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MV Weekly Market Flash: Baby Blues

May 18, 2018

By Masood Vojdani & Katrina Lamb, CFA

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We came across one interesting little data point this week amid the usual news avalanche. The US birthrate reached a 30 year low in 2017: fewer babies were born here last year than any year since 1987. What caught our eye was the odd timing. Birth rates tend to be loosely, but positively, correlated with economic growth (rising during good times and falling when growth goes south). 2017 was the eighth year of what is now the second longest economic expansion in US history. And yet…fewer babies. The fertility rate has fallen from 2.1 kids per woman of childbearing age a decade ago to 1.8 today.

The Growth Recipe

Population data like birth rates don’t typically figure in to short term market movements; we would feel confident in opining that these latest reports, which came out yesterday, did not figure into the day’s movements of the S&P 500 or the 10-year Treasury yield or the price of a barrel of Brent crude oil. But they do matter for the bigger picture, which is why every now and then they will show up in one of our weekly commentaries. Population growth is one part of the long term economic growth equation, along with labor force participation and productivity. Right now, all three of these variables are either negative or stagnant, which puts a big asterisk next to that longevity record for the current recovery. What good is an expansion if the rate of expansion is, by historical standards, so low? And while there may not be much we can do about broad population trends, what is it going to take to bring back higher productivity? The chart below shows the long term trends (since 1950) for productivity and labor force participation.

This is a useful chart for understanding what we mean when we talk about “long term growth.” There are two notable dynamics here. The first was the remarkable burst of productivity that came in the immediate postwar era. This was the heyday of Pax Americana, when our factories and the goods they produced were the envy of the world. As the chart shows, the average rate of productivity (the thin blue vertical columns) was substantially higher during this period than it has been at any time since. Productivity stared to decline in the early 1970s as the economy globalized and other nations – notably a rebuilt Germany and Japan – caught up.

But another trend kicked in around the same time that kept the growth going. This was labor force participation, represented in the chart by the green line. The baby boom generation started to enter the workforce, and so did women, heralding the arrival of the two income household as mainstream. Labor force participation went on a massive surge that didn’t crest until the late 1990s. Then, another productivity boom (though less impressive than that of the 1950s-60s) happened in the late 1990s and early 2000s, this one driven mostly by the delayed impact of information technology in the office and new business processes, like just-in-time inventory management and enterprise resource management, that made efficient use of all that new computational capacity.

Alexa, Make the Economy Grow

Which brings us to today. The decline in the labor force participation rate appears to have stabilized at a level close to that of the late 1970s, while productivity for the last decade is the lowest since record-keeping began in 1948. Imagine for a moment that you are looking at the above chart in 2030, twelve years from now. Or even farther down the road, in 2040. What will it look like?

As for labor force participation, we have some clues in those population trends we observed in the opening paragraph of this commentary; namely, the US population is ageing and the fertility rate is moving farther away from the replacement rate (where each new generation has enough children to replace the outgoing generation). We are not likely to see another phenomenon akin to the sudden surge of two-income households in the 1970s and 1980s to boost participation rates.

That leaves productivity as the only variable with potential energy. If our kids and their kids are looking at this chart and remarking on the great growth cycle of the 2020s, it will be due to a new wave of productivity that we have not yet seen but that may well be lurking under the surface. Artificial intelligence, immersion reality, quantum computing…these are technologies that are known but that have not yet shown themselves to translate to economic growth. But that may be simply a matter of time. The computer technologies developed in the vast mainframe labs of the mid-20th century didn’t flex their commercial muscles until much later, after all.

Or maybe our grandkids won’t care about this chart at all. “Economic growth” didn’t become the go-to proxy for “quality of life,” with all the attendant statistics like GDP, inflation and labor productivity, until after the Great Depression (which is why all the official records for these numbers didn’t start until the 1940s). Maybe some other metric will matter more to them…and to us, in our advanced years.

In the meantime, though, a healthy dose of productivity would be a nice antidote to those baby blues.

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MV Weekly Market Flash: Carlyle, Tolstoy and the 2018 Investor

March 23, 2018

By Masood Vojdani & Katrina Lamb, CFA

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History is simply a collection of the biographies of great people, the charismatic heroes and anti-heroes whose supreme self-confidence, fanatical drive and decisiveness write the chapters of the ages. So believed Thomas Carlyle, the 19th century Scottish philosopher and historian who penned works on Napoleon, Frederick II of Prussia and a “Great Man Theory of History” in general.

Or, history is actually not that at all. History enslaves all humankind, great and small alike, to bit-player roles in a complexity of events, near-events and non-events that evolve in ways unfathomable and inaccessible to simplistic storytelling. So believed the great Russian writer Tolstoy, who devoted over 1,000 pages to a novel, War and Peace, to make this point.

To read War and Peace is to read of the cacophony of random events, missed communications, uninformed decisions and human behavioral traps that ultimately shaped events like the battles of Austerlitz and Borodino – not the genius of Napoleon, nor the resolve of Tsar Alexander I, but those thousands of probable and improbable things that had nothing to do with the supposed destinies of great men. “The tsar” wrote Tolstoy “is but a slave to history.” Outcomes have as much to do with weird supply-line hiccups, melting ice on river crossings and rioting prisoners as they do with those bold commands from the top generals.

Tolstoians Under Fire

Investment markets have been in a decidedly Tolstoian frame of mind for several years now. This view aligns with an understanding of the global economy as its own inscrutable, constantly evolving sea of complexity wherein rulers of nations and titans of industry float and bob like tiny specks on the surface. Geopolitical flare-ups happen; currency crises spring up in the Eurozone, citizens vote in seemingly irrational ways, but the global economy just keeps on keeping on. Real GDP keeps growing, corporate earnings grow even faster, job markets and consumer prices reassure us that there are no nasty recessions lurking around the corner. This mindset reached its high point in 2017, when volatility reached historically low levels no matter how crazy, dire or improbable the news of the day.

But this Tolstoian view has run into some stiff headwinds among investors in early 2018. There seems to be a newfound sense, among many, that humans vested with considerable power can, in fact, make consequential decisions that directly impact the value of portfolios of risk assets. The specific catalyst bringing out investors’ inner Carlyle is the growing threat of a trade war. Thursday’s reversal of 2.5 percent on major benchmark indexes was driven in large part by the latest show of bellicosity by the Trump administration and threats of retaliation by China, currently the primary intended target of a new round of punitive tariffs. Investors who were hoping for a quick V-shaped recovery from the original sell-off a few weeks ago can blame that original announcement of new tariffs on aluminum and steel for cutting off the nascent recovery in share prices.

Great (by which we mean “vested with lots of power,” not to be confused with “good”) leaders making bad decisions: a Carlyle-esque reprise of that ill-fated summer of 1914? Or, ultimately, a brief tempest that sooner or later will fall back into an inconsequential ripple on the ever-expanding sea of the global economy? Your own view of markets in 2018 may well be shaped by whether you are more inclined to agree with Carlyle or with Tolstoy.

The Corporate America Variable

If Trump and his inner circle continue to raise the stakes on a trade war, they will be due for an earful from many corners of Corporate America for whom such an outcome is the very opposite of their business growth models. S&P 500 corporations derive in the aggregate more than half their revenues from outside the US. Almost any major company that produces a good or service with a viable market in China is focused on that market for a considerable amount of its potential future growth. This doesn’t just apply to the obvious names of retailers like Starbucks, Nike and Yum! Brands that have been in that market for years, but to firms in any industry from property & casualty insurance to pediatric nutrition to semiconductors. Sure, steel producers may cheer the prospects for protective tariffs in the short run, but their collective market cap weight is considerably less than that of those who forcefully champion more open trade.

So what will it be? Is the global economy, the creation of millions of random interactions of events and non-events and near-events over the past four decades, destined to simply keep evolving, too massive and too necessary in its current form for a sudden reversal into autarkic nation-states waging economic war on each other? Our general inclination is to take a Tolstoian view of things, and we think it likelier than not that the threat of $60 or even $100 billion in punitive tariffs and associated bellicose posturing will not have the power to topple a global economy worth more, in nominal GDP, than $85 trillion.

That is not to say that we have a Panglossian “best of all possible worlds” take on things. Tolstoy never said that history always works out for the best. Sometimes those random, incoherent things that happen or that don’t happen lead to unhappy outcomes – see 1914, 1917 and 1933 as examples of this in the last century. Disciplined investing requires keeping emotions in check, but it also requires us to not rule out improbable, but possible, scenarios.

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MV Weekly Market Flash: The Fork in the Road

March 16, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Readers of a certain age might remember a perennial favorite among the many outstanding skits performed by late-night TV host Johnny Carson (hi, kids! – ask your parents or their parents). Playing a manic movie review host named Art Fern, Carson would suddenly display a spaghetti-like road map and start giving inane directions to somewhere, leading to the gag: “And then you come to – a fork in the road” at which moment he points to a space on the map where an actual, eating utensil-style fork is crudely taped over the incoherent network of roads. Ah, kinder, simpler, Twitter-less times, those were.

The fork in the road was a key theme of our annual outlook a couple months ago (no match for Art Fern in wit or delivery, but still…). Are we heading down one path towards above-trend growth powered by an inflationary catalyst, or another one characterized by the kind of below-trend, muted growth to which we have become accustomed in this recovery cycle thus far? For now, the data continue to point to the latter.

No Seventies Show, This

Carson’s heyday as host of the Tonight Show was in the 1970s, that era of cringe-worthy hairstyles, mirror balls and chronic stagflation. When the Bretton Woods framework of fixed currencies and a gold exchange standard fell apart in the early years of the decade it freed countries from their exchange rate constraints and encouraged massive monetary stimulation. The money supply in Britain, to cite one example, grew by 70 percent in 1972-73 alone. More money chasing the same amount of goods is the classic recipe for inflation, which is exactly what happened. OPEC poured flames on the fire when, as a geopolitical show of strength, it raised crude oil prices by a magnitude of five times in late 1973. A crushing global recession soon followed as industrial output and then employment went sharply into reverse, with countries unable to stimulate their way out of the mess caused by inflation.

A popular delusion in the immediate wake of the 2016 US presidential election was that some modern day variation of that early-70s stimulus bonanza was about to flood the economy with hyper-stimulated growth. Interest rates and consumer prices would soar as the new administration tossed out regulations, slashed taxes, lit a fire under massive public infrastructure and induced companies to kick their production facilities into high gear. The “reflation-infrastructure trade” flamed out a couple months into 2017 (though CNBC news hosts never got tired of hopefully invoking the shopworn “Trump trade is back!” mantra for months afterwards, every time financial or materials shares had a good day).

Herd-like investor tendencies aside, though, there was – and to an extent there continues to be – a case to make for the return of higher levels of inflation. Economies around the world are growing more or less in sync, which should push both output and prices higher. Taxes were indeed slashed – the one piece of the reflation trade puzzle that actually transpired – and as a result the consensus estimates for US corporate earnings have moved sharply higher. And yet, the numbers keep telling us something different.

Secular Stagnation Then, and Now

When we say “numbers” we refer generally to the flow of macroeconomic data about growth, production, consumption, labor, prices et al, but we’ve been paying particular attention to inflation. The core (excluding food and energy) Personal Consumption Expenditure (PCE) index, which is how the Fed gauges inflation, has been stuck around 1.5 percent for seemingly forever. This past Tuesday gave us a fresh reading on the core Consumer Price Index (CPI), the one more familiar to households, holding steady at 1.8 percent. We also got another lackluster reading on retail sales this week, suggesting that consumption (the largest driver of GDP growth) is not proceeding at red-hot levels. And last week’s jobs report showed only a modest pace of hourly wage gains despite a much larger than expected increase in payrolls. These numbers all seem to point, at least for now, towards the path of below-trend growth. Perhaps the bond market agrees with this assessment: the yield on the 10-year Treasury has been cooling its heels in a tight range between 2.8 – 2.9 percent for the past several weeks.

The economist Alvin Hansen coined the phrase “secular stagnation” back in the late 1930s, at a time when it seemed that long term growth lacked any catalyst to kick it in to a higher gear. We know what happened next. The war came along and rekindled productive output, followed by the three decades of Pax Americana when we ruled the roost while the rest of the world rebuilt itself from the ashes of destruction. Former Treasury Secretary Lawrence Summers brought the term “secular stagnation” back into popular use earlier in this recovery cycle. The numbers seem to tell us that this remains the default hypothesis.

But the story of the late 1930s reminds us that all a hypothesis needs to knock it off the “most likely” perch is the introduction of new variables and resulting new data. Foremost among those variables would be productivity (hopefully productivity from benign sources, and not from hot geopolitical conflict). It may well be that we have not yet arrived at that “fork in the road” but are still somewhere else on Art Fern’s indecipherable road map – and that a new productivity wave will pull us off the path of secular stagnation. The data, though, aren’t helping much in signaling when, where, and how that might happen.

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MV Weekly Market Flash: Hope Accelerates – Will Reality Follow?

February 23, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Every fiscal quarter, publicly traded companies and the securities analysts who cover them engage in a series of time-honored rituals. The rituals follow the elaborate pantomimes of a Japanese Kabuki drama, and the underlying message is almost always the same: Hope Springs Eternal. Consider the chart below, which shows quarterly earnings per share trends for the S&P 500. 

How to Speak Kabuki

Here’s how to interpret this chart. The green line represents projected earnings per share for the next twelve months. Basically, analysts project what they think will happen to the companies they analyze in the year ahead, based on the economic context and all the usual industry- and company-specific competitive variables, and those assumptions boil down to the one NTM (next twelve months) EPS figure. This chart shows the composite NTM EPS for all the companies in the S&P 500. For example, on January 31, 2017, the composite estimate for what S&P 500 shares would be worth a year hence (i.e. at the end of January 2018) was $133.17 per share.

The red line illustrates the actual earnings per share for the twelve trailing months, known in finance-speak as LTM (last twelve months). So if the green line represents the hope, then the red line shows the reality, or what actually happened. As you can see, the actual LTM earnings per share for the S&P 500 on January 31, 2018 was $118.08. It wasn’t $133, as the analysts had forecast a year earlier.

Moreover, the chart shows that this “reality gap” plays out in virtually every quarter, year after year. What often happens as earnings season approaches is that analysts start to dial back their earlier predictions to bring them closer to reality. In so doing, they are playing another important role in the Kabuki drama: managing expectations. Earnings season is only partly about the actual growth number; it is also about whether this number is better than, or worse than, what was expected. The downward revision that customarily takes place in the weeks before a company reports has the effect of lowering the bar, so that whatever number the management team actually reports has a better chance of beating expectations.

This Time Is (Sort of) Different

Clear as a bell, right? In summation: expected earnings are usually rosier than the actual figures that come out later, and the elaborate play-acting between management teams (forward guidance) and securities analysts (downward revisions to expectations) contrives to deliver happy surprises to the market.

Except that the script is a bit different this year. Analysts are actually raising – not lowering – their expectations for 2018 earnings performance. Let’s consider the case for Q1 2018. This is the quarter we are currently in, so we don’t know how the companies are actually going to perform. What we do know is that the analysts’ consensus estimate for Q1 S&P 500 earnings as of today is 17.1 percent growth. When the same analysts made their Q1 forecasts at the end of last year, the estimate was 10.9 percent. That’s a big difference! And not just for Q1. The analysts’ Q2 estimate is also significantly higher today than it was seven weeks ago. In fact, the consensus estimate for full year 2018 earnings growth is 18.2 percent, which is 8 percent higher than on December 31, when analysts predicted growth of just 10.3 percent.

That difference – the difference between 18 percent and 10 percent – matters a lot for equity valuation. If companies in the S&P 500 grow their earnings by 18 percent this year, then a similar rise in share prices will not make stocks any more expensive, when measured by the price-earnings multiple variable. That would ease investors’ worries about a potential share price bubble. Double digit price growth matched by double digit earnings growth is arguably the best of all possible worlds for long equity investors.

Here is the one caveat. Much of the apparent optimism in the current earnings projections comes from one single fact – the tax cuts enacted in December that were disproportionately skewed towards corporate tax relief. You can see from the green line in the above chart just how dramatically expectations accelerated right around the time the relief package took shape. More than any other factor, the tax cuts help explain why, contrary to the usual practice, earnings estimates have been raised rather than lowered as reporting dates come closer (though we should also note that a weaker US dollar, should it persist, could also be an earning tailwind for companies with significant overseas activities).

More to Life than Taxes

Investors should take in this seemingly good news with a measure of caution. First, to the extent that the tax relief does make a strong impact on the bottom line (which would be the case for companies that actually pay something close to the previous statutory tax rate, by no means a majority of S&P 500 companies) it will be a one-and-done kind of deal. The growth rate will kick up for one fiscal year cycle of “comps” – comparisons to the previous year – and then stabilize at the new level.

Second, there are other variables in flux that could at least partially offset the tax advantages. Corporate borrowing will be more expensive if (a) interest rates generally continue to rise and (b) credit spreads widen in response to higher market volatility. Companies in more price sensitive industry sectors may have to address issues of how much new inflation they can pass on to their customers. And, of course, corporate top lines (sales) will be dependent on the continuation of global economic growth leading to increased organic demand for their products and services.

Finally, the only way that companies can consistently grow their earnings above the overall rate of GDP growth is through productivity-enhancing innovations to their value chains. There may be a new wave of such innovations just around the corner – or there may not be. How these developments play out over the coming months will determine whether the current rosy predictions of the analyst community play out – or whether they quickly go back to that familiar old Kabuki script of hope and reality.

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MV Weekly Market Flash: Another Miss for Productivity

February 2, 2018

By Masood Vojdani & Katrina Lamb, CFA

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Longtime readers of our research and commentary know that we spend quite a bit of time dwelling on the economic metric of productivity. Our reason for that is straightforward: in the long run, productivity is the only way for an economy to grow in a way that improves living standards. Curiously, the quarterly report on productivity issued by the Bureau of Labor Statistics generally fails to grab the kind of headlines the financial media readily accord to unemployment, inflation or GDP growth. So there is an excellent chance that today’s release showing a drop of 0.1 percent in productivity growth for Q4 2017 (and a downward revision for the Q3 number) didn’t show up in your daily news digest. And while one quarter’s worth of data does not a trend make, the anemic Q4 reading fits in with a larger question that bedevils economists; namely, whether all the innovation bubbling around in the world’s high tech labs will ever percolate up to deliver a new wave of faster growth.

Diminishing Returns or Calm Before the Wave?

The chart below shows the growth rate of US productivity over the past twenty years. A burst of relatively high productivity in the late 1990s and early 2000s faded into mediocrity as the decade wore on. After the distortions (trough and recovery) of the 2007-09 recession, the subsequent pattern has for the most part even failed to live up to that mid-2000s mediocrity. 


There are two main schools of thought out there about why productivity growth has been so lackluster for the past 15 years. The first we could call the “secular stagnation” view, which is the idea that we have settled into a permanently lower rate of growth than that of the heyday of 25 years or so following the Second World War. The second school of thought is the “catch-up” argument, which says that scientific innovations need time before their charms fully work their way into the real economy. Readers of our annual market outlooks may recall that we closely examined the secular stagnation argument back in early 2016, while the catch-up philosophy occupies several pages of the 2018 outlook we published last week.

The most persuasive evidence made by the catch-up crowd is that both previous productivity waves – that of the late ‘90s – early 00s shown in the above chart and the longer “scale wave” that ran from the late 1940s to the late 1960s – happened years after the invention of the scientific innovations that powered them. Most economists ascribe a significant impact to the products of the Information Age – hardware, software and network communications – in explaining the late 1990s wave. But those products started to show up in business offices back in the early 1980s – it took time for them to make an actual impact. According to this logic, it should not be surprising that the potentially momentous implications of artificial intelligence, deep machine learning, quantum computing and the like have yet to show that they make a real difference when it comes to economic growth.

Productivity and Inflation

The economic implications of productivity tend to be longer term rather than immediate – that is probably why they don’t merit much coverage on the evening news when the BLS numbers come out. After all, the economy is not going to stop growing tomorrow; nor will millions of jobs disappear in one day if another productivity wave comes along with the potential to make all sorts of service sector jobs redundant (a point we make in our 2018 outlook if you’re interested). The lack of immediacy can make productivity debates seem more like armchair theory than like practical analysis.

But productivity (or its lack) does have a lot to do with a headline number very much in the front and center of the daily discourse: inflation. What the BLS is reporting in the chart above is labor productivity: in other words, the relationship between how much stuff the economy produces and how much it costs to pay for the labor that produces that stuff. If compensation (wages and salaries) goes up, while economic output goes up by a smaller amount, then effectively you have more money chasing fewer goods and services – which is also the textbook definition of inflation.

In fact, the BLS notes in its Q4 productivity release that higher compensation was indeed the driving factor behind this quarter’s lower productivity number. Bear in mind that unemployment is currently hovering around the 4 percent level (this is being written before the latest jobs report due out Friday morning), and anecdotal evidence of upward wage pressures is building. An upward trend in unit labor costs (the ratio between compensation and productivity) has the potential to catalyze inflationary pressures.

Keep all this in mind as we watch the 10-year Treasury inch ever closer towards 3 percent. As we noted in our annual outlook, it makes sense to watch the bond market to understand where stocks might be going. And anything related to inflation bears close monitoring to understand what might be happening in the bond market.

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