November 2014 Monthly Commentary
November witnessed a barrage of better than expected economic data that ordinarily would have pushed interest rates higher. Instead, rates fell as bond prices rallied.
In evaluating what went wrong, the obvious culprit is our misjudgment of the demand for U.S. Government securities. We anticipated that the steadily improving economic backdrop would have spooked investors and caused them to sell bonds in advance of a tightening of monetary policy. However, buyers seemed convinced that monetary policy would remain unchanged at least until 2016, despite comments from Federal Reserve members indicating a rate hike in 2015. The primary driver of that view has been the stagnant Consumer Price index. As measured by U.S. government statistics, inflation is running just below 2%, the rate targeted by the Federal Reserve. Our forecast had been that the measure would have been closer to 3% and that would have prompted the Federal Reserve to raise rates. It didn’t and with many investors holding short positions in Treasury bonds, a short squeeze ensued. Exacerbating the squeeze has been a lack of liquidity among banks and brokers.
Ironically, our forecast for economic activity was mostly correct. As extended unemployment insurance benefits expired last year, we were of the opinion that the change would be beneficial for employment. Our rational had been that those recipients of the extended benefits would be forced to get a job and that would be supportive for the economy. As it turned out, that view was correct as witnessed by the 2.6 million jobs that have been created during the first 11 months of this year. That rapid job growth has driven the unemployment rate to 5.8% from 6.7%, where it stood 12 months ago. Despite that better than expected outturn, some cite the somewhat anemic wage growth as an indication that the jobs are not quality, high paying jobs. Again, we take the opposite side of that opinion and argue that wage growth is a lagging indicator and will soon rise. First, the demand for Science, Technology, Engineering, and Mathematic jobs continues to tighten. Demand for workers in those areas has created shortages with employers forced to offer higher wages to attract talent. Secondly, as profits continue to rise as they have over the last several years, those with jobs for more than a year or two can expect to see annual merit raises. That means that the 2.6 million net new jobs created this year are likely to enjoy such raises next year.
The automobile industry is a sector that should be quite supportive for job growth. Prior to the crisis, the average run rate for automobile production was 15 million units per year. Following the crisis, that rate fell to a low of 10 million units per year, as fearful consumer postponed new car purchases. That postponement has resulted in a significantly older auto fleet. The average age of a car on the road today is 11 years. While car quality is far higher today than in decades past, the fleet, nonetheless, is old and will need to be updated. That leads us to conclude that auto sales should consistently exceed 16 million units annually for the foreseeable future.
The housing industry is similar to that of automobiles. The average inventory of new homes over the last twenty years has been approximately 300 thousands, before spiking to a high of 550 thousand units in 2006. That inventory plunged to 150 thousand after the crisis, and while it has corrected somewhat, it currently stands at a lean 200 thousand. We expect as the job force continues to expand the demand for new homes will also continue to expand.
While we have been on the wrong side of the market recently, we have not lost our conviction that rates will rise. In recent client meetings, we present a chart which compares the price of the S&P 500 with the yield of the 10-year note over the last ten years. The equity index is in record territory, supported by strong top and bottom line growth, while the 10-year Treasury note is just above the level at which it stood in the depths of the financial crisis. One of those indices does not reflect economic reality and with GDP growing in excess of 4%, we argue that the mispricing lies in bonds. While we are extremely disappointed to report a fourth monthly loss, our thesis has not changed and we remain convinced that the bond market is wildly overvalued.