David Joy: Investors Keeping Close Watch on Economic Reports

A stronger than anticipated employment report for October drove stocks sharply higher on Friday, and in the process propelled the S&P 500 to its fifth straight weekly gain. Financial stocks were particularly strong following the labor report, which saw the creation of 204,000 new non-farm jobs, well above the consensus estimate of 120,000. In addition, upward revisions to the two prior months added 60,000 more jobs to the total.

The report sent bond yields sharply higher. The yield on the ten-year note spiked higher by 15 basis points to 2.75 percent on Friday, its highest level since the day following the Fed’s decision in mid-September not to commence tapering, as investors raised the odds of the start of Fed tapering in December or possibly January.

The October labor report wasn’t the only economic surprise last week. The advance estimate of third quarter GDP surprised to the upside as well. Instead of the 2.0 percent consensus estimate, annualized growth in the quarter came in at 2.8 percent, the strongest reading since a similar report in the third quarter of last year.

However, the components of that unexpected strength left some to caution against being overly encouraged by the headline number. Personal consumption slowed to its slowest pace since the second quarter of 2011 and business investment on equipment contracted for the first time since last year’s third quarter. The contribution to growth from accumulating inventories doubled from the prior quarter, as final sales growth slipped to a 2.0 percent pace.  While the quarter did not overlap with the government shutdown, which began on October 1, the anticipation of it no doubt had a chilling effect on economic activity in the weeks leading up to it. Despite these qualifiers, activity in the third quarter was consistent with the general trend.

These two reports, taken together with firmer readings last week from the ISM’s non-manufacturing survey and a decline in initial weekly jobless claims, suggest some underlying firmness in the economy and also that any impact from the government shutdown may be relatively muted. Of course, the government data remains distorted by the shutdown and is subject to future revision. However, the surprise so far has been in the strength of the data, not its weakness, and that is encouraging. But if it brings forward expectations for the commencement of Fed tapering, keep in mind that the last time tapering was thought to be imminent, in early September, the ten-year note yield climbed to 2.99 percent.

Last week we noted that, according to the Investment Company Institute, for the week ended October 23, net flows into long-term domestic equity funds were stronger than for any total month since January. Although at a reduced pace, that trend continued in the week ended October 30, when inflows totaled $4.3 billion, down from $9.2 billion, marking three straight weeks of inflows. At the same time, bond funds experienced outflows in each week in October and in each month since May. This shift is raising cautionary flags among those who view the current wave of equity optimism as a sign of a market that is ripe for a correction. Surveys of investor sentiment are also showing evidence of excessive bullishness.

Whether these recent trends are consistent with a sustainable, long-term rotation away from bonds and into stocks remains to be seen. If so, they could provide a powerful tailwind for equity prices. On the other hand, if underlying investor sentiment remains fragile, belying the current strength in equity flows, those flows could dry up quickly at signs of any market correction.

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