Blockbuster jobs report could have major implications for your portfolio

Last week we discussed the roller coaster that has been U.S. economic data in 2016. This week didn't exactly clear anything up. Belying the recent disappointing 1.2% GDP print, the U.S. economy produced 255,000 non-farm jobs in July, well above consensus expectations of 180,000. Revisions added an additional 18,000 jobs to overall payrolls in the previous two months. Unemployment remained at 4.9% as labor force participation ticked up to 62.8% while wages grew 0.3% to keep up with June’s annualized growth pace of 2.6%. Upward wage pressures will indicate to the Fed that more robust headline inflation could be just around the corner.

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Further reflecting the disappearance of slack in the labor market, the unemployment rate for workers without a high school diploma fell a massive 1.2% in July to 6.3%, the lowest reading since October 2006. As we’ve seen recently with the likes of J.P. Morgan and Starbucks, businesses are being forced to hike wages in order to retain talented employees. Now companies are also having to move down the skill scale to find workers. Open job positions are near record highs, now exceeding the number of people outside the workforce immediately seeking a job (for the first time since before the crisis).
 
Personal consumption is the driver of nearly all U.S. economic growth at the moment, but manufacturing activity continues to move higher. The ISM Manufacturing Index fell from 53.2 in June to 52.6 in July, one basis point below expectations, but still reflected growth. As we mentioned last week, economists expect headline GDP growth to normalize in the second half of the year as the inventory de-stocking cycle winds down. The Atlanta Fed’s GDPNow tracking tool boosted its estimate of Q3 GDP growth up one basis point to 3.8%.
 
Prior to Friday’s employment report, Fed Funds Futures indicated only a 32% chance the Fed would raise interest rates in 2016. Following the report, implied probability grew to 43%. Resurgent expectations of a rate hike pushed bank stocks to their largest gain in nearly two months in anticipation of higher net interest margins. The financial sector climbed nearly 2.0% Friday, leading the S&P 500 to another new all-time high.
 
The meat of earnings season is now behind us as well. While overall corporate earnings contracted for the fourth straight quarter, around 75% of companies met or exceeded consensus expectations. Sound familiar? That’s because almost every quarter the percentage of companies meeting or exceeding analyst estimates is around 75%. This week the Wall Street Journal ran an illuminating piece about companies quietly nudging analysts to downplay expectations leading up to earnings when they know numbers will come in light. “A federal rule bars companies from selectively disclosing material nonpublic information but doesn’t prohibit private conversations in which companies can gently push analysts in helpful directions.”
 
The fact that earnings and job growth exceeded estimates says more about the expectations than they do about the results. We are clearly in a lower-growth new normal. However, that doesn't mean current conditions warrant emergency-level interest rates. As we discussed in last week’s SkyBrief, the post-crisis scramble for safety has given rise to outsized duration risk among fixed income investors. Those moving further out on the curve got a warning shot last week with the rapid rise in Japanese bond yields, and alas this week following Friday’s employment report, the U.S. 10-year yield spiked ten basis points to 1.59%.

Don’t expect treasuries to give up all their gains for the year, but with slack leaving the labor market, wage growth exceeding the Fed’s inflation target and the GDP growth expectations much higher for the second half of the year, it wouldn’t be unreasonable to see the 10-year yield gradually climb back to May levels in excess of 1.80%.

BANK OF ENGLAND (BOE) CUTS BOTH WAYS

Markets this week were pricing in basically 100% certainty the Bank of England (BOE) would cut interest rates. They were right, as the BOE cut its benchmark rate 25 basis points to a historic low of 0.25% on Thursday. But what investors didn’t expect was the bold resumption of the BOE’s long-dormant quantitative easing (QE) program. BOE President Mark Carney announced a ￡70 billion asset-buying program that includes an unprecedented ￡10 billion dedicated to investment-grade bonds from companies with significant U.K. operations. Also surprising was the introduction of a new “term funding scheme,” which is equivalent to the European Central Bank’s (ECB) targeted long-term refinancing operations (TLTRO). In essence, both programs attempt to offset the damage negative interest rates have on bank balance sheets by paying financial institutions to make long-term loans.
 
While Carney has previously indicated he “is not a fan” of negative interest rates, leaving the BOE with little wiggle room going forward, he did his best to strike a dovish tone by echoing ECB President Mario Draghi’s infamous “whatever it takes” line regarding policy accommodation. The result of Thursday’s announcement was a 1.5% drop for the pound and matching rally for British blue chip stocks. (Weekly reminder: with companies in the FTSE 100 index deriving 70% of their revenue from outside the U.K., a weaker pound is a boon to British multinational stock prices.)
 
U.K. factory activity was hit harder by Brexit than initially estimated, falling by the most in three years, but Euro-area manufacturing output unexpectedly accelerated to its highest level in six months. The news helped calm fears about Eurozone contagion from Brexit. Main Street isn’t waiting around to see if the U.K. can survive the break-up as retail investors redeemed $4.7 billion from U.K. investment funds in June. That figure was larger than any outflow for an equivalent period during the 2008 financial crisis. The National Institute of Economic and Social Research (NIESR) estimates a 50-50 chance the U.K. economy will slip into recession by the end of next year. 
 
While Europe’s banks largely got clean bills of health in last week’s stress tests, the market isn’t buying the rosy outlook. On Monday, the rally in Europe’s Stoxx 600 Bank Index lasted only a few hours as investors questioned the stress test's opaque methodology and flimsy results.

The test’s biggest casualty, Monte dei Paschi di Siena, came up with a well-received plan to trim its inventory of sour loans, but investors are skeptical about whether, after two previous bailouts, the bank can raise capital and sell off assets at prices currently being quoted. MPS, once known as the ATM for its benevolence in the Siena community, is having to face up to a harsh new reality. The bank's presence made the little Tuscan hilltop town one of the most desirable places to live in Italy, but unfortunately those days are long over.

RIDE-SHARING RIVALS REACH CEASEFIRE

Ride-sharing is often seen as a winner-takes-all game, with billions in venture capital funding setting the stage for a World War I-style battle of attrition. When someone wants a ride, the thought is they are unlikely to open two or three different apps to search for the cheapest and fastest ride. Alas, the biggest players in the industry – Uber, Lyft and, in China, Didi Chuxing – have engaged in a no-holds-barred battle to gain market share. And the war has been bloody. In many major cities, the companies operate at a substantial loss, subsidizing fares and burning through those VC billions. Nowhere has that dynamic been more damaging, especially for industry leader Uber, than in China.
 
This week Uber waived the white flag in China, selling its Uber China unit to fierce rival Didi. You know what they say: “if you can’t beat ‘em, join ‘em.” The company reportedly lost $2 billion trying to make inroads in China over the last two years, prompting investors to push for a ceasefire. The deal goes like this: Uber gets a 20% stake in Didi (with the new combined entity valued at $35 billion) while Didi will invest $1 billion in Uber (most recently valued at $68 billion). The arrangement not only allows Uber to turn its attention to other international markets, but also fulfills Didi’s wish to begin expansion beyond its communist home-base. (Didi had also previously invested $100 million in Uber's U.S. rival Lyft.) For Uber, the deal also removes a major impediment to an initial public offering (IPO).
 
In addition to bringing the global ride-sharing industry closer to singularity, the deal underscores how hard it is for American companies to do meaningful business in China. The New York Times' Farhad Manjoo wrote: "American technology giants have each followed a similar script for world domination. Like an imperial armada rolling out from North America’s West Coast, these companies would try to establish beachheads on every other continent. But when American giants tried to enter the waters of China, the world’s largest internet market, the armada invariably ran aground.” 
 
Because of tight government control and the importance of local knowledge in China, local companies almost always usurp their international counterparts. Uber CEO Travis Kalanick was determined to be the exception. He traveled frequently to China for meetings with local officials to smooth over regulatory concerns. He vigorously defended the steep losses incurred by the company in its battle with Didi. But the reality is Uber China was doomed from the start. You could say Kalanick’s efforts were vindicated by the favorable terms of the merger, but the saga is the latest humbling of an American tech giant in China.
 
The opacity to doing business in China is among the reasons MSCI declined to add Chinese A-Shares to its benchmark emerging-market index earlier this year. Until the communist government allows for freer flow of information and greater regulatory transparency, it will struggle to gain the international credibility it craves, and Silicon Valley will fail to penetrate a market it so dearly covets.

TECHNOLOGY M&A WAVE CONTINUES

Mergers & acquisitions (M&A) activity in the tech sector remains robust.

The controversial Tesla-Solar City merger looks set to move forward, with seemingly everyone despising the deal except for the only group that matters: shareholders. After negotiations between independent directors of the two companies, Tesla lowered its offer price and encouraged Solar City to seek higher bids. Elon Musk is pledging to support one if it came. He even cancelled his cousins’ stock options in Solar City to remove any remaining concern over conflict of interest.
 
Salesforce bought work-collaboration app Quip for $750 million in what is largely seen as an acqui-hire. Salesforce CEO has long expressed an admiration for Quip founder Bret Taylor, who was recently added to Twitter’s board of directors and is the former Chief Technology Officer for Facebook.
 
Microsoft became the latest tech giant to tap the receptive corporate bond market rather than repatriate its mountain of foreign cash to fund strategic initiatives. The company is raising $20 billion in debt to fund its purchase of LinkedIn.
 
Wal-Mart is reportedly in talks to buy web retailer Jet.com for around $3 billion in an obvious attempt to gain ground on Amazon in the e-commerce space.
 
Verizon made another acquisition to bolster its internet-of-things initiative, buying trucking tracker Fleetmatics Group for $2.4 billion in cash.

IMAGE OF THE WEEK

The spread between those not in the labor force who want a job now and total non-farm job openings has been erased, further evidence that the U.S. labor market is nearing full employment.

QUOTE OF THE WEEK

“It has done better than any Silicon Valley company in China. Uber has been a grand rival and we have had an epic battle…?We raged an earth-shaking war, and when we join hands our love will last ‘til the end of time.”
 
-  Didi Chuxing president Jean Liu in an internal email announcing a new partnership deal with Uber

FURTHER READING

Facebook wanted to buy Snapchat a few years ago for $3 billion. Snapchat said no. Now Snapchat is worth more than $20 billion, owing largely to the success of its “Stories” feature. Thus, Facebook-owned Instagram this week launched its own version “Stories,” and unlike previous Facebook-Snapchat copycats, it’s been a hit.

China's top communist leaders gathered for a secretive meeting over the party’s future while economic policy makers are contemplating the launch of acredit-default-swap market, a move that would accelerate the inevitable deleveraging effort.
 
The U.S. Treasury should be refinancing federal debt at today’s low interest rates. No matter who becomes the next President, expect deficit spending to rise. 
 
Theranos was offered the chance to defend its technology at a medical science conference but instead pulled a bait-and-switch by announcing a new product.
 
While the American political process may not be rigged, flaws may be contributing to polarization, gridlock and fringe behavior in both parties.
 
India enacts sweeping tax overhaul that will make doing business in the country much easier.  
 
For the second straight week, the media examines whether Wall Street has been tamed.
 
Oil prices enter a bear market on oversupply worries before rebounding late in the week.
 
Peter Thiel wants to live forever by running young people's blood through his veins.
 
Bitcoin’s reputation suffers another major blow as hackers steal $65 million.
 
Short-sellers bet against Mexico as it gets caught in U.S. political crossfire.
 
Big banks are cutting jobs while bolstering their quantitative know-how.
 
Berkshire Hathaway draws Fed scrutiny over Wells Fargo investment.