Rate Cut Hopes Squashed by December Payroll Data

The U.S. added 256,000 jobs in December, according to Bureau of Labor Statistics nonfarm payrolls data, significantly more than expectations of 155,000 for the month. The unemployment rate was revised down to 4.1% from 4.2% the prior month.

The data all but eliminate the chance of a cut to the fed funds rate in the first half of the year. The CME Group’s FedWatch tool estimates a 97.3% chance the Federal Open Market Committee will keep rates unchanged at its January 29 meeting. Stocks fell following the report, and Treasury yields ticked up.

In the minutes of the FOMC’s December 17 and 18 meeting, Federal Reserve officials made multiple references to a weakening labor market, but the official December 2024 numbers show the labor market is not weakening.

“Participants pointed to various risks to economic activity and employment, including downside risks associated with weaker output growth abroad, increased financial vulnerabilities stemming from overvaluation of risky assets, or an unexpected weakening of the labor market, and upside risks associated with increased optimism and continued strength in domestic spending as upside factors,” according to the FOMC minutes.

For more stories like this, sign up for the CIO Alert newsletter. 

Next week’s Consumer Price Index data point will be important, as the CPI has steadily increased from 2.4% in September 2024 to 2.7% in November 2024. With rising job growth and rate cuts off the table, worries of increasing inflation could cause the Fed to consider policy rate hikes, some investors posted Thursday in reacting to the BLS data.

Investors React

Investment professionals reacted with a variety of opinions and thoughts on what to expect in the next several months.

Peter Graf, CIO of Nikko Asset Management warns that the firm cannot rule out a rate hike as the Fed’s next move. “Today’s unemployment report likely sounds the death knell for this easing cycle from the Fed,” Graf said. “The beat on the fickle payrolls number could later be revised away, but its strength is legitimized by household unemployment survey results that have at least plateaued, if not peaked. The maturity wall for corporate borrowing will start to seem much closer now that the balance of risks has tilted toward inflation, and we can’t rule out a hike as the Fed’s next move.”

“Data did not earn a January cut. The U.S. labor market ended 2024 on a firm footing with strong employment growth, falling unemployment and resilient wage pressures,” said Lindsay Rosner, head of multi sector fixed-income investing at Goldman Sachs Asset Management, in a statement. “The strength of today’s December jobs report puts to rest lingering chances of a 25 [basis-point] cut in January and shifts the focus to the March meeting, where further rate cuts will depend on progress on inflation.”

Jack McIntyre, a portfolio manager at Brandywine Global, said in a statement: “The outsized strength in the November employment report put a stake in the heart of more Fed rate cuts in the first half of 2025” and added that the Fed made a policy mistake by cutting rates by a total of 100 basis points last year. “The longer the Fed is on pause, the more likely the next move will be to start increasing policy rates. As important as the labor situation is, THE critical variable for the Fed and markets is all things inflation. Next week’s inflation data will be more important. Look for [the] Treasury market to shift to a bear-flattening from its recent bear-steepening trajectory. Higher oil prices won’t help the Treasury complex.”

Gina Bolvin, president of the Bolvin Wealth Management Group, advised in a statement reacting to the employment data, that “investors may want to brace themselves for more volatility as the market recalibrates expectations for fewer cuts. I’d be a buyer on a dip; we expect another good year of solid earnings growth. At some point, the market will embrace good news, but maybe not today.”

Jeffrey Roach, chief economist for LPL Financial, offered some perspective on the data in a statement: “Despite the blow-out report this morning, the 2024 average monthly gain in private payrolls of 149,000 was cooler than the 2023 average of 192,000. Investors should expect another step downward in 2025. In the meantime, the Fed will keep rates unchanged unless we see significant cooling in the job market.”

Chris Zaccarelli, the CIO of Northlight Asset Management, said in a statement: “Although the stock market doesn’t need lower rates in order to go higher, lower rates are a tailwind for equities and, more importantly, a Federal Reserve bank that is easing policy is always a better environment for equity investors than one where they are tightening policy (or leaving policy unchanged. At this point in the cycle, earnings will need to improve—and not just within the large tech companies—in order to have markets ‘grow into’ their already high valuations, so we would be cautious in the short term.”

MSCI Japan and TOPIX Indices, 10-Year Performance (2014-2024)

Corporate Fundamentals Outweigh Macro Developments

I believe the performance of Japan’s equity market offers solid evidence that corporate fundamentals are more important than broad domestic and international trends in generating investment returns. So, while Japan’s equity market is sensitive to macro developments and is experiencing a period of volatility, the strong fundamentals of Japanese equities helped to support the market in 2024—and I believe will do so in the future.

This positive outlook is based on the dynamic nature of Japan’s corporate sector, which has dramatically improved its productivity and has deployed more capital to drive increasing shareholder returns in recent years. I believe Japanese equities can maintain and even accelerate their momentum, provided that corporations are willing to become even more disciplined about capital efficiency—deploying their massive cash hoards to drive further increases in shareholder value.

Better Capital Allocation Can Drive Higher Valuations

While many Japanese stocks historically suffered from low price-to-book value multiples, this situation began to improve as a result of governance reforms mandated by the Tokyo Stock Exchange. In 2021, the exchange required all listed companies to enact policies to improve profitability and long-term returns in order to correct chronic undervaluation. Specifically, companies trading below book value were required to adopt strategies to achieve an above-book valuation and to disclose their capital allocation policies to make that happen.

This initiative has already raised valuations for a number of very low price-to-book stocks. Most Japanese companies that previously traded below book value have disclosed strategies to become better capital allocators, usually by adopting share buyback programs or raising dividends. That said, the aggregate price-to-earnings ratio represented by the MSCI Japan Index stood at about 15.1x as of early December 2024 and remains slightly lower than the 10-year average. Thus, I believe there is still plenty of room for further valuation improvement.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

Japan’s corporate sector has the ability to drive further value creation through better capital allocation. Many Japanese corporations simply hold too much cash on their balance sheets. Companies that are naturally asset light and cash flow generative often “punch below their weight” when it comes to producing a return on equity. As a result, they must be content to generate a return-on-equity in the mid-teens. By deploying capital more productively and reducing cash levels in the process, I believe many companies could deliver ROE upwards of 30%—and would thus merit a corresponding increase in stock valuation.

Corporate Earnings Benefit From Productivity Growth

Japanese companies have been able to accumulate large cash positions because they are masters at increasing productivity. Even though Japan’s economy remains slow-growing—with the IMF projecting a growth rate of just 0.3% in 2025—corporations have become proficient at managing those factors that are under their control, especially in terms of cost savings and investments in greater operating efficiency, albeit from a low starting base.

One key contributor to the strong performance of Japan’s corporations is the fact that they are not heavily dependent on the domestic economy to fuel their growth engines. Approximately half of the aggregate revenues of the largest Japanese companies is generated outside of Japan. Additionally, even in a stagnant domestic market, Japan is still the third-largest economy in the world, providing ample opportunity for emerging growth companies to take market share from the incumbents.

As a result of productivity enhancements and exposure to faster-growing markets, “Japan Inc.” has enjoyed healthy earnings growth, which has translated into a robust return on equity asset class even without expansion of P/E multiples. Over the 10-year period that ended November 27, 2024, the MSCI Japan Index returned 160.65% excluding dividends, of which the majority has come from earnings.

Excess Capital for Buybacks and Dividends

Thanks to years of productivity improvements and conservative (some might say miserly) cash management practices, the balance sheets of Japanese companies are awash in cash. While some companies have tapped these cash hoards to fund share repurchases and strong dividend growth, the levels of both buybacks and dividend payouts at present still lag behind their U.S. and European peers.

To help persuade global investors that Japanese corporations are deeply committed to increasing shareholder value, the companies, especially those with good fundamentals and robust cash flow generation capability, will need to show the will to go beyond their fundamentals and have a more dynamic capital allocation strategy.

Investors also need to understand that, despite the recent market volatility, Japan’s corporate profit fundamentals remain resilient and companies still have considerable room to increase shareholder returns independent of the macro economy or interest rate cycle. Earnings growth is in the high single digits, while dividends and buybacks are growing by double digits year-over-year. Yet the market’s valuation is currently at or slightly below historical highs, as noted earlier, which we see as a positive sign for investors.

It is likely that many longtime observers of the Japanese economy are still put off by the memory of the post-1990s “lost decades” or simply find it easier to invest in companies that have results buoyed by faster-growing economies like that of the U.S. However, I believe Japan’s corporations are well- positioned to overcome these obstacles—if they continue to unleash the power of their capital to drive shareholder returns.

Shuntaro Takeuchi is a portfolio manager at Matthews Asia.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.

Tags: Japan, Japanese Equities