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MV Weekly Market Flash: Crunch Time for “Secular Stagnation”

March 10, 2017

By Masood Vojdani & Katrina Lamb, CFA

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One of the great debates among the economic literati in recent years has been whether the subpar growth trends of late are cyclical or more long term in nature. The bearish long term view goes by the name “secular stagnation,” with advocates including former Treasury secretary Lawrence Summers making the case for a world stuck in a rut of anemic capital investment and lackluster demand. Two years ago, secular stagnation seemed like a pretty good theory to explain the deflation trap threatening to ensnare the Eurozone, zero-bound interest rates in the US, and many former growth darlings in emerging markets falling into low single digit or negative growth.

Macro headlines today tell a rather different story. In the US jobs, wages, prices and consumer confidence are all trending uniformly higher, as indicated in the chart below.

Meanwhile, Eurozone inflation has bounced back and even Japan is enjoying a relatively unusual run of positive growth. Most Asian economies are performing decently, if not necessarily spectacularly, while erstwhile basket cases Brazil and Russia seem to have gotten through the worst of their travails. Is it time to put a fork in the secular stagnation theory and call it done? Asset markets certainly seem to think so; today’s valuation levels can only appear reasonable if premised on the imminent resumption of historical-trend growth. But before we read last rites and sing Psalm 23 over the corpse of secular stagnation, we need to supply an answer to the question of what forces are present to drive that historical-trend growth.

1938 Calling

The term “secular stagnation” is not new; it was coined in 1938 by prominent US economist Alvin Hansen. If you are familiar with US economic history you will recall that 1938 was the trough year of the second sharp pullback of the Great Depression: not as deep as the earlier one that bottomed out in 1932 but still painful, with unemployment at 20 percent and a steep decline in US population growth. Hansen looked around him and saw no way out; the world was locked into that dreaded feedback loop where businesses invest less because they expect continued lower demand, and households spend less because there are fewer jobs. Secular stagnation, in other words.

As we know now, of course, the world didn’t turn out that way at all. Instead, the onset of the Second World War unleashed a torrent of economic growth to supply the war effort, and after the war the US, as the sole economic superpower, ushered in a glorious thirty year period of steady and sustainable growth. The secular stagnation theory was laid to rest, until its resurrection by Larry Summers et al in the 2010s.

Attractive Economy Seeks Feisty Catalyst for Growth, Good Times

The headline economic data shown in the chart above are promising, but they are not yet sufficient to return secular stagnation to the box where it rested from 1939 to 2010. While the circumstances that produced the magnificent growth from the late 1940s to the early 1970s are complex and varied, the growth drivers themselves are easy to pinpoint. First, a return to population growth after the anomalous decline of the Depression years. Second, growth in labor force participation as returning war veterans went into a booming job market (and were later joined by a rising level of participation by women). Finally – and most importantly – was growth in productivity, or efficiency gains in how much output businesses could produce for each hour worked.

Are we on the cusp of another productivity boom? The data do not yet point to one. The chart below shows US productivity trends, along with the labor force participation rate, for the last thirty years. Both of these growth indicators remain decisively below-trend.

Some argue that the innovations of recent years will be that much-sought catalyst desired by the global economy. Expansive pundits talk of the Holy Trinity of the Three Industrial Revolutions: the steam engine of the late 18th century, electricity and the internal combustion engine a century later, and the smartphone in the early 21st century. Perhaps history does move in such well-tempered cycles; alternatively, perhaps the culture of growth that grew up around the first two Industrial Revolutions will be seen by future historians as a delightful anomaly rather than an inevitable forward march of progress. Time will tell whether this third iteration can deliver the goods.

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MV Weekly Market Flash: GDP Matters, Productivity Matters More

January 27, 2017

By Masood Vojdani & Katrina Lamb, CFA

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It would appear that a lesson in US civics might be in order for Mr. Market. Investors breathlessly followed the staccato blast of tweets and executive orders emanating from Week One at the White House, rekindling the reflation-infrastructure trade that had seemed, tentatively, to be starting to take off the rose-tinted glasses. An executive order does not an actual implemented policy make, and the vaunted sausage-making process of legislative accomplishment continues to be at odds with the market’s bobby-sox crush on all things Trump administration.

Meanwhile in the world of actual data, this morning we got a preliminary reading on Q4 real GDP growth. The headline number came in a bit below consensus: the quarter-on-quarter increase of 1.9 percent was about 30 basis points below expectations. That translates to an annual average growth rate of 1.6 percent, making 2016 the lowest-growth year since 2011. How do the latest data affect expectations for next year and beyond? We look at both the near-term implications and what we see as the longer-term growth headwinds fiscal stimulus will not likely solve.

Buy Now, Pay Later

The overall consensus of economist views on the US economy in the coming 1-2 years has ticked up measurably since the election. Not to the levels of four percent real growth promised on the White House website (or the credulous investor herds who appear to agree), but increasingly closer to three percent than two. Much of the incremental growth, according to the new consensus, would start to show up in the latter half of 2017 and more fully in 2018. It would be premised on the realization of at least some form of the fiscal stimulus measures being tossed around, most directly corporate tax reform and new infrastructure spending. Most economists, when asked, stress that the nature of uncertainty around any of these measures or their timing adds a level of uncertainty to their outlook. And many are careful to add that successful implementation of these policies in the short run could have deleterious knock-on effects, as higher trade and budget deficits accompanied by higher than expected inflation could likely push up interest rates and the US dollar, making exports less competitive and thus detracting from growth. There are indeed many moving parts to the growth equation, which is why we habitually argue for caution against reading too much optimism – or pessimism for that matter – into likely scenarios for any given set of policies.

All that Matters

Ultimately, though, what long-term investors should care about, more than whether fiscal stimulus measure X gets implemented and causes interest rates to do Y and the dollar to do Z, is whether economic productivity will ever get back on track. GDP growth is important, but ultimately the growth comes from only three sources: population growth, an increase in the percentage of the population in the labor force, or productivity (the ability to produce more goods and services for each hour of effort and cost). Forget about the first two. Population growth is anemic: 1.2 percent per year for the world and just 0.8 percent per year for the US. Meanwhile the labor force participation rate, which reached a peak of about 68 percent at the beginning of the 21st century, has slumped to less than 63 percent for a variety of structural and cyclical reasons (more retirees, lingering effects of the recession etc.).

That leaves productivity. Unfortunately, there’s not much good news here either. Average output per hour, the standard measure of productivity, was lower for the last ten years than it has been for any ten year period since 1950. The current calendar decade thus far has been even worse: the 0.72 percent average annual growth rate for the period since 2010 is only one quarter of the rate for the 1960s, the most productive decade to date.

Opinions vary on why this is so, from the “best growth is behind us” view of the likes of Robert Gordon (author of “The Rise and Fall of American Growth”) to techno-optimists like Thomas Friedman of the New York Times who imagine that the true value-creating capabilities of more recent innovations have yet to bake themselves into macroeconomic statistics (Friedman ascribes 2007 – the year the iPhone was introduced – as a pivotal year in world history sine qua non).  A separate but likewise relevant question is whether a new bout of technology-inspired productivity, particularly if it were to come from the gains in robotics brought about by deep-learning methods of artificial intelligence, might be severely counterproductive in its effect on the labor market. Again – lots of moving parts to consider in the complex adaptive system that is our economy.

Now, a genuine burst of real productivity (of the non-job killing ilk) could potentially smooth out the rough edges of the fiscal overheating that would be the likely outcome of the kind of programs this administration appears to want to implement. That is, of course, if the protectionist dark side of these programs were, at the same time, to not materialize. All those things combined could be a recipe for sustainable growth. But we will need to see far more evidence that any of them are likely to transpire before we think about joining the growth bandwagon.

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MV Weekly Market Flash: The Valuation Ceiling’s Moment of Truth

January 6, 2017

By Masood Vojdani & Katrina Lamb, CFA

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It’s a new calendar year, but markets continue to party like it’s late-2016. Remember Murphy’s Law? “If something can go wrong, it will” goes the old nostrum. U.S. equity markets, in the pale early dawn of 2017, exhibit what we could call the inverse of Murphy’s Law. “If something can go right, it will!” goes the happy talk.

Happy Talk Meets Sales & Profits

We’re about to get an indicative taste of how far these rose-tinted glasses will take us through the next twelve months. Earnings season is upon us. Analysts expect that earnings per share for last year’s fourth quarter will have grown by 2.81 percent from a year earlier, according to FactSet, a market research company. Stock prices grew by a bit more than that – 3.2 percent – over the same period, so valuation measures like price to earnings (P/E) and price to sales (P/S) edged up further still. In fact, the price to sales ratio is higher than it has ever been since the end of 2000, and within striking distance of the nosebleed all-time high reached at the peak of that bubble in March 2000. The chart below illustrates this trend. 


Price to sales is a useful metric because it shines the spotlight on how much revenue a company generates – from sales of its goods and services – relative to the price of the company’s stock. We inhabit a world where global demand has been persistently below-trend for most of the time since the 2007-08 recession. Weaker demand from world consumer markets, along with the added headwind of a strong dollar, has impeded U.S. companies’ ability to grow their sales from year to year, and that in turn helps explain why stock prices have run so far ahead of revenue growth.

Knock Three Times on the Ceiling

While price to sales is important, investors generally tend to place more emphasis on the bottom line – earnings – than on the revenue metric. Some investors focus on past results, such as last twelve months, or full-cycle measurements like Robert Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio. Others believe that forward-looking measures are more useful and pay closer attention to analysts’ consensus estimates for the next twelve months. By any of these measures the market is expensive. The Shiller CAPE ratio, for example, currently stands at 28.3 times. That’s higher than it has been any but two times in the last 137 years (yes, one hundred and thirty seven, that is not a typo). The CAPE ratio was higher in September 1929, before the Great Crash, and again in March 2000 before that year’s market implosion.

While CAPE is a useful reality check on the market, neither it nor any other metric is necessarily a useful timing tool. There is no reason to believe that the so-called “Trump trade,” based largely on Red Bull-fused animal spirits, will end on a specific date (all the silly chatter of the “sell the inauguration trade” aside). What particularly interests us as earnings season gets underway is whether – and this would be contrary to the trend of the last several years – the earnings expectations voiced by that consensus outlook actually squares with reality. Consider the chart below. 


There’s a lot on this chart, so let’s unpack it piece by piece. Let’s start with the horizontal lines depicting two “valuation ceilings” which, over the past two years, have served as resistance levels against upward breakouts. The first such ceiling is defined by the S&P 500’s high water mark reached in May 2015. The index challenged that high several times over the next 14 months but consistently failed to breach it. Then Brexit happened. The post-Brexit relief rally in July 2016 powered the index to a succession of new highs before topping out in August. It then again traded in mostly sideways pattern through early fall up to Election Day. Of course, we know what happened next.

Hope Springs Eternal

Now we come to the second key part of the above chart, and the one to which we are most closely paying attention as we study the forward earnings landscape. The thick green and red dotted lines show, respectively, the last twelve months (LTM) and next twelve months (NTM) earnings per share for the S&P 500. In other words, this chart is simply breaking the P/E ratio into its component parts of price and earnings, using both the LTM and NTM figures.

So how do we interpret these LTM and NTM lines? Take any given day – just for fun, let’s say December 10, 2015. On that day, the NTM earnings per share figure was $125.79. If we could travel back in time to 12/10/15 and talk to those “consensus experts,” they would tell us that they expected S&P 500 EPS to be $125.79 one year hence, on December 10, 2016. But now look at the green line, showing the last twelve months EPS. What were the actual S&P 500 earnings in December ’16, twelve months after that $125.79 prediction? $108.86 is the right answer, quite a bit lower than the consensus brain trust had expected!

Why is this Kabuki theater of mind games between company C-suites, securities analysts and investors important? Look at the NTM EPS trend line, which has gone up steadily for the last year even as real earnings have failed to kick into growth mode. Right now, those gimlet-eyed experts are figuring on double-digit earnings growth for 2017. Double digit earnings growth would offer at least some justification for those decade-plus high valuation levels we described above. Is there a chance that reality will fall short of that rosy outlook? That is the question that should be on the mind of any investor at all concerned about the fundamentals of value and price.

Global demand patterns have yet to show any kind of a significant pick-up from recent years, though the overall economic picture continues to improve at least moderately. And the headwinds from a strong U.S. dollar do not appear to be set to abate any time soon. As we said above – and have said numerous times elsewhere – none of this means that the market is poised for a near-term reversal. Animal spirits can blithely chug along as long as there is more cash sitting on the sidelines ready to jump back in, or a sense that there is still a “Greater Fool” out there, yet, to come in and buy.

But pay attention to valuation, and specifically to whether double-digit earnings truly are just around the corner or yet another case of hope flailing against reality.

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MV Weekly Market Flash: Apocalypse Where? The Case for (Guarded) Optimism

November 4, 2016

By Masood Vojdani & Katrina Lamb, CFA

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The most contentious U.S. presidential election in modern history is approaching its dramatic conclusion, and the media discourse is saturated with breathless prognostications of doom and gloom. Even the stock market has gotten in on the act, with the S&P 500 retreating eight days in a row and flirting with a 5 percent pullback from the record high of 2190 set way back in the middle of August. Trumpkins and Clintonistas alike (not to mention “Pox on Both Houses” malcontents) see a Dark Ages v2.0 on tap if their candidate fails to snag 270 Electoral College votes next Tuesday. Strange times, these.

The Devil’s in the Data

And then there are the data. Actual numbers, lovingly compiled by earnest toilers at the Bureau of Labor Statistics and the Bureau of Economic Analysis and various other Bureaux in our fair land, reflecting how the economy is doing through the prism of job creation, price trends, consumer habits and much else. These numbers have painted a fairly consistent picture for the past couple years: moderate but below-trend growth, a weak recovery in wages and prices, stable spending patterns and improving consumer confidence. One important trend that appears to be solidifying is that of real wage growth.

Below today’s headline jobs number of 161,000 new payroll gains (which itself is notable in extending the post-Second World War record number of  consecutive monthly jobs gains) is the 2.8 percent year-on-year growth in average hourly wages. This is not an outlier; wage growth in recent months has consistently outpaced inflation, whether measured by headline or core (ex food & energy) CPI or by the Fed’s preferred Personal Consumption Expenditures (currently 1.7 percent).

Real wage growth indicates that, after all those months of falling unemployment and new payroll gains, the labor market is tightening along the lines of historical norms. Those gains should help push consumer prices further towards the 2 percent target rate as a higher chunk of household earnings finds its way into spending on staple and discretionary goods and services. That, in turn, should be good news for GDP, about 70 percent of which derives from consumer spending. This is the virtuous circle that has driven past periods of economic growth.

One Cheer for Productivity

Sustained economic growth, as we never tire of pointing out, derives from growth in the overall population, or from an increase in the percentage of the population at work, or from improved productivity per average hour worked. That third option is critical, and economists have been puzzled by the chronic recent failure of the economy to achieve meaningful gains in productivity. In fact, productivity as measured by the BLS had decreased for three consecutive quarters leading up to the release this past Thursday (given the importance of this metric to overall growth, why is there no celebrated Productivity Thursday, along the lines of the popular Jobs Friday nerdfest?).

In any case, Q3 productivity surprised to the upside, growing 3.1 percent against expectations of 1.7 percent. That’s good! But of course it is only one quarter, so too early to break out the Veuve Cliquot. The other good thing about productivity, though, is that productivity gains help businesses leverage their operational expenses, including labor expenses. Improving productivity, all else being equal, should enable businesses to accommodate wage increases (see above) while maintaining or even improving profit margins.

Connecting the Dots from Macro to Earnings

Maintaining those profit margins will be extremely important for businesses as they try to work themselves out of the recent funk in corporate earnings. Average earnings had fallen for five consecutive quarters heading into the current (3Q16) earnings season. With about 85 percent of S&P 500 companies reporting, it appears the negative streak will come to an end: expectations now are for 2.6 percent EPS growth, as opposed to the minus 2.6 percent expected at the beginning of the quarter. That’s all well and good, but investors are keen to see a return to the double-digit earnings growth environment of years past. Productivity gains will need to continue to offset the effects of a tighter labor market.

Meanwhile, the headwind effect of the U.S. dollar should be expected to continue if, as likely, the Fed goes ahead with a resumption of its rate hike program come December. And while the virtuous cycle of stronger demand may take root here at home, there are still too many pockets of weakness and uncertainty in other geographic markets where large U.S. companies manufacture and sell. In short: an improved U.S. economy won’t be of much help to domestic share prices unless the dots between macro and earnings can be connected.

The Human Effect

Our optimism will thus remain guarded until we see more evidence of an improved economy having a measurable impact on business performance. Which brings us back to the topic that opened this commentary – the upcoming election. Is there any substance to those abundant prophesies of the imminent apocalypse? Or, in other words, how much actual damage could politicians create to choke off any nascent improvement in our little economic garden?

We must, of course, be cognizant of the profound dissatisfaction registered by many voices – not just here at home but around the world – against political structures and other perceived elite institutions. The dissatisfaction certainly influences the policy discourse and shapes how political leaders present themselves and their policy intentions. But we remain of the view that, regardless of what configuration of Democrats and Republicans win their races next Tuesday, the more extreme elements of their platforms will have a very hard time finding their way into actual law.

History has shown that ill-conceived human intervention can have a real, long-term negative impact on a society’s standard of living. History also shows, though, that revolutions don’t happen far more often than they do happen. We may live in strange times, but we do not see them as strange to the extent of Petrograd 1917 or Paris 1789. Until we have reason to think otherwise, we remain guardedly optimistic.

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MV Weekly Market Flash: Quarterly Diversions and the Long Term Growth Mystery

October 28, 2016

By Masood Vojdani & Katrina Lamb, CFA

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It has been called the window into the soul of the modern economy; the headline macroeconomic data point against which all others are measured. Many claim that Gross Domestic Product fails to capture a large part of what actually constitutes progress in the living standards of human beings around the world, yet there are as of yet no widely accepted methodologies for a more comprehensive measure. So the brainchild of economist Simon Kuznets, GDP’s founding father back in the dark days of 1937, remains our best proxy for the contribution of individuals, businesses and government entities to our economic well-being. All this by way of saying that today’s third quarter GDP release (preliminary) showed a pleasing upside turn after a disappointing first half of 2016. While the quarterly 2.9 percent spurt gives further support to the likelihood of a December Fed funds rate hike, though, today’s report sheds little light on the continuing mystery of where all the growth has gone.

The Trend Is Not Your Friend

Quarterly GDP releases are subject to considerable variance as they go through the iterative process of revisions before the final number is etched into the record books. We focus instead on the bigger picture: how strong is economic growth today, more than six years into the current economic recovery, relative to where it has been at a similar point in previous recovery cycles? The chart below shows year-on-year GDP growth for each quarter (for example, 3Q2016 compared to 3Q2015) from 1950 to the present.


In this context, the most remarkable thing about the current (2009 – present) recovery is that it has only once even grazed the long term real growth average for the past sixty six years of 3.25 percent. In other words, the current growth trend is far and away the weakest of any recovery cycle in the post-World War II economy. Now, this recovery came off the worst economic downturn since the Great Depression. But compare the rate of recovery in the first post-recession years of 2009-10 to that of 1983-84. Then, after the wrenching double-dip recession that spanned 1980-82, year-on-year GDP growth rates ran in the high single digits before settling down to a comfortable trend rate in the four to five percent range. The booming economy of the 1990s was characterized by fewer extreme outliers, but a consistent run rate above the long term average. But growth in the 21st century, thus far, bears little resemblance to its 20th century counterpart.

The Mystery Lies Not in GDP

The long term growth mystery is not why GDP has been so persistently low. That is relatively easy to answer. Economic output – which is what GDP measures – is a fairly simple formulation: the aggregate number of hours employed by working hands to produce things, and the value of things those hands can produce for each hour worked. That formulation, in turn, depends on just three things: (a) growth in the overall population; (b) growth in the percentage of the population employed in the labor force; and (c) the productivity of the labor force.

For example, a significant contributing factor to the strong GDP growth of the 1980s was the rise of labor force participation as a percentage of total population. That trend was driven primarily by the large scale entry of women into the full-time work force – a one-off growth phenomenon that peaked in the early 1990s.

By contrast, the underlying driver of growth in the booming 1990s was a resurgence of productivity, as earlier technological innovations facilitated the ability for workers to produce more in each hour worked than they had before. This was partly due to the delayed impact of 1970s-era technologies like personal computers, and partly due to business process innovations like supply chain optimization and integrated enterprise resource planning.

Productivity, Where Art Thou?

The mystery underlying today’s anemic growth rate is all about productivity; specifically, why it is not only below trend but has actually been negative for much of the recent recovery period. The chart below shows the thirty year trend in labor productivity alongside the concurrent decline in the labor force participation rate. 


This decline in labor force participation and chronically low productivity are all we need to know to understand why GDP remains so persistently below trend – and why periodic upside surprises like today’s Q3 release don’t shed much light on the bigger picture. One quarter of brisk goods exports and business investment in structures – the catalysts for today’s outperformance – does not a sustainable growth trend make. What we do not know – the mystery in other words – is if and when any of the innovations of the past decade will show up in the form of higher productivity. The answer to that riddle will likely determine whether GDP ever finds its way back to those brisker 20th century norms.

The third quarter number – with whatever revisions happen between now and then – will be the most recent growth data point for the Fed to consider when they weigh the prospect of a rate hike in December. Assuming no negative surprises between now and then – either surprises from other headline macroeconomic numbers or a major pullback in risk asset markets – odds are good they will go ahead with a 0.25% move. We believe that will be the right thing to do. But this larger growth question will persist beyond December and will, in our opinion, be a major factor at play in shaping market performance in 2017.

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