Why the strong US jobs data could be bad news for investors

This week, a great deal of attention will be on the US mid-term elections.

Yet the most important piece of data for investors this month may already have been released.

The latest monthly US jobs report came out on Friday and its message was not a comforting one for investors.

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Good news for workers, bad news for investors

The US non-farm payrolls report comes out on the first Friday of every month. It's one of the most important economic data releases of the month. That's despite the fact that it is subject to regular revisions, so you can't necessarily rely on it to be accurate when it's first issued.

Why does it matter? It measures the number of new staff that US businesses outside the farming sector have taken on. In effect, that covers pretty much all employment farm work accounts for about 2% of employment in the US these days.

In other words, it's the key US employment statistic. It gives us a snapshot of the unemployment rate, plus wage inflation. So it's incredibly important in terms of giving a picture of how the economy is doing. In turn, that is very significant for US interest rates.

And of course, US interest rates are the most important interest rates in the world, because they dictate the global "risk-free" rate and they also affect the value of the most important currency in the world, the US dollar.

So, as investors, it's worth paying attention to where the US employment data is going. And right now, it's very solid indeed.

US companies hired another 250,000 people in October. That was well above expectations for 200,000 (which would have been a strong number in any case). Meanwhile and this is what the Fed will really be keeping an eye on wage inflation came in at 3.1%. That's the highest annual rate of increase since April 2009.

As David Rosenberg of Gluskin Sheff points out, this is before Amazon's 15% minimum pay rate hike has shown up in the data. And it's not a one-off. Over the past three months, annualised wage growth has risen to 3.4%, compared to around 2.5% in early summer.

It's also interesting, notes Rosenberg, that we're at the stage now where employers are competing to retain staff. The voluntary "quit rate" has fallen from a peak of 14% in August to 11.9% in October. This suggests that higher wages are having the desired effect people are no longer as tempted to move jobs for more money, because they're getting pay rises for staying put.

This is all good news for employees, and it's also decent for the wider economy. When people get paid more, they tend to spend more. And with employers now clearly aware that quality labour is a scarce resource, they're growing increasingly willing to pay to retain that labour.

However, it paints a much trickier picture for stockmarkets. The problem is that the Fed now really has no excuses even if it wanted them not to raise interest rates in December.

Given that October was one of the worst months the market has seen since the financial crisis, investors had probably been hoping, in the back of their minds, that we might soon find out where the "Powell put" the point at which the Fed will intervene to comfort markets kicks into action.

That looks a lot less likely now.

The Fed may keep raising rates until something breaks

And the market is more than aware of this. After the data came out, long-term interest rates rose as investors bet increasingly that inflation will go up and that the Fed will have to raise rates to combat it.

The yield on the ten-year US Treasury bond leapt to its highest level since 9 October at 3.22%. That doesn't sound like a big deal, but it was the highest since May 2011. Meanwhile, the 30-year yield hit a four-year high of 3.46%. The US dollar also strengthened in line with rising yields.

None of those are terribly positive things for equities at the best of times. There are many reasons why rising interest rates represent a hurdle for equities.

The main factor is that US bonds are the market equivalent of a bank account (loosely speaking they're seen as being as low risk as it gets). If you can get 3.2% a year from US Treasuries, that means you would need to get more from any other investment that involves taking more risk.

So let's say you are looking at equities. Let's assume that the price of a company is dictated (as it is in theory) by the sum of its future cash flows. If your required return from an investment goes up, then there are two main ways for a company to remain attractive to you.

Either you need a reason to believe that its future cash flows will be better than you expected yesterday (in other words, it will grow more rapidly and make more profit than you previously believed), or its price needs to fall while its expected future cash flows remain static.

Both of these things would drive up the prospective return on the stock. But what's more likely?

You can argue that interest rates are rising because the economy is strong. And if people are getting paid more, then corporate profits will go up. Those are not unreasonable points.

However, there are a number of factors stacked against them. One problem is that earnings have already been boosted by recent corporate tax cuts. Another problem is that companies have taken on a lot more debt, which means that they will start to look like riskier investments, the more interest rates go up. Another problem is that higher wages mean pressure on profits.

In short, it's hard to argue that rising interest rates are bullish for equities.

That doesn't mean that they won't go up. Markets tend to keep their fingers crossed until something finally breaks. But we must be on the way to that turning point and if the economic data stays strong, we'll get there all the sooner.