Friday June 7

Stock prices finished the week on a strong note after the release of the June NFP report. The S&P 500 rose 0.6% to 2,425 and the Dow Jones rose 0.4% to 21,414. Over the course of the week those indices were 0.07% and 0.3% higher respectively. The KBW Bank index today advanced 0.6% and utilities rose 0.2%. The June NFP report showed that payrolls rose by 222k in June which was higher than estimates of 170k. However the trend of strong payrolls and weak wage growth continues as earnings rose just 0.2% on the month. The report seemed to land in a sweet spot for investors based on the market reaction. The “risk-friendly” report sent indices higher in spite of a renewed sharp selloff in oil prices. On that backdrop the 2 year Treasury yield was unchanged again at 1.40%. The 10 year Treasury yield rose 2bp to 2.39%. Accordingly 2yr vs 10yr bear steepened to 0.99%. Over the course of the week the 2 and 10 year were 1 and 9bp higher respectively. The dollar also found strength from the NFP report. USD rose 0.2% against EUR to $1.1406. USD rose 0.6% against JPY to Y113.91. USd rose 0.7% against GBP to $1.2884. WTI fell 2.7% to $44.30 while Brent also fell 2.7% to $46.80. 

Data today showed that nonfarm payrolls rose by 222k in June, which exceeded analyst estimates which called for a 170k gain. The prior month was also revised upwards by 14k. The monthly trend for nonfarm payrolls continues to look positive for 2017. The unemployment rate ticked up one tenth of a percentage point to 4.4% however that could be attributed to a slightly higher participation rate. In spite of the very strong reading on payrolls, wage growth continues to disappoint. Average hourly earnings rose just 0.2% on the month compared to estimates which called for a 0.3% gain. That amounts to an annualized pace of 2.5% which is somewhat stagnant. This is a recurring trend over the last year, as the Fed maintains that low unemployment will eventually drive wage growth. Stock markets rally as this is somewhat of a goldilocks scenario for investors. The economy is healthy as reflected by the continually low unemployment and strong payrolls. However wage growth and inflation is not high enough to the point when it could cause the Fed to raise rates. That ideal scenario for investors has send the S&P 500 forward P/E ratio to 17.5x which is elevated by historical standards. 

Richard Koo at Nomura writes about the potential market effects of the Fed unwinding its balance sheet. He believes that it potentially could lead to a big increase in interest rates. When the Fed is reinvesting principal payments of maturing securities, normally the Treasury will issue refunding bonds to private investors, and pay the Fed with the proceeds of the refunding bond. As the Fed continues to reinvest principal and interest payments, all of the money stays in the fixed income market. However once the Fed stops reinvesting, the proceeds of the refunding bonds will be paid to the Fed and at that point they will effectively disappear and be removed from the market. Koo believes that this should have the same effect as a massive increase in the fiscal deficit which would normally lead to a selloff in rates. Koo believes that over the next four years private savings will have to increase by 300, 600, 600, and 450 billion in order to make up for this gap. However based on his conversations with clients, he believes that many investors are surprised and unaware of this fact, and that as a result Treasury yields may still be supported. He likens the situation to Greece before the European sovereign debt crisis. At that point Greek bond yields traded close to Germany because Koo argues investors prioritized the belief that the government was observing the Maastricht Treaty’s cap on deficits over Greece’s actual deficit. The report states that value is a social construct, meaning that if investors don’t notice that interest rates should be higher, they may not ever increase. 

Funding from investors has allowed oil companies to weather the storm and continue opening new wells. Oil prices have fallen 13% since April, and in that time frame US producers have put 100 rigs online. Oil production is on track to hit a record high of 10 million barrels a day in the United States as more oil companies expand their drilling initiatives. However to some it seems to be an inefficient allocation of capital. Investors are rewarding producers who are able to report production growth, as opposed to those who are able to tighten their belts and get by at the current levels. Around current price levels oil companies spend more money than they earn back through revenues. Last year when oil prices averaged $43 oil companies spend $1.58 for every $1 in revenue. Over the next six months oil companies are on track to spend $20bn in excess of their revenues. Part of the reason for this could be that oil executive compensation is oftentimes tied to production growth as opposed to profitability. At the same time investors are rewarding companies for growth as opposed to earnings, which is reminiscent of how they will pay a high multiple for a loss making tech company as long as it is reporting growth. Investors have been a lifeline for oil companies, which have raised capital in high yield and equity markets since oil prices took a turn for the worst. Last year oil companies issued a record amount of equity. However times may be turning if oil companies continue to shoot themselves in the foot by increasing production at all costs. After a busy 2016, capital raisings from the energy sector have trailed off in 2017 which could suggest that investor appetite is full. 

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Friday June 7

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