Wall Street entrance of the New York Stock Exchange is seen on Oct. 2, 2014RICHARD DREW/The Associated Press
As the U.S. heads for full employment, risk is rising for stocks.
That's the implication of new research into the jobless rate and equity prices. While an improving labor market instilled confidence in the economy, helping sustain an eight-year bull market, the unemployment rate has fallen close to levels that most Federal Reserve policy makers view as full employment. That hasn't boded well for future stock returns.
Four of the last five peaks in the S&P 500 came after the rate fell to between 50 and 100 basis points below full employment levels, according to Credit Suisse Group AG. And once it dipped below 4.5 per cent, stocks saw negative returns one year later almost half the time since 1980, the study showed.
"Perhaps the biggest potential challenge for U.S. equities in 2017 is the prospect of the U.S. labour market reaching, or exceeding, full capacity," Credit Suisse strategists led by Andrew Garthwaite wrote in a note last month. "Once full employment is reached, not only do profit margins come under pressure, but pressure grows on the Fed to respond with more aggressive monetary tightening."
What is full employment? "A judgment call," according to Garthwaite. While the Congressional Budget Office views it as consistent with a jobless rate of around 4.8 per cent, there's a chance it's less than that. Fed Chair Janet Yellen said in a Jan. 18 speech in San Francisco that "it's fair to say the economy is near maximum employment." Economists forecast a government report Friday will show the rate stayed at 4.7 per cent in January, near a nine-year low.
Stagnant wage growth and low interest rates have helped S&P 500 companies more than double their profits since the global financial crisis, propelling stocks to record highs. Now that the labour market is approaching saturation and Fed policy makers mull three rate hikes for 2017, the scope for earnings expansions is narrowing. The Fed kept rates unchanged Wednesday while acknowledging that job gains "remained solid" and the unemployment rate "stayed near its recent low" at the end of 2016.
Complicating the employment picture is President Donald Trump's promise to boost public spending. According to Morgan Stanley, it's rare to see government pursue aggressive spending plans at a time when so many people are working. Such a combination only occurred twice, in the 1960s and 1980s.
In 1968, the S&P 500 ended a two-year bull market in November and lost more than a third of its value during the next 18 months. In the other instance when Ronald Reagan's fiscal stimulus in 1983 helped the economy recover from "double dip" recessions, the bull market in stocks lasted through 1987.
Limited history on how assets perform when fiscal policy loosens at low levels of unemployment means investors should own volatility to prepare for "unusually wide distribution of outcomes," Morgan Stanley strategists led by Andrew Sheets wrote in a note last week. "We are headed for uncharted territory."