XLRE - Where To Invest As September Employment Report Raises Odds Of A Fed Rate Hike

2023-10-06 14:52:54 ET

Summary

• With the non-farm payroll rising by a huge 336,000, the likelihood of a final Fed rate hike has risen, even as the unemployment rate stays steady.
• The stock market's initial response was understandably negative, though I wouldn't read too much meaning into it, going by their past unpredictability to the report.
• With rates expected to stay high for some time, US Treasuries continue to look attractive, and over the medium term defensives like pharmaceuticals and contrarian picks like real estate look good.

The Fed’s latest decision to halt rates was clearly based on softening in labor market trends. To this extent, the latest employment report was particularly crucial to assessing if it would hike one last time or not.

Massive non-farm payroll rise

The odds have now risen after the latest employment report showed an increase in non-farm payrolls by 336,000, which is 26% higher than the average monthly gains of 267,000 seen over the past year. This is almost double the expected 170,000 additions. There also were substantial revisions to the figures for July and August, which are together up by 119,000 (see chart below).

Particularly notable are the job gains in cyclical segments like retail trade and leisure and hospitality, which is counterintuitive at a time when the economy is expected to slow down. But retail trade added 19,700 jobs in September, up from a figure of 400 last month.

Leisure and hospitality grew even faster, adding 96,000 jobs compared to 44,000 last month. The sector’s additions also are 57.4% of the past 12 months’ average. Much of this is because of increases in the food services and drinking places segment, which the US Bureau of Labor Statistics notes shows that it has "returned to its pre-pandemic February 2020 level."

Unemployment rate steady

Still, there could be some chance for the Fed to hold rates steady as unemployment rates remained at a high of 3.8% in September, the same as in August. Note that this figure remains higher compared to the 3.4% to 3.7% of the unemployment rate range seen between March 2022, when the Fed started the rate hike cycle, and up to July 2023.

The static unemployment rate also is mirrored in the unchanged participation rate at 62.8% and the employment-to-population ratio of 60.4%. Further, average hourly earnings grew by 0.2% month-on-month (MoM), slightly less than expected.

Employment report takeaway

On the whole, though, the latest employment report indicates that GDP growth could remain higher than anticipated in the third quarter (Q3 2023). The Fed itself expects GDP growth to come in at a slightly above trend of 2.1% this year, in line with the current 3.8% unemployment rate.

At the same time, with the unemployment rate staying unchanged from last month, and question marks on whether the non-farm payroll increases can be sustained, the latest report is still not a sure sign that the Fed will raise rates. Considering its data-dependent approach, I believe many hinges on the upcoming inflation numbers. This is especially so since the figures have risen consecutively for the past two months and were at 3.7% at the latest reading.

Stock market response

The stock markets have responded negatively to the release, likely due to the potential for another rate hike. The S&P 500 ( SP500 ) is down by 0.2% in intraday trading as I write this afternoon. The Dow Jones ( DJI ) is down too.

That said, it’s essential to note that the index’s response isn’t always in tandem with expectations from the Fed, considering that in five of the past 10 months, it has actually risen on the employment report even though the Fed eventually halted the rate hikes just twice. The takeaway is only that the employment report doesn’t provide trading opportunities on the index.

Where to invest

Short to medium term: US Treasuries

There are, however, other investments that look good right now. One of them is the WisdomTree Floating Rate Treasury Fund ETF ( USFR ), which invests in US Treasuries with two-year maturities. The ETF has naturally seen a rise in dividend yield over the past year and a half, with a healthy forward dividend yield of 5.3% right now.

With the catchphrase in the current scenario being “higher for longer” in the context of interest rates, the returns on it could remain relatively elevated up to 2025. The Fed forecasts a 3.9% median Fed funds rate for the year, by which time it expects inflation to come to the whereabouts of 2%.

Medium to long term: Defensives, but also cyclicals

Over the medium term, the Fed’s expectations are of a 1.8% GDP growth rate in 2025, which is slightly below trend. This isn’t a good outlook for the economy, of course, which makes me tilt toward defensives. In the past , I’ve talked about sectors like pharmaceuticals which look particularly good as defensives, and also utilities. And these still look attractive.

But here I’d also like to point out cyclicals like real estate that have taken quite some losses in the past few years (see chart below) as high inflation, high interest rates and dimming growth prospects have softened demand.

I believe real estate stocks would be due an uptick as interest rates stabilize and as the cycle turns upward again. One to consider here is the Real Estate Select Sector SPDR Fund ETF ( XLRE ), which is down by 10% year-to-date. Essentially, these are for patient investors who can buy into the sector at its lows and wait for it to rise.

What next?

The latest employment report has thrown up an unexpected increase in non-farm payroll figures, even as the unemployment rate continued to stay steady at 3.8% from the month before. The odds of one final Fed rate hike are now higher, considering that the economy’s performance in Q3 2023 may well turn out to be firm. Much will hinge on the inflation figures due next week, especially since they have seen an uptick in the past two months.

The S&P 500’s initial response was negative, but going by past trends, I wouldn’t read too much meaning into it or base any trading bets on the index’s response to employment figures. I would, however, consider buying into US Treasuries, through ETFs like the USFR, as interest rates will stay elevated for some time.

Over the medium term, as the prospects for the economy are still uncertain, I like the pharmaceuticals sector. But also cyclicals like real estate may be interesting over a longer time period. Real estate has suffered recently, and can make gains as the cycle turns. It looks like a good time to buy into the sector when it’s still at a low.

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