What The Jobs Report Could Mean For Your Portfolio

A long period of slow economic growth and dormant inflation has led to almost universal complacency.

Everyone continues to repeat the same mantra that the Federal Reserve will continue to support the economy through ultra-low interest rates well into the future. Yet beneath the surface, the economy is beginning to rumble, and such a benign view can catch the market off guard.

And as soon as June 6, the investor chatter may start to take on a very different tone.

That day will bring the all-important monthly employment report, which is likely to produce a gain of at least 200,000 net new jobs for the fourth month in a row. The four-week moving average of weekly unemployment claims has moved to its lowest level in seven years, underscoring the improving health of the job market.

Yet economists at Deutsche Bank think the forward view is more important. They looked at a series of recent economic data points and then took a fresh look at the current 6.3% national unemployment rate. Their conclusion: "Based on its current trajectory, the rate should fall significantly further over the next year and a half."

Quite suddenly, the U.S. economy is shaping up to a look a lot different than when Fed Chairman Janet Yellen took the reins in February. "We expect the labor market to reach its full capacity at least one year ahead of the Fed's schedule," added the Deutsche Bank economists.

These economists go one step further: "During this time, core inflation is expected to continue to trend higher, as we have found the change in labor slack to be highly predictive of turning points in inflation -- at least this has been the case for the last two decades."

Flickr/donkeyhoteyWith job growth on the rise, investors will be watching closely how the Federal Reserve treats interest rates in coming months.

Curiously most other economists still believe that the economy -- and inflation -- will stay on a more benign trajectory. Although it's widely understood that employment growth will likely lead to more robust wage growth, analysts at Citigroup speak for the consensus view when they note that "any wage cost increases will likely be absorbed by the elevated margins, rather than kindle inflation."

Citigroup's economists have laid out their 12-month view. "The unemployment rate should continue to decline, hitting 6% by the end of this year and dipping toward 5.5% by year-end 2015. "So wage pressures may begin to emerge sometime late this year or early next," they conclude. They also predict that unemployment will drop to just 5.2% in 2016.

As more economists take such a view, the Fed's easy money strategy will start to look risky. Esther George, who oversees the the Kansas City Fed, thinks rates should be boosted as soon as the quantitative easing (QE) taper ends in September. Other Fed governors think the central bank needs to start hiking rates at least by next spring, according to a recent Wall Street Journal article .

What does all this mean for investors? It means the investing playbook in place since early 2009 is no longer applicable. Remember that the two pillars of this bull market have been low interest rates, which have made stocks relatively more appealing than fixed income, and remarkably corporate strong profit margins. Both of these pillars are at risk.

First, interest rates can start to rise long before the Fed boosts its own rates. The 10-year Treasury note's rate, which is pegged off of economic sentiment and underpins many loan rates such as mortgages, will likely rise over the next six to 12 months. You should watch how the 10-year Treasury note responds to Friday's employment report to gauge the bond market's view of economic growth. If rates start to move higher in coming days and weeks, it could signal the start of a longer uptrend, which puts pressure on any yield-producing stocks.

Corporate profit margins are the other question mark. As the Citigroup economists note, "we don't see a pickup in wages as inflationary, because competitive firms probably would absorb the higher labor costs and accept lower profit margins." That means that corporate profit growth may barely budge over the next year or two, as a moderate rise in sales is offset by a drop in profit margins.

Yet there is a silver lining to these clouds. Any solid wage increases will have a direct and positive impact on consumer spending, which is why you need to stay focused on the out-of-favor retail sector. (I'll be focusing on these stocks in an upcoming column.)

Industrial stocks are also reasonably priced and poised for above-average profit growth if the economy is truly on a firming path. The day may be coming when companies start to deploy their robust cash flow away from buybacks and higher dividends and toward capital spending, which would be good news for a wide range of industrial segments.

Risks to Consider: The economy has made a few false starts over the past five years, so we'll need to see robust GDP growth figures for several quarters before concluding that higher wages and higher interest rates are coming.

Action to Take --> Your action plan is clear: It's time to scrutinize the U.S. economy, which could be on the cusp of a virtuous cycle whereby growth begets more growth. A rising number of economists think we'll end the year at a 3% GDP growth rate, which would set the stage for 3% growth in 2015 as well as a pickup in consumer and corporate spending. That would create an entirely different backdrop for stocks, with both positive and negative effects.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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