When Bad Is Good

The Upshot

9/10/2012

Disappointing data on the U.S. job market couldn’t keep stocks down, as sluggish job growth fueled high hopes for another round of stimulus from the Fed this week, writes Kristina Hooper.

Kristina Hooper, CFP®, CIMA® is head of portfolio strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Faith in the Fed is growing more devout.

Despite another disappointing jobs report, stocks drifted higher Friday to close out a strong week for the major averages as investors pinned their hopes to an imminent policy move from the Federal Reserve. The lack of job creation since the financial crisis has hampered the economic recovery forcing central bankers to consider additional stimulus measures.

However, there was legitimate cause for applause. Investors cheered the unveiling of the European Central Bank’s new bond-buying program and renewed commitment to fiscal integration in the euro zone. Then they cheered the ADP employment report, which actually suggested 200,000 new jobs. Then they cheered again for the government’s lackluster jobs report—96,000 new jobs—which suggested a greater likelihood that the Fed will intervene this week.

Heading Off Tail Risks

Last Thursday, ECB President Mario Draghi expressed full commitment to the euro, calling it “irreversible.” He laid out a plan to stabilize the euro zone through the purchase of short-duration government bonds and the imposition of fiscal tightening. The plan promises that the ECB will buy "unlimited" quantities of short-term bonds of those countries facing fiscal problems, provided they enter a program with outside oversight and guarantee that they will make fiscal adjustments. What makes this bailout plan different than all other plans before it is that it looks like a true, open-ended commitment by the ECB to put its balance sheet to work—provided governments are willing to live by its conditions.

The goal of Outright Monetary Transactions—a program that involves buying government bonds in the secondary bond market—is to provide an “effective backstop for removing tail risks.” It can be interpreted as insurance and, as such, we think it will be successful because there are no restrictions. The new program is a significant upgrade from the now-retired Securities Markets Program in terms of conditionality, transparency and duration as well as ECB seniority.

Of course, this plan is not without risks. European governments now have less of an incentive to implement reforms between the start of OMT and the first reviews, as the ECB has essentially given them a free pass for the interim period. In addition, potential balance-sheet risks rise in the euro system, increasing the risk for creditor countries to be coerced into further support. In addition, a number of question marks remain including the degree to which the International Monetary Fund participates, whether the European Stability Mechanism will be an effective partner for the OMT and other issues. However, we believe this is a positive development for the euro zone, and investors seemed to agree.

Job Crunch

On the employment front, ADP released its private sector jobs report, which showed an increase of 201,000 jobs in August, well above economist expectations. In addition, the July estimate was upwardly revised to 173,000 from the 163,000 that was reported last month. While the ADP series is more volatile than non-farm payrolls and is not necessarily a reliable proxy, it does give some sense of employment conditions.

Still, the numbers released by the Bureau of Labor Statistics painted a very different picture of employment. The BLS reported that U.S. payrolls fell short of expectations, increasing by a seasonally adjusted 96,000 jobs in August. The number of private-sector jobs created totaled 103,000, while the public sector lost 7,000 jobs. Economists surveyed by Dow Jones Newswires had forecast a gain of 125,000. In addition, previous months were revised downward by a cumulative 41,000 jobs. The change in total nonfarm payroll employment for June was revised from 64,000 to 45,000, and the change for July was revised from 163,000 to 141,000.

However, the disappointing jobs report was cause for more celebration by investors, who viewed it as another sign that the Federal Reserve will intervene. It’s becoming more apparent every day that the U.S. economy is sputtering. While housing appears to have stabilized, this is not the case for jobs. Since the beginning of the year, employment growth has averaged 139,000 jobs per month, compared with an average monthly gain of 153,000 in 2011. And the manufacturing situation is also troubling. The ISM manufacturing index fell to 49.6 for August, marking the third consecutive month that the index has been below the critical 50 level, signaling contraction. The last time we saw contraction for three straight months was in mid-2009.

But while the economy is in the doldrums, stocks are posting impressive returns as they climb a wall of worry. Those focused on the economy this year may not have noticed this stealth rally: the S&P 500 Index, on a total return basis, is up more than 15% so far in 2012 while technology stocks, as represented by the NASDAQ Composite Index, have gained more than 20% year-to-date. Defensive stocks have been eschewed recently, as investors anticipate Fed action. All eyes are on the Federal Open Market Committee’s decision later this week, which should wield great influence over how stocks finish the year. For investors, it could be the difference between cheers and tears.

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