Unemployment sliding, but the Fed remains skeptical
The US unemployment rate (IWM) (QQQ) (VOO) is down to 4.9%. Yet the Fed remains skeptical about raising rates again. On February 10, 2016, Federal Reserve Board chair Janet Yellen said, “Financial conditions in the United States have recently become less supportive of growth.” Yellen also said, “These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market.”
Bill Gross on return and cost of capital for an economy
This point was also raised by Bill Gross in his interview with Bloomberg Radio, in which he weighed in on the US (SPXL) (VFINX) jobs report for January. According to Gross, every economy needs a certain level of nominal growth (real growth plus inflation). Gross believes nominal growth should be at least 4%. However, for the past few months, nominal growth in the United States has hovered around 2.9%. The Fed’s monetary policy has failed to do this over the last five years. The central bank seems to be focused on the cost of labor and wages rather than the cost of interest rates and the cost of stocks.
The math is simple. Growth rate is the return on capital invested in an economy. In the case of the United States, this return on capital is at 2.9%. This is far below the cost of capital, which, according to Bill Gross, stands at 4%–6%. For equity, with the PE (price-to-equity) ratio at about 16%, the cost of capital stands at about 6%. The S&P 500 index, which tracks the SPDR S&P 500 ETF (SPY), is currently trading at a PE of 17. For debt, this cost of capital would be somewhere around 4%–5%.
When the return on capital falls short of the cost of capital in an economy, growth does become a rare commodity.