Economic Insights - November 2017
- The “Energizer Bunny” expansion: The robust global expansion just keeps going and going and going. The global economy is near peak capacity, but the upturn should last into early 2019.
- Normal monetary policy… ever? Central banks are starting or will soon start to return monetary policy to some semblance of normal. Price pressures are rising and long-term yields will too at some point.
- Asset allocation – November tremors: The melt-up, then melt-down, of high-flying U.S. tech stocks may be one sign of markets adjusting to the eventuality of higher long-term interest rates. There are other signs, and caution is likely warranted.
The “Energizer Bunny” expansion
The commercial icon for Energizer batteries is a pink bunny with enough energy to endlessly beat on its drum. That’s a great symbol for the robust synchronized global economic expansion that just keeps going and going and going. The uptrend began in early 2016 as a recovery from a near recession after commodity prices, especially oil, collapsed and the U.S. dollar soared when central banks in the Eurozone and Japan began their aggressive easing. But, the dollar peaked in January 2016, oil prices bottomed in February, and the upturn began in March.
The consensus was still bearish through summer 2016, especially after the UK vote to exit the European Union. By early fall, it was clear an expansion was underway and the upturn became consensus by last spring. Profits surged in the United States and companies began to boost capital spending. Strong earnings gains and good investment generated excellent job growth and created a positive feedback loop, creating a sustainable expansion. The global economy is surely now operating close to peak capacity, so the question may be how long can the Economic Energizer Expansion continue to beat the drum?
The economy is on fire. Third-quarter growth was revised up to 2.5% with a big 3.3% gain in Germany and Spain. Consumer confidence struck new 17-year highs. German business confidence hit another record. Purchasing manager surveys are surging; the composite index reached 57.5, the best of the cycle, consistent with growth over 3%. Car sales and loan growth are rising. The jobless rate fell in October to 8.8%, the best since January 2009, and hiring intentions stay at high levels. Job gains are widespread; the jobless rate in Spain plunged from a peak of 26.3% to 16.7%; the rate in Greece is off seven percentage points from the top. Capital spending is robust; consumer spending has been a laggard but is turning higher, especially in Germany. We expect growth in the Eurozone to be 2% to 2.5% in 2018 with plenty of upside risk.
The U.S. two threes:
No, it’s not a poker hand; it’s two straight quarters of growth above 3%. The latest estimate of third-quarter U.S. gross domestic product (GDP) upgraded growth to 3.3%. The big driver was business investment, up 4.7% over the prior quarter. Consumer spending was a solid 2.3%, helped by robust spending on durable goods.
Real residential investment fell in both the last two quarters from weakness in multifamily construction and Hurricane Harvey. With single-family housing activity, starts and sales, clearly trending higher, that weakness should disappear this quarter. Robust capital spending has driven growth for several quarters and there should be no letup in strength; third-quarter U.S. business profits were up 4.3% over the prior quarter annualized, and 5.4% over the prior year. It was helped by domestic company profits, up 4.3%, led by financials. Profit margins may have fallen, but they’re in solid territory. Total U.S. profits are only 0.8% below their late-2014 peak.
Household spending should pick up. Consumer confidence is near the highest in history. Job growth is spectacular since workers are coming back to the workforce, replacing Baby Boomers who retire. Wage growth is accelerating: average hourly earnings are up 3.1% annualized, three months over three months, near the highest since before the financial crisis. Median weekly earnings from the Census Bureau are up 4.2% over the prior year in the third quarter. With good investment and solid consumer spending, that string of 3% gains should continue two or maybe three more quarters. Passage of tax reform would mean upside risk.
Land of the Rising Sun:
It’s still shining. Japanese corporate profits reached new record heights each of the last several quarters along with profit margins. The economy is driven by capital spending and exports. Nominal growth hit new records too, a real success for a country enmeshed in deflation for two decades. The output gap has closed and the country is operating at full capacity. The jobless rate is an incredibly low 2.8% with 1.55 job openings for every applicant; it’s no wonder senior citizens are being drawn back into the work force in large numbers. We expect growth in Japan next year to be in the 1% to 1.5% range; yes, that sounds slow, but Japan’s population is declining, a huge drag on growth.
No hard landing:
For all the fear about high debt levels in China, no major slowdown is likely for the next couple of years; mild deceleration, yes, but no hard landing. Officials have near-term goals to reduce air pollution and rein in excessive debt growth. The net effect will weaken economic growth, which at 6.7% is already nearly the slowest in modern history. And as the labor force will likely peak by 2020, growth will decelerate more over the next five years. Industrial activity picked up meaningfully the last year and profits have been surging. The pace of property price gains has shriveled with small losses in a few cities. Investment has fallen from its other-worldly velocity of the 2000s, but is still solid and picking up nicely in the private sector. Purchasing manager surveys have been flat at a low level of expansion for months. We estimate growth in the low 6% range in 2018, with some risk of the upper 5% range into 2019.
The expansion is broad-based around the world. Job growth in Australia is quite strong with the unemployment rate now at a four-and-a-half-year-low. In Canada, employment growth is spectacular with 115,000 new jobs in the last two months; adjusting for population, that’s like 1.15 million in the United States. India GDP advanced 6.3% over the prior year in the third quarter, up from 5.7% in the second, with little contribution from agriculture and government spending. India’s economic reforms have been rewarded with a bond upgrade by Moody’s, the first in 14 years. Further, India moved up 30 spots to 100th on the World Bank’s “Doing Business” rankings. Other developing countries are benefitting from almost 4% global growth.
Can it last?
The acceleration of the last year surely won’t, so 2018 will likely be a year of deceleration. China is clearly past peak momentum, likely Japan too. The United States will benefit from tax reform and the Eurozone may still pick up a bit. The output index of JP Morgan’s global index of manufacturing purchasing managers rose to its highest is almost seven years in November, so no immediate cooling. The U.S. business cycle has expanded the longest, but unless long-term interest rates spike, growth will continue into 2019.
Normal monetary policy…ever?
At some point, yes, but not soon. The minutes of the recent Federal Reserve (Fed) meeting contained the usual discussion about whether low inflation was transitory or permanent. Naturally, the group wanted firm evidence inflation was heading towards 2%. That came this week as the core personal consumption deflator (excluding food and energy, the Fed’s favorite target) rose from 1.3% over the prior year to 1.45%. And with economic growth and capital spending still surging, the expected hike at the December meeting is surely a go. We expect further hikes in March and perhaps July, unless forestalled by a stock market correction.
The European Central Bank (ECB) and the Bank of Japan (BOJ) may curb their accommodation. The ECB plans to cut its bond purchases in half next January and end the buying in September, assuming there’s sufficient inflation progress. President Draghi made clear that interest rate hikes would wait until well after bond purchases end. Given surging Eurozone growth, the ECB would be advised to curtail its bond purchases sooner.
BOJ Governor Kuroda has been speaking about when easy monetary policy would do more harm than good, suggesting the BOJ may want to raise its yield peg on 10-year government bonds from 0%. Clearly, a steeper yield curve (difference between long and short rates) is better for banks than the current nearly flat curve. Core inflation in Japan ticked up to 0.8% in October, so there is progress against deflation. The BOJ could target five-year maturity yields at 0% and let longer dated bond yields rise a bit, taking some pressure off banks. We expect more progress on inflation and an earlier than expected change in policy given Japan’s robust economic growth. Recent U.S. rate history is in Exhibit I.
Inflation pressures growing:
Recall that inflation is a very lagging indication and much of the price weakness since March was likely a leftover impact of plunging commodity prices and a surging U.S. dollar 18 months ago. Now, signs point to a resurgence of price pressures around the world. In Japan, the producer price index jumped 3.4% over the prior year in October, one of the largest gains on record. U.S. import prices are rising the fastest since 2011; core producer prices also increased the most since 2012. The New York Fed’s gauge of underlying inflation trends is up 3.0% at last count.
We expect these price pressures to continue as the global expansion persists through 2018. There are no inventory excesses or surging interest rates to derail it, so robust growth should continue into 2019 bringing more job gains and higher wages. Some commodity prices are surging; oil, nickel, and zinc are up 30% to 35% over six months. Copper leapt 23% since May, while lumber gained more than a third in a year. The Baltic Dry Freight Index is up more than double since February. Prices of new and existing U.S. homes are moving up along with rents and the cost of living in one’s own home. We expect the core U.S. consumer price index to hit 2% early next year.
These pressures and growing probability of tax reform should keep U.S. growth strong. So, short-term U.S. yields will move higher as the Fed hikes rates. U.S. long-term rates should strengthen some yet this year and mover higher in 2018 as cyclical and fiscal forces build. Bond markets, though, are global and super-low rates in Europe and Japan remain a drag on U.S. Treasury yields. The fear of, and growing likelihood, of a stock market correction next year will keep U.S. yields from spiking higher. Our interest rate forecasts are shown in Exhibit II.
Asset allocation — November tremors
For frothy tech stocks like Apple, Amazon, Google, and Facebook, it was a melt-up from late October, then a melt-down the last of November. Whether it’s profit-taking after an incredible run from 2016, worries about super-high valuations and inevitable correction, or sudden fears that inflation and interest rates won’t stay “lower for longer,” we’d guess the move down is significant.
There were other tremors in late November. After years of overall underperformance, the Dow Jones Transports streaked higher versus the Dow Industrials this week. And after similar years of lousy returns from value stocks relative to growth companies, value stocks’ performance spiked. Further, returns to emerging country stocks tanked compared to developed countries, especially from November 22nd. Last, corporate bond yields, both high yield and investment grade, retreated in early November from the narrowest spreads to U.S. Treasury bonds since 2014.
Widows and orphans:
And check out the stocks passing for bond surrogates: those sectors with solid-earning, safe, constant-dividend-paying, trusty stocks usually held in trust funds for widows and orphans. They are declining, flat, or underperforming: U.S. consumer staples stocks underperformed since April; while up nicely for the month, U.S. telecom services is off 10% year-to-date; U.S. energy infrastructure Master Limited Partnerships have been falling since February; even the health care sector has underperformed the S&P 500 Index since September. What’s going on?
Some of last week’s gyrations could be explained by the suddenly greater probability of tax reform passing the U.S. Congress. That would help value stocks over growth; it might boost transportation company earnings significantly as the economy heats up. But, there’s likely more to it.
Lower for longer?
A fundamental market mover is the future of interest rates and inflation and whether the consensus view of “lower for longer” for both will come true. It might not. We see four reasons for the widespread consensus of “lower for longer:” Super-easy monetary policy by the world’s central banks, the “recency bias” where investors overestimate the probability that recent events persist, and the deflationary impacts of both globalization and technology. Let’s examine the case.
Yields on long-term U.S. Treasury bonds are clearly being held down by the Fed’s huge bond portfolio, as well as ongoing bond purchases by the ECB and BOJ. But, all three banks are or will be reducing their monetary easing. Second, yes, interest rates have been low and inflation has mostly been below the Fed’s target for a decade; deflation has been the worry. However, low inflation and rates were the result of a decade of fear and crisis from the summer of 2007 and the extraordinary monetary policies it spawned; that near decade ended in early 2016. Why should we expect low rates and inflation to continue after that decade is over?
Bringing hundreds of millions of low-wage, underemployed workers into the world’s labor force through globalization has been a restraint on inflation for nearly three decades. But, once those workers get integrated into the world economy, their impact fades. Wages have risen at low double-digit rates in China for over 15 years; China is less competitive than in the 1990s. Chinese manufacturers are building plants in the United States because of lower costs. Where will there be another billion workers to add to the international marketplace to perpetuate the cost pressures of low wage workers? Not in Vietnam and not likely Africa unless many dictators are deposed. No cycle lasts forever and the cost benefits of globalization are waning.
Gains in technology have also kept cost pressures under wraps, Those gains have been true for over 200 years of industrialization and will continue to contribute to higher standards of living at lower costs. Yet over those 200 years, both inflation and deflation have raged at various times. So, while technology will always have a deflationary effect, the upward price pressures of a world economy with diminishing spare capacity and rapidly falling unemployment will likely overwhelm those benefits at least temporarily. There’s nothing new on the technology horizon to offset that cyclical pressure in the near-term.
So, it’s possible that the tremors noted above are markets beginning to realize that interest rates and inflation will come under upward pressure at some point. Prices of long-term bonds seem to have been mostly ignoring the cyclical strength in the world economy and the intent of central banks to normalize policy. Long-term U.S. yields have already risen some and we’d suggest there’s more upward pressure to come.
What to do?
Higher long-term interest rates will be a drag on stock markets where valuations have surged from years of super-low interest rates and extraordinary monetary easing. U.S. stocks are soaring from ebullience over the rising likelihood of tax reform and pulling other markets along for the ride. If long-term yields stay quiescent, stocks may continue to rally with robust earnings. Still, we expect the probability of higher rates creating a stock market correction is relatively high. Caution is warranted. Two-year U.S. Treasury bonds surely have value if yields hit 2%. Medium duration corporate bonds might be a good port in a short-term storm. Tax reform could boost the financial sector and value stocks.