A misreading of profit strength and inflation boost equities and bond yields

While the mix of recent reports suggests the economic recovery is still gaining ground, the evidence also indicates the recovery is sluggish and fragile without any near term risk of excessive or mounting consumer inflation. But the stock and bond markets appear to be only reacting to selected signs of recovery and commodity inflation, not to the economy's slow growth and its pronounced vulnerability. That creates the potential for an eventual reversal of recent gains in equity prices and bond yields. That is because the markets will ultimately recognize that the vitality of the economic recovery is not sufficient to justify current exaggerated expectations of continued vigorous corporate profit growth or rampant inflation, which are the prime catalysts for the rapid rise in equity prices and bond yields. However, there is no clear indication of when that critical realization that the markets have gone too far will occur. Indeed, the trend to higher equity prices and Treasury bond yields is likely be extended further before that market turn-around realization ultimately sets in.

The Friday release of the January employment report is clear example of conflicting set of signals on the economy. The seeming positives include a steep drop in the official unemployment rate to 9.0% from 9.4% in December. While 9.0% is still exraordinarily high, the drop is welcome. The U-6 unemployment rate, which includes part-time workers who are unable to find the full-time employment they seek, declined to 16.1 from 16.7. However, these declines are suspect. The unemployment rate declines were largely due to an outsized and counter-trend 504,000 drop in the labor force. And that decline was due to more discouraged workers leaving the labor force and perhaps a weather-related rise in those who were unable to report that they had looked for work in the preceding 30 days. Also among the positive aspects to the report was a stronger rise in earnings.

The forgoing seemingly economic positives in the employment report were more than offset by a disappointingly small 36,000 rise in January nonfarm payrolls and ominous declines in the average work-week and aggregate hours worked. That suggests more sluggish real GDP growth in the first quarter than the 3.2% in the fourth quarter. But, these were not the aspects of the report on which the markets focused.

Nor did the markets respond favorably to the still modest rates of inflation, 1.5% for the CPI, 0.3% for the GDP deflator. Instead, fear of inflation mounted with persistent Fed easing and the rise in commodity prices. Markets fail to recognize at least two fundamental flaws in its thinking. Regardless of money growth, credit is still not expanding, a prime source of inflation. And commodity price increases are difficult to pass along to final prices amidst still low capacity utilization rates,which were still a very low 76.0% in December. That is far from the 86% capacity utilization level where bottle-neck and production price pressures typically only begin to emerge. Nevertheless, the Treasury 10-year rose to 3.63% on Friday, up from 2.33% as recently as October. There is no reason to believe that yield uptrend will not be extended further before it is reversed. As I have discussed before, when the equity indices decline by at least 4.0% in a single week, past experience suggests the turn around is at hand. Last week they up sharply.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square, # 249
East Northport, New York 11731

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