Posts published in July 2016
The headline number was underwhelming. Today’s quarterly release by the Bureau of Economic Analysis showed real US GDP growing at a rate of 1.2 percent for the second quarter of this year – less than half the 2.5 percent clip projected by analysts. Moreover, the already tepid first quarter growth rate was revised down to 0.8 percent, putting the total average growth rate for 2016 to date at about half the pace of the past four years. Right on cue, Fed funds futures markets tossed out the string of recent upside macroeconomic surprises – from wages and job growth to retail sales and capacity utilization – and lowered the probability of a 2016 rate hike to below 40 percent. Below the headlines, though, there appears relatively little about which to be concerned in the short run. The S&P 500 appears to have opened its eyes, digested the GDP data, shrugged and turned over on its beach towel to get an even tan.
Seventy Percent Okay
Consumer spending accounts for roughly seventy percent of our GDP, and by this important yardstick the quarter would appear just fine, thank you. The chart below shows the recent trend in consumer spending next to that of private domestic investment – i.e., what private sector enterprises invested into growing their businesses. The contrast is clear: brisk consumer activity alongside a lackluster pace of business capital outlays.
Below the headline number, in fact, GDP activity looks quite consistent with other recent data, notably wages and prices. With wages and inflation ticking up in recent months, it is not surprising to see consumer spending moving along at a respectable pace. On the other side, the fact that business spending dropped by 9.7 percent this quarter, notching a third consecutive quarter of declines, is probably less of a cause for concern than the magnitude of the number may suggest. The two big losers in the category were structures (minus 7.9 percent) and equipment (minus 3.5 percent). These were attributable in no small part to the sharp reduction in capital expenditures by companies in the energy, mining and other resources sectors. In other words, the reversal in business spending likely contains a much more cyclical than secular component, which should stabilize along with oil and other commodities prices.
Long Term Remains Murky
Our relatively benign interpretation of the Q2 GDP release, though, does not change the considerably murkier set of circumstances surrounding long term growth trends. The fact remains that the pace of recovery from the worst economic pullback since the Great Depression has been far below historical norms. The chart below shows the pace of overall real GDP growth from 1980 to the present.
A deep recession more often than not is followed by a sharp recovery off the trough; consider the pace of recovery following the painful double-dip recession of 1980-81 and even those following the comparatively mild recessions of 1990-91 and 2001-02. Not only was the post-2008 off-trough recovery weaker than these previous cases but, as the chart clearly shows, the average growth rate throughout the ensuing seven years has been well below trend. Weak growth is an outcome of a persistently diminished rate of productivity, a trend with no clear causal factors that continues to perplex economists.
Janet Yellen’s Tea Leaves
Whether or not today’s Q2 GDP release moves the needle one way or the other on the Fed’s policy dashboard remains to be seen. The press release following this week’s FOMC meeting was a bit more upbeat than the previous one, though – as has become customary – the language appeared more reactive to asset market conditions than anything else. We translated the press release’s phrase “Near term risks to the economic outlook have diminished” to read thus: “Brexit happened and stock markets didn’t implode, so we feel okay.” A healthy pace of consumer spending alongside a short cycle of reduced business spending shouldn’t get in the way of any plans for a rate hike. But in the end it is likely to matter much less than some other random event, somewhere in the world, sparking another technical correction in the stock market.
A deadly terrorist attack in Nice last Thursday was followed by a failed coup over the weekend in Turkey. China’s contentious “Nine-Dash Line” in the South China Sea is on a potential collision course with the U.S. military. A dismal post-Brexit PMI reading in Britain offers the first piece of data suggesting a possible autumn recession. Establishment institutions around the world reel from public distrust, and in politics it seems conventional rules no longer apply.
Yet stock markets appear blissfully dismissive of the planet’s woes. The S&P 500 has resumed its record-setting ways after a hiatus of more than one year. Meanwhile the CBOE VIX, the so-called “fear gauge” of market sentiment, fell to a two year low earlier this week, a stunning 54 percent plunge from the June 24 high in the immediate aftermath of Brexit. Do these signals – a placid VIX and a stock market upside breakout – signal the beginning of another extended run for the seven year old bull? Or are we in a brief calm before the next storm?
The VIX is subject to abrupt and dramatic mood shifts, as the above chart clearly shows. Those Alpine spikes tend to occur when something unexpected shocks investors out of complacency. Three notable examples in this chart, which goes back two years, were the Ebola freak-out in October 2014, the Chinese yuan devaluation in August 2015 and of course the Brexit shock last month. The Ebola and Brexit events appear similar in their brevity – less than a week of fear – and in the fact that in both cases stocks went right back to setting record highs. In both cases the market’s snap judgment appeared to be “nothing here, carry on”.
By contrast, risk and uncertainty lingered longer after the yuan devaluation last August, with the VIX staying at an elevated level for about five months until peaking again this past February. This is perhaps not surprising. The importance of China to the world economy makes it harder for investors to simply shrug off a negative surprise like the devaluation. Questions about China’s growth sustainability, debt overhang and impact on world commodity markets remain, even if they have mostly been out of the headlines of late.
A Tale of Two PMIs
Is Brexit really just an Ebola-like flash in the pan, an event unlikely to have much impact outside Great Britain’s borders? Since the vote one month ago (a month already, really?) there has been plenty of opinionating about what it all means, but not much in the way of data. Today we finally got a little quantitative morsel on which to chew. The July monthly purchasing managers surveys (PMI) came out for both Britain and the Eurozone, and they painted a distinctly diverging picture. In the Eurozone, both the manufacturing and the services PMI came in right about where they were a month ago, at 51.9 and 52.7 respectively. A PMI greater than 50 signifies an expansion while a number below 50 indicates a contraction.
In the UK, by contrast, the manufacturing PMI fell from 52.1 last month to 49.1 in July, while the services PMI fell from 52.3 to 47.4. Analysts have been quick to point out that the data are consistent with a scenario for a UK recession as early as this fall. We should note that PMI is only one measure of economic activity, so due caution is advisable before rushing to judgment. In our opinion, though, if there is anything substantive to take away from today’s PMI it is the Eurozone number. A British recession spilling over into a Eurozone recession would be cause for concern, but evidence in support of that scenario has not shown up yet. Indeed, while leaving Eurozone interest rates untouched this week, ECB Chair Mario Draghi expressed confidence in the current economic state of the union.
Not Worried, or Not Present?
Perhaps the market is right that, even with all the mayhem going on in the world, there is no compelling case to make for the bull to change course and reverse. It’s also possible that the lack of worry indicates that nobody is paying much attention. As we noted in our piece last week, we are in that time of the year when trading volume subsides and gives way to beach reads. Volume on the New York Stock Exchange has been well below average during the recent post-Brexit rally. Maybe investors are more concerned about leveling up in Pokémon than they are about world events. For now, in any event, this quiet spell appears fairly impervious to disruption.
We are heading into the dog days of summer, and this one has a distinctly retro feel to it. Just a few weeks ago we used this space to comment on the US stock market’s having a distinct 1970s vibe to it. But the big socio-cultural phenomenon of the moment is Pokémon Go, an app which appeared out of nowhere to rival Twitter in popularity. What with Pikachu and friends roaming all over our virtual spaces, the S&P 500 setting new record highs, the prospect of a Clinton White House and even a new reality show for ex-‘N Syncer Lance Bass, we may have to revise our cultural reference markers a couple decades ahead to the late 1990s. Of course, the silly season will eventually give way to the more purposeful back-to-school month of September. This year’s ninth month could be plenty interesting and potentially tricky for investors.
Yellen and the Markets
For a first clue as to what September might have in store, we will be paying close attention to the language Janet Yellen uses to convey her sense of the state of play at the FOMC meeting later this month. The odds of any actual rate action in July are vanishingly small; at this point it would be a huge surprise, and probably not a pleasant one, for the Fed to act. But Chair Yellen and the markets need to have a little conversation. In the aftermath of Brexit, short-lived tempest though it was, market expectations on the timing of the next Fed move pushed out well into 2017. Bond yields remain near historically low levels pretty much everywhere, despite a bit of a jump this week.
But Brexit is oh-so three weeks ago. There is much less uncertainty around Britain’s near-term future as the new Conservative government of Theresa May settles into office and the identity of the key players charged with negotiating the terms of Brexit become known. Meanwhile, a new string of macroeconomic numbers on this side of the Atlantic suggests that markets may be overly optimistic in their never-never expectations on rates. There was last week’s release by the BLS with all kinds of good news about jobs and wages, of course. This week we saw a strong uptick in producer prices, suggesting that the wage-price trend of the past several months is more durable than the Fed might have thought back in the spring. Retail sales and industrial production both outperformed and capacity utilization nudged up slightly. If economic conditions suggest that the Fed’s mandate of stable prices and full employment is best served by bringing rates up, if ever so slightly, can Yellen and her colleagues still make the case for staying put? Or will she use the July meeting to reset expectations towards a September move?
Earnings Finding Bottom?
By September we will also have a good sense as to how Q2 earnings will finish out and whether, as currently expected, the growth trend turns positive again for Q3 and beyond. Even as energy, industrials and materials continue to be a drag on average earnings, consensus estimates call for strong positive reversals in key sectors like consumer discretionary, healthcare and technology. The evidence from recent market trends suggests that investors are, for the moment anyway, putting oil prices and the dollar in the rear-view mirror and focusing on a potential return to double-digit earnings growth by next year.
The TINA Syndrome
Much chatter continues – including in some of our recent commentaries – about the mixed messages being sent by stocks and bonds, with the former seeing the world’s metaphorical glass as half-full and the latter viewing it as half-empty. A derivation of this is the so-called TINA view on US blue-chip equities: There Is No Alternative. This view suggests that bond investors have become the new stock investors. With historically low or negative yields distorting whatever information the bond market is sending, high quality stocks with healthy total shareholder return programs have become the new safe haven, in the world according to TINA.
IF the TINA syndrome persists into the fall, we could be in for one of those Santa Claus rallies so beloved of investors as the year heads to a close. For this to happen, though, will still require a few things to go right; at the very least, a continuation of the more favorable earnings and economic trends discussed above, and a minimum of surprises as this very strange political season draws towards Election Day. And just yesterday, of course, we were sadly reminded once again of the persistent presence of terror with the Bastille Day tragedy in Nice, France.
All of which is to say that conditions continue to be supportive for stocks, but not without plausible downside catalysts. There will be plenty of things to focus on and prepare for as the dog days give way to a potentially busy and challenging fall.
It is perhaps appropriate that jobs reports in the middle months of 2016, the Year of Anything Goes, confound the consensus expectations to a much greater degree than they did in the comparatively sane world of 2015. Last month the FactSet analyst consensus projected payroll gains of 160,000 for May; the BLS report delivered 38,000 (subsequently revised down to 11,000). This month, the consensus plodded right along with a 180,000 estimate. In a reversal of fortune (or, statistically speaking, trading places with the other end of the margin of error) the payroll gains for June shot up to 287,000. That’s 2016 in a nutshell: you never know what version of reality will show up on the day, but the experts will be reliably wrong in either case.
All Well, Move Along
The chart above, our go-to headline snapshot of payroll gains and the unemployment rate, shows that, despite the wider fluctuations of the last couple months and fewer incidents of 200,000-plus gains compared to previous years, there is not much in the US jobs picture to suggest a worsening domestic economic picture. That remains true below the headline numbers: the participation rate is steady (if well below historical norms), wages continue to outpace inflation, and weekly unemployment benefits claims remain at very low levels. Other measures like reluctant part-time workers (looking for full-time work) and the long-term unemployed show little change from month to month. In the context of other key data points like inflation, GDP, consumer confidence and retail spending, the overarching story remains more or less the same: growth that is slow by post-World War II long-term trendlines, but growth nonetheless. And better, more consistent growth than elsewhere in the developed world.
Stocks Have a Say…
US stocks signal a positive reaction to the jobs data, though it is still too early in the day to call a win. That pesky S&P 500 valuation ceiling of 2130 looms ever closer – just a rally or two away. US stocks seem to have been caught up in the post-Brexit flight to quality story, mixed up with the usual safe haven plays of Treasuries, gold and the yen, and today’s jobs report may play easily into that sentiment. Money has to go somewhere, and even at rich valuation levels US stocks make a more compelling story than other geographies. Central banks have had some measure of success in pushing bond investors out of their once-safe habitats into riskier assets. If you’re a traditional bond investor forced to make a bigger allocation to equities, your first port of call would logically be blue-chip US names with high dividend payouts. This trend could continue to suggest relative outperformance by US equities.
…And So Do Bonds
The bond market is communicating a view as well; the problem is that the language can seem as intelligible to the average investor as Ixcatec or Tharkarri . What does it say about the world when precisely every single maturity for Swiss government bonds, right out to 50 years – 50 years! – carries a negative interest rate? Think about the logic behind those yields: is there really no better way to invest one’s savings than to pay the Swiss government for the privilege of holding its debt for half a century? The only rational economic argument to make for the viral spread of negative interest rates is that, if general price levels in the economy fall over a long time, it sorta-kinda makes sense to hold a security that falls in value by less. That’s a pretty pessimistic take on the next 50 years, though.
And it’s not just in Europe or Japan – Treasury rates here in the relatively strong US are also at all-time lows, if at least still breaking positive. This goes back to the point we made a couple paragraphs above: domestic stocks and bonds both seem to be tagged as safety assets, unlike the usual situation where stocks and bonds move in opposite directions. The normal rules appear to no longer apply. But hey, it’s 2016. Anything goes.