important for Europe than the US—and could turn out to be more positive for European markets and the euro than for Wall Street or emerging markets.
This doesn’t mean that Europe is out of the woods. In the next month Europe will face four huge risks: the Ukrainian election on October 26, the European Commission’s French budget judgement on October 29, the Asset Quality Review in “late October” and the next ECB meeting on November 6. Any of these events could trigger a disaster that would easily overwhelm the relief rally that seemed to start on Friday and would quickly spread from Europe around the world. At the margin, however, the evidence of improvement in the US economy will increase confidence in Fed policy and will wear down German resistance to monetary and fiscal easing. That is the real significance of good US payrolls.
