Watch profits and yields, not jobs: James Saft

July 16, 2013

July 16 (Reuters) – The Federal Reserve is watching job
creation, but investors will be better off keeping a wary eye on
profits and bond yields.

Yields have risen in the past two months, while corporate
profits may be on the slide, both of which should undercut job
growth and exercise a powerful influence over the Fed’s next

While the evidence from the first week of corporate profit
reporting season is mixed, profits and margins look to have
weakened in the second quarter as companies struggle with lower
spending by governments and a difficult environment of falling

At the same time, evidence of an improving jobs picture, as
well as dovish statements (now partly taken back) from the Fed
have convinced markets that they are on a path towards ‘normal’
interest rates. In other words, higher rates.

Benchmark 10-year Treasury yields rose by more than a
percentage point from early May to early July, topping out above
2.71 percent.

That move, in and of itself, is bad news for both the U.S.
and the global economy, as is shown by Fed Chairman Ben
Bernanke’s efforts to partly row back on remarks which convinced
investors he’d soon begin scaling back the central bank’s
purchases of bonds. Rates rocketed higher in May after
Bernanke’s remarks convinced many that relatively encouraging
jobs figures were setting the stage for a tapering of bond
purchases as soon as September.

“Our conclusion is that these yields are unsustainable and,
if they last long enough, will sow the seeds of their own
destruction by weakening (and possibility terminating) the
domestic and global expansions,” economist David Levy, of the
Jerome Levy Forecasting Center writes in a note to clients.

Levy argues, convincingly, that higher yields, if sustained,
would hurt the domestic economy in at least three ways. First,
by crimping the recovery in housing, as higher mortgage rates
are felt and the marginal buyer turns away from purchases.

Second, rising yields will cap stock markets’ gains, which
in turn may encourage higher savings rates. Higher savings,
while a good idea and much needed in the long term, will slow
growth now. Finally, higher yields will hurt exports, both by
hitting growth in emerging markets and by driving the dollar
higher, making U.S. products less attractive.


Other than a view on future Fed policy, why does the market
believe market rates will rise over the coming year? Much stock
is given to what have been genuinely encouraging jobs figures,
which have been on an unmistakably upward slope in recent
months. With the Fed having placed a strong emphasis on
achieving a 6.5 percent unemployment rate, as against 7.6
percent today, before it raises rates, it is easy to conflate
job growth today with rising rates tomorrow.

There is a tendency too to see jobs growth as
self-sustaining, and indeed there are solid links between jobs
and household creation and auto purchases.

Still job creation follows GDP growth, which itself tracks
profits. With profits moderating it becomes hard to see the jobs
recovery as self-sustaining.

That’s especially true given the frankly bizarre behavior of
corporations during the most recent recovery in profits, which
took them to nosebleed territory. Basic economic theory holds
that companies, which on the whole like to make more money,
invest in new production when their margins and profits are
high. That simply didn’t happen this time round, which is
perhaps why job growth only really became solid once housing
began to bubble again.

There is disagreement about why companies failed to invest
when times were good. Some believe it’s because they recognize
and fear the vulnerability of households and governments with
shaky balance sheets. Others, notably economist Andrew Smithers,
argue that piratical executives have hijacked companies and
won’t invest because they know that they will soon jump ship.

Either way, if companies didn’t invest as profits and
margins rose, it is very hard to see them doing it as they fall.

To be sure, profits so far this reporting season have been
mixed, with banks such as JP Morgan, Wells Fargo and Citigroup
providing bright spots.

David Levy uses a metaphor his economist father was fond of,
that an economy in transition is like a train rounding a bend:
the caboose can still be going one direction while the engine is
already going another.

It is unclear whether we are in transition, but profits are
usually the engine, and this time particularly, interest rates
will help to decide how fast the train goes.

Based on the last two months, that is not faster.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at and find more columns at

(Editing by James Dalgleish)

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