Economic Insights - September 2016
The End of the Beginning, U.S. Redux
For some months, our thesis has been that the U.S. economy was about to start the second phase of a business cycle, an economic expansion. After seven years of a long, slow, fragile, tortuous, and ultimately mediocre recovery, that beginning or the first phase of the cycle is ending. An expansion is characterized by a virtuous circle of rising wage growth, robust job gains, and good household spending, which generates corporate profits and brings capital spending. That is the virtuous circle that sustains an expansion. We described this process in detail at the end of August (Economic Insights).
In early September, though, some U.S. data turned weak. Regional and national business surveys were gloomy; light vehicle sales missed expectations, August job gains, retail sales, and industrial output were anemic, wage growth slowed a bit, and our thesis of a sustainable expansion appeared more hope than fact. Should investors give up on the expansion even before it gets going? No, we don’t think so, at least not yet.
Strong job gains:
Signs imply this is the best U.S. labor market in years. Initial claims for unemployment compensation have stayed super low, under 300,000 weekly, for well over a year. When viewed as a portion of total employment, jobless claims are at a huge all-time low. Layoffs are the lowest in decades, which augurs well for the expansion to materialize. In the latest consumer confidence report from the Conference Board, the percent of those thinking jobs were easy to get less those who believe jobs are hard to get was +6.3, the best reading since August 2007. The job market is broadening now as low and medium-wage jobs are being created faster than high wage jobs. The number of people who want a job and are available for work divided by the number of job openings is just over two, the lowest since 2001. Wage growth disappointed a bit in the last payroll report, but is up a smoothed 2.6% over the prior year, the best of the cycle.
Good for confidence:
The solid job market is boosting consumer confidence. The latest data from the Conference Board shows consumers are the most upbeat since August 2007. Confidence rose the most at the lower end of the income distribution; for households with income under $15,000, optimism is the highest in 15 years. More jobs, rising wages, and improving enthusiasm suggest consumer spending could stay strong and resilient.
The key to a sustainable expansion is capital spending, which has been moribund for months. It’s still a question mark, but the latest indications hint a turn for the better. Orders for nondefense capital goods ex aircraft, a good proxy for future capital spending, have risen for three consecutive months, the first time that’s happened since mid-2013. Core durable-goods orders are also up three months in a row. Further, the third estimate of second-quarter real gross domestic product revised business investment to up 1%, the first advance in three quarters. Business surveys for September are much improved. Renewed growth in capital spending needs a pickup in profits; we believe that’s coming as the drags from the surge in the dollar, the plunge in oil prices, and the inventory overhang fade away.
After the weak reports in early September, recent data says a sustainable economic expansion is very likely in its beginning stages. We expect U.S. growth in the second half of 2016 to be about 3%, with the potential for next year’s growth to be 2.5% or more. Some selected U.S. forecasts are in the table below.
The Upturn Is Global
The economic upturn is not just in the United States; it’s around the world. The key to revival is that deflation pressures are easing broadly. The economic troubles brought by the 20-month surge in the dollar and plunge in oil prices are fading since the trade-weighted dollar peaked and oil prices hit bottom in January. Real growth is still slow, but nominal growth is picking up as deflation fades and it is nominal growth that brings profits.
As in the United States, capital spending needs to recover to lead the expansion. Hints of that are in the latest data flow where industrial production and exports are accelerating in emerging Asia. Manufacturing output in Taiwan soared 4.4% in August over July, with a 4.7% jump in high-tech production. Exports from Hong Kong rose 2.3% in August over July. The good trade numbers are driven by China.
A China rebound:
The story is positive for China’s economy: stabilization, now a mild bounce. Once again the key is that deflation pressures are easing. Producer prices in China have fallen year-over-year for almost five years, putting companies, both private and state-owned, under terrific profit stress. It now appears that producer prices will turn positive over the prior year by this quarter. It’s already helping profits: industrial earnings jumped 19.5% year-over-year in August, up from 11.0% in July, and the fastest in three years. Business surveys, both official and private, are well up off their early-year lows for both services and manufacturing. Confidence is improving. Electricity use and rail freight are up over the prior year, the latter for the first time in almost three years. The driver of the modest revival has been fiscal spending, so this is no economic boom. But the economy has stabilized and, with deflation easing, is picking up.
Issues from the UK vote to exit the European Union may haunt the area in the longer term, but the economies are paying little heed at the moment. UK factories are doing very well with the collapse in the currency; the latest business survey jumped to the highest level since June 2014, long before the referendum. UK consumer and business confidence have improved and there was a strong gain in services output for July. Forecasts for growth yet this year and next are being raised across the board and former predictions of severe recession are fast being rewritten.
The key across the Eurozone is that growth has been driven by solid household spending. Consumers seem to be eager to spend some of their savings on gasoline and interest expense. The UK referendum hasn’t changed those fundamentals. Lending standards have eased and credit is more available; loan demand is rising from both businesses and households, albeit slowly, as interest rates have fallen. Eurozone business surveys have held steady since the UK vote, but the latest manufacturing reading is up nicely in September. Consumer confidence is rising in France, Germany, and Italy. Economic sentiment is better across the Eurozone; business optimism in Germany is the best since May 2014. We expect Eurozone growth to be around 1.5% with some upside potential.
Is Monetary Policy Still Effective?
Central banks have pursued extraordinarily easy monetary policy for years. Their tools: zero interest rates, negative interest rates, massive bond purchases, and more. Nearly 38% of the sovereign debt of so-called G10 countries has a zero or negative yield. Both the Federal Reserve (Fed) and the Bank of Japan (BOJ) have very large balance sheets of about $4 trillion, or about 24% and 94% of gross domestic product (GDP), respectively. Are these experiments working?
The evidence is mixed:
The United States has made gains: full employment is near, wage growth is picking up, household wealth has recovered, and confidence is returning. Yet, growth is still slow and inflation below target. In Japan, any success from their monetary experiments is hard to see. More broadly, many believe ultra-low rates are a source of stagnation rather than economic lift. Savings rates have risen sharply; cash holdings are high and growing; and ultra-low rates encourage high debt levels and keep unproductive companies in business, exacerbating excess capacity, deflation, and low investment return.
Part of the problem:
Expectations of central banks have been too high. The long economic surge in China and emerging markets of the 2000s and beyond created enormous excess capacity; so business has no appetite for expansion, keeping growth very slow. The long-term buildup in debt in developed countries constricts household demand, restrains fiscal policy, and further suppresses economic growth. Third, the financial crisis and subsequent pummeling from one global economic calamity after another have left consumers and businesses in no mood to expand, borrow, or spend. None of these problems are solvable by central bank action. The passage of time will help, but, economic reform would be the best therapy. So, yes, monetary policy is still effective, but it’s trying to solve problems that central banks aren’t set up to fix.
Central bankers meet:
The Fed took no action at its September meeting, except to signal that fed funds would likely go up in December. It should and we believe it will. Markets, though, see just a 50% chance of a December hike. Perhaps rightfully so: despite lots of guidance by Fed speakers toward rate hikes, the Yellen Fed has always found reasons to delay.
Some of those delays have been essential. In essence, the Fed is central bank to more than just the United States. China and many emerging countries have, to a large extent, aligned their currencies with the U.S. dollar. More Fed rate hikes, as the dollar was surging last year, would have negatively impacted their economies with feedback complications for the United States. That’s why the Fed turned cautious late last year and rightfully so.
With the U.S. dollar well off its highs and the U.S. economy bouncing back from the oil-dollar challenges of early this year, some on the FOMC (Federal Open Market Committee) are getting antsy for higher rates. Three regional bank presidents dissented from the rate hike decision at the last meeting. Their time is coming. Rates did move lower after the meeting and will likely stay range-bound until there is action from the Fed and the U.S. economic rebound that we expect becomes clear. Recent rate history is shown in the table below.
Japan, much ado about something:
As noted last week, the BOJ made two changes to policy at its September meeting. First, bond purchases will be used to peg the yield on 10-year government bonds at 0.0%, so the amount of monthly bond purchases will be flexible. Second, the BOJ committed to keep the current policy in place until well after inflation reaches the 2% target. Many investors sloughed this off as much ado about nothing. We disagree. Given that 2% inflation is a long way off, these changes mean the BOJ balance sheet will keep growing and stay very large for a very long time. This is essentially government spending financed by new money from the central bank with no cost, i.e., Milton Friedman’s helicopter money. It may take a while for markets to recognize it, but this is surely super-negative for the Japanese yen in the long term.
What about U.S. rates?
We look for mild upward pressure on treasury yields. Justifying the decision to delay a rate hike, Yellen framed the issue as below-target inflation. She implied the labor market needed more room to grow and inflation time to actually reach the target. As she said, “the fact that unemployment measures have been holding steady while the number of jobs has continued to grow shows that more people…have started actively seeking and finding employment.” We expect the case for a rate hike will have strengthened considerably later this year. We anticipate a 0.25% boost in fed funds this year and likely two more in 2017, if the economic expansion lasts. With inflation near target and wage gains picking up, we expect long-term yields to move up in sympathy; there is some chance the yield curve could strengthen a bit rather than the reverse. Our outlook for treasury yields is in the table below.
Asset Allocation: Fully Invested
As we suggested back at the end of May, this was not a good year for the old adage to “sell in May and go away.” September was a flat month but within a good quarter for most broad equity indices except REITs. The S&P 500 Index lost a tenth (‑0.1%) in price in September, but rose a nice 3.3% for the third quarter. Over the year-to-date, the S&P 500 Index is up 6.1%, but from the depths of the early-year plunge in February, it soared 18.5% and returned 20.2% with dividends.
Deflation strains eased during the quarter, commodity prices extended their rally, the cyclical upturn became more evident, and our favorite commodity indicator, the CRB index of raw industrials, picked up another 2.2% over the quarter. Easier financial conditions for emerging markets allowed the bounce to continue with the MSCI Emerging index up 8.3% for the quarter and 1.1% for the month, while MSCI Asia ex Japan rose 9.4% in the quarter. Brazil was the top country performer, up 13.3% for the quarter and 34.6% for the year-to-date. The mild lift in global growth spurred cyclical sectors, especially technology, the big gainer, which would be the beneficiary of any surge in capital spending.
Many see only risks:
The investment consensus stays quite bearish. In a Barron’s article two weeks ago, 10 investment strategists were interviewed and most forecast that the S&P 500 Index would be lower at yearend than it was during the dialogue. Last year, the problem was China risk as its stock market melted down and currency devalued. Early this year, the plunge in stock prices was to be caused by the wholesale default on high-yield debt by scores of oil and energy companies; the United States was also clearly in recession at the time. Many emerging market corporates were thought to be unable to ever repay their bonds. Next, it was the severe UK recession that would come after the referendum vote to leave the European Union with contagion throughout the Eurozone. Last week, it was that Deutsche Bank would create a Lehman moment. Now, the calamity is a Trump win in the U.S. presidential election or a Renzi defeat on his constitutional vote in Italy.
Recovery and reflation:
Certainly, one of those risks could have mushroomed into a real calamity. And a Trump presidency would surely have radical and unknown consequences, which should give one pause. Nevertheless, in the long run, financial markets are determined by the economic environment and overall, today, it’s getting better. As noted above, deflation stress is easing and nominal growth is picking up. This should help profits return after several quarters of losses. The mild upturn is becoming entrenched and seems to be mostly synchronized around the world. Commodity prices have reflated raising emerging-market prospects with them. The big drop in all interest rates after the UK referendum result has eased financial conditions worldwide and postponed whatever financial crisis was about to occur in the developing world.
With interest rates likely to stay low for some time and the Fed very cautious about tightening policy, we’d suggest a fully-invested portfolio in one’s choice of risk assets and to one’s risk tolerance. We still like equities and believe there is some time left in the rally that began in March 2009.