Posts tagged Us Macroeconomic Data
Today is the first day of the last month of 2017, which means that predictions about asset markets in 2018 will be flying about fast and furious over the coming three weeks. As practitioners of the art and science of investment management ourselves, we know that quite a bit of work goes into the analysis that eventually finds expression in the “bonds will do X, stocks will do Y” type of formulations characteristic of these holiday season prognostications. A layperson might be excused, though, for concluding that all the market pros do is dust off last year’s report, or the year before, for that matter, and repackage it with the same observations. “Rates will rise because of the Fed, stocks will rise because of a stable economy and good earnings” worked for 2016 and it worked for 2017. Here’s visual proof: the price appreciation of the S&P 500 and the trend in the 2-year Treasury yield since December 2015:
It wasn’t linear, of course. There was the technical correction in early 2016 when both stocks and rates pulled back. Still, though, investors positioned for rising short term rates and steady gains in large cap domestic stock prices would have had little about which to complain over the past two years. Which, of course, brings us to the point of today’s commentary: is it Groundhog Day again, or does 2018 have something entirely different in store?
At the heart of this curious Groundhog Day phenomenon over the past couple years is the remarkable sameness in the broader macroeconomic environment. “Moderate GDP growth, with a healthy labor market and modest inflation” is a phrase you could have uttered on literally any given day over this period and been right. The only thing measurably different about 2017 was that this “Goldilocks” set of conditions was true not just of the US, but of almost any part of the developed (and much of the emerging as well) global economy. Adding the word “synchronized” to “moderate GDP growth” gives the phrase a distinct 2017 flavor. Thus, the good news for equities disseminated into non-US markets and finally gave investors some measure of reward for diversification.
There is almost nothing in the way of macro data points today suggesting a deviation from this “synchronized moderate growth” mantra. The major question mark, as we have discussed in other commentaries, is whether inflation will ever get in line with what the Fed’s models call for and rise above that elusive 2 percent target. Now, if inflation were to suddenly go pedal-to-the-metal, that could change assumptions about risk assets and blow up the Groundhog Day framework. In particular, an inflationary leap would likely send shockwaves into the middle and longer end of the bond yield curve, where rates have remained complacently low even while short term rates advanced. The 10-year yield is right around 2.4 percent today, almost exactly where it was at the beginning of the year and in fact not far from where it was at the beginning of 2016.
The sideways trajectory of the 10-year, in fact, supplies the explanation as to why stocks could rise so comfortably alongside the jump in short-term rates. While short term rates are closely correlated to the Fed’s monetary policy machinations, longer yields reflect a broader array of assumptions – including, importantly, assumptions about inflation. The flatness of intermediate rates suggests that bond investors expect economic growth to remain moderate, and inflation low. The bond market is not priced for a high inflation environment – which is reasonable, given the scant evidence that such an environment is imminent.
Can Stocks Keep Going?
So far, so good: the economic picture seems supportive of another Groundhog Day. What about stocks? There are still plenty of alternative paths for equities to travel in 2017 (and they are going kind of helter-skelter today on some breaking political news), but a solid double-digit performance would be a reasonable prognosis (the S&P 500 is up just under 20 percent on a total return basis for the year thus far). The current bull market is already the second longest historically, and valuations are stretched. Is there more room to run?
As we write this, the tax bill which has riveted the market’s attention for most of the past two weeks has not formally passed the Senate, nor been reconciled with the earlier House version to a final bill to send to the White House. But the odds of all that coming to pass are quite good. As we have noted before, the market’s obsession with taxes has little or nothing to do with fundamental economic growth. The non-partisan Joint Committee on Taxation said as much in the report it released late yesterday on the proposed bill’s likely economic impact: at best, contributing no more than about 0.1 percent to annual GDP growth over the next ten years.
But the market’s interest in the fate of the tax bill has little to do with long-term economics, and much to do with shareholder givebacks. To the extent that the bill results in tangible cash flow benefits for corporations in the next 1-2 years (and the quantification of such benefits remains quite variable), precedent informs us that the vast bulk of such gains would flow right back to shareholders in the form of buybacks and dividends. Buybacks and dividends don’t help the economy, but they most assuredly do help shareholders. That fact, alone, could supply enough of a tailwind to keep the bulls running long enough to grab the “longest duration” mantle.
Everything’s the Same, Until It Changes
So if you read a bunch of reports over the next couple weeks that sound incredibly similar to what you read a year ago, don’t rush to the judgment that its authors are lazily phoning it in. There remain very good reasons for the Groundhog Day framework for yet another year. Gains in stocks, an increase in short term rates alongside monetary policy moves, and longer term rates tempered by modest inflation are all plausible default-case scenarios.
But never forget that any scenario is just one out of many alternative outcomes. Market forces do not pay heed to the calendar year predilections of the human species. There is no shortage of factors out there that could upend the benign sameness of today’s conditions, and they will continue to demand our vigilance and readiness to adapt.
Like most of our fellow investment practitioners, we subscribe to a variety of daily market digests – those couple paragraphs at the market’s opening and closing bell that purport to tell us what’s up, what’s down and why. A brief summary of these digests over the course of 2017 might go something along the following lines: la la la la TAXES la la la la TAXES la la la…you get the picture. Not corporate earnings, certainly not geopolitics – nothing, it would seem, has the power to capture Mr. Market’s undivided attention quite the same way as potential changes to our tax code.
Well, this week is one of those times where the subject is front and center as Congress attempts to set the process in motion for some kind of tax “reform” before the end of the year. As we write this, more information is coming out about what the legislation may, and may not, ultimately include. We should note that it is far from certain that anything at all will be accomplished within this year. Taxes affect everyone in some way – individual and institution alike – and literally every item on the table will have its share of vocal backers and opponents. Over the coming weeks we will share further insights on these developments; our purpose today, though, is to consider at a more fundamental level the relationship between taxes, economic activity and markets.
Taxes and Growth
One of the central motivations for just about any attempt at tax reform is to stimulate economic growth. There are plenty of competing ideologies about this – and it matters for purposes of the discussion whether we are talking about the short term or the long term. But one reasonable question to ask would be how relevant a factor tax rates have been as an influencer of growth over the long term. The chart below illustrates year-on-year GDP growth in the US since 1950, along with the top marginal (individual) tax rate over the same period.
Top tax rates on wealthy individuals were very high – 91 percent in the 1950s and a bit lower (77 and then 70 percent after 1964) before coming down to 50 percent in the first wave of Reagan-era tax reform in the 1980s. Subsequently they have fluctuated between the high and the low 30s through the successive policies of the Clinton, Bush and Obama administrations. What conclusions could be drawn from the impact of alternative tax regimes on long term economic growth? In our opinion only one; namely, that any correlation between marginal tax rates and growth is very weak, at best. The high rates of GDP growth in the 1950s and 1960s took place neither because of nor in spite of high taxes, but for a whole host of other reasons based on global economic conditions at the time.
The same could be said when considering the economic growth spurt of the 1990s, after the Clinton administration had raised taxes in 1993: the growth happened because of many different variables at play, and taxes were at best a peripheral consideration. It is particularly important to keep this absence of causation or even correlation in mind when we are told by policymakers that any revenue lost from tax rate reduction will pay for itself from higher growth. That’s ideology – but the numbers simply aren’t there to back it up, and not for lack of ample data.
Taxes and Earnings
Individual tax rates are only part of the equation, of course. A big part of the market’s focus this year has been on corporate taxes. The statutory US corporate tax rate of 35 percent is high by world standards, so the argument goes that reducing this rate to something more competitive (with 20 percent being the number floated in the current version of the plan being floated by Congress) would be a powerful catalyst to grow US corporate earnings. How does this claim stack up?
At one level the math is fairly simple. Earnings per share, the most common number to which investors refer to measure the relationship between a company’s profits and its stock price (expressed as the P/E ratio), is an after-tax number. If Company XYZ paid 35 percent of its operating profits to the tax man last year, but this year Uncle Sam only gets 20 percent of those profits, then the other 15 percent is a windfall that goes straight to the bottom line (to be retained for future growth or paid out to shareholders at the discretion of Company XYZ’s management). That growth – all else remaining equal – will make XYZ’s shares seem more reasonably priced, hence, good for investors.
There are two things to bear in mind here. First, that tax windfall happens only once in terms of year-on-year growth comparisons. Once the new rate sets in, XYZ will get no future automatic tailwind from taxes (i.e., EPS growth will then depend on the usual revenue and cost trends that drive value). Second, the potential ongoing benefits from the lower tax rate (e.g. a larger number of economically viable investment projects) will depend on many factors other than the tax rate. It’s not irrelevant: taxes do figure into net present value and weighted average cost of capital, which in turn are common metrics for go / no-go decisions on new projects. But many other variable are also at play.
The other issue with regard to the statutory tax rate is that it is a fairly poor yardstick for what most companies actually pay in taxes. The mind-numbing complexity of the US tax code derives from the many deductions and loopholes and credits and other goodies that influential corporate lobbyists have won for their clients over the years. The influence of these groups is already on display: the US homebuilder industry, for example, has come out vehemently against some of the proposed changes being floated by policymakers. Time will tell how successful any new legislation will be at productively broadening the base (i.e. reducing the loopholes and exclusions).
So what’s the takeaway? There are many miles to go before the proposal coming out today arrives at any kind of legislative certainty. As managers of portfolios invested for long term financial objectives, our views on taxes focus largely on how they impact, or do not impact, key economic drivers over the long term. We will continue to share with you our views as this process continues.
Where’s the inflation? That question has lurked behind most of the major headline stories about macroeconomic trends this year. Jobless rate falls to 4.3 percent. Where’s the inflation? GDP growth revised up to 3 percent. Where’s the inflation? The Fed has an official dual mandate of promoting price stability and the maximum level of employment achievable in a stable price environment. By all available measures, our central bank policymakers would appear to be living up to their mandate in spades. Inflation has remained subdued for pretty much the entire run of the recovery that began in 2009. Over the same time, unemployment has come crashing down from a post-recession high of 10 percent to the gentle undulations of 4 percent and change from month to month. And therein lies the problem, or rather the riddle that neither the Fed nor the rest of us can answer convincingly: why hasn’t a robust jobs recovery reignited inflation?
Math, Models and Markets
Those of us who do not hold Ph.D. degrees in economics from the nation’s most prestigious universities at least have one advantage over those maven economists on the Fed Open Market Committee: we can freely speculate about the perplexing absence of inflation. Here at MVF we have our own views, largely proceeding from the larger issue of long term growth that has been the central subject of our in-depth research for much of the past three years. The catalysts that drive growth over successive business cycles – productivity and labor force participation – have both chronically underperformed for many years. Quite simply, we may have reached a point of diminishing returns on the commercial innovations that powered a historically unique run of growth through the middle and mid-late portion of the last century. Without that growth, we shouldn’t expect wages and prices to do as they did before.
Which is fine for us to say, because – see above – we are not doctorate-level trained economists. But Janet Yellen is, and so are most of her colleagues. And unlike us, they do not have the freedom to brainstorm and speculate about what’s keeping inflation from showing up. All they have are models. Models with months, quarters and years of data providing quantitative insights into the relationship between the labor market and consumer prices. Models written in beautiful mathematical formulations, the legacy of giants who inhabited the “freshwater” (University of Chicago) and “salt water” (MIT and Harvard University) centers of economic research in the years after the Second World War. Models premised on the hyper-rational choices of economic actors, models that do not actively incorporate variables about capital and financial markets but that assume that money is just “there.”
Follow the Dots…Not
The models say that a higher uptrend in inflation is consistent with where the labor market is. Accordingly, the “dot plot” predictions by FOMC members continue to assume one more rate hike this year (most likely December) and three more next year. This despite the fact that the core personal consumption expenditure (PCE) rate that the Fed uses as its inflation gauge remains, at 1.4 percent, well below the Fed’s 2 percent target. Fixed income markets, though, continue to largely ignore FOMC dots (despite some of the usual post-event spasms after Wednesday’s press release). There remain about 100 basis points of difference between what the Fed thinks is a “normal” long term trend for the Fed funds rate (closer to 3 percent) and what the bond market thinks (closer to 2 percent).
In a nutshell, the bond market, and analysts such as ourselves, look at inflation trends and say, why rush? The Fed says, because the models say we have to act. If the models are right, there could be some very nasty shocks in fixed income markets that spill over into risk assets like equities. But for the rest of us, with our parlor game speculations about how the relationship between prices and jobs today may simply not be as statistically robust as it used to be, it is difficult indeed to spot the hard evidence supporting a major bout of inflation on the horizon.
It’s Jobs Friday, always a fun day for financial pundits as they craft ways to put a defining, click-friendly metaphor on the latest signal of health (or lack thereof) in the labor market. This month’s winning metaphor is that staple of kids’ birthday parties, the bouncy house. “US jobs growth bounces back” says the Financial Times. Adam Samson, the FT reporter whose byline is attached to that article, appears to be on the same cosmic wavelength as Patricia Cohen of the New York Times, whose lead headline today reads – wait for it – “U.S. Job Growth Bounces Back”. The style manuals of the FT and NYT – U.S. or US? Jobs plural or singular? Caps or no caps in the headline? – were on full display. Over at the Wall Street Journal they seem to have quietly retired the “Jobs Friday Live Blog” of times past, but the WSJ’s team of economists nonetheless has a massive “Everything You Need to Know” section on the April jobs report. Indeed, to the credit of those featured, that is one exhaustive parsing of the BLS release.
If Productivity Fell and Nobody Heard It, Did It Still Fall?
Not every macroeconomic headline gets the popular-kid treatment of the monthly BLS release, of course. Consider the financial headlines just yesterday, May the Fourth (insert nerdy Star Wars reference here). Yesterday was Productivity Thursday. Ha-ha, of course it wasn’t, because there was basically no coverage of the only economic data point that actually has the capability to deliver sustained growth. What did yesterday’s headlines focus on? Postmortem commentary on the FOMC’s meeting pointing to a June rate hike…the final pre-election debate between Macron and Le Pen over in France…the sausage makers on Capitol Hill hastily throwing together a gambit on the 18 percent of the US economy represented by health care. Important stories, all. Meanwhile, nonfarm labor productivity fell 0.6 percent for the first quarter, well below the consensus expectation of 0.1 percent and yet another lackluster contribution to a chronically underperforming long term trend.
Stop Us If You’ve Heard This One Before
Everyone talks about growth; the notion that the economy will be stronger in the future than it is today is literally the single animating notion behind the capitalist impulse to defer the benefits of a dollar today for the payoff of that dollar’s growth over a defined period of time. But talking about growth without focusing on productivity is like talking about why you just came down with a nasty cold without considering the fact that you recently went out for a walk in the snow barefoot, in shorts and a t-shirt. That is what makes the absence of Productivity Thursday so conspicuous, and why the obsessive focus on monthly payroll gains appears so misplaced.
If anything, the leading number of Jobs Friday should be the labor force participation rate. That nudged down to 62.9 percent from last month’s 63 percent. It remains far below the peak of more than 67 percent reached at the end of the 1990s. Why is this number important? All together now…long term growth is a function of three variables: overall population growth, growth in the number of people working as a percentage of total population, and productivity (how much gets produced for every hour of effort invested).
For most of human history the only variable that mattered was population growth. If that were still true, we would have to content ourselves with annual GDP growth around 0.7 percent, which happens to be the most recent annual rate of population growth. We have little reason to believe that labor force participation is going to improve anytime soon: both demographics and job-replacing technology will see to that. Which leaves productivity, and which is why Productivity Thursday deserves its rightful place at the cool table in the cafeteria of macroeconomic data. Yes, those payroll numbers are useful. But with the unemployment rate at 4.4 percent one might wonder why participation remains stagnant and wage growth is still relatively subdued. Productivity Thursday could help shed some light here.
Another Friday, another “hard” piece of data that comes in shy of expectations. The Bureau of Economic Analysis released the first estimate of Q1 2017 real GDP growth, and the 0.7 percent quarter-on-quarter growth rate was a bit below economists’ consensus estimate of one percent. As a standalone data point this does not tell us very much. There will be two further revisions that could increase (or reduce) this first estimate. Q1 is notoriously subject to seasonal factors; for example, a warmer than average winter resulted in lower utility consumption by households, which in turn had a slowing effect on personal consumption expenditures. The first quarter of 2016 also produced sub-one percent growth, but that perked up to more robust levels as the year played out. As always, one data point doth not a trend make.
That being said, today’s release will do little to shed light on the mysterious “hard versus soft” debate that has been a staple on the menu of financial gabfests this year. The GDP number comes on the heels of two other underwhelming “hard” macro releases of recent Fridays past: headline inflation below the Fed’s two percent target, and March payroll gains falling short of 100,000. By contrast, a number of “soft” numbers reflecting sentiment among consumers and small business owners have being going gangbusters; by some estimates consumer confidence is higher than it has been any time since the tech bubble peak in 2000. The upbeat sentiment has served for many in the commentariat as an easy go-to explanation for the stock market’s bubbly performance in the year to date (our own take on the market is a more mundane assessment of momentum feeding on itself, more or less impervious to outside catalysts).
Hard, Hard Road
The sentimental bullishness may yet converge into the subdued hard numbers, but it’s not a given. Take retail sales, which posted a modest gain in February and then fell in March. Now, with consumer sentiment being so jazzed up, shouldn’t some of that effervescence be showing up in the actual spending numbers? You can’t blame the weather for this one: those balmy February days should have been mall and DIY store magnets. In fact, the poor showing of retail sales throughout the first quarter was as good a sign as any that GDP might come up short. Seventy percent of growth in output is driven by consumer spending. If consumers aren’t walking the walk, then all the happy talk in the world isn’t going to move the growth needle.
And Now for the Ugly
Behind all these month-to-month metrics we use to measure the economy’s health is the grim reality that long-term growth remains challenged by three major headwinds: declining population growth, a smaller percentage of the population at work in the labor force, and anemic levels of total factor productivity. Of those three headwinds, the only one that can plausibly deliver growth as we know it is productivity. It was the unique convergence of productivity advances with baby boom demographics that delivered the amazing, historically unprecedented growth rates of the 1950s and 1960s. The demographics are no longer in our favor, so to have any growth at all we will need to see some material evidence that all the technology innovations of the last 10 to 15 years can deliver a new, sustained dose of productivity gains. Until that happens, we should not expect to see the kind of go-go growth being promised by some who should know better (ahem, Treasury Department tax plan crafters). At some point, sooner rather than later, this reality will likely make itself known in the soft data as much as the hard.