Economic fundamentals were ignored as if they were merely background noise as markets attempted once more in early August to breach their record high levels put in late last January. The common theme in the business media is that, due to great corporate earnings (24%+ in Q2), the equity markets are cheap. Never mind that a good part of that earnings growth was due to one-time tax reduction (in fact, pre-tax earnings grew at 7% in Q2, nothing to sneeze at, but not all that out of the ordinary), or that PE ratios are still sky high. As quoted in the August 10th issue of the Wall Street Journal (WSJ), Goldman Sachs reported that “the S&P 500 is currently trading in the 88th percentile of historical valuations…while the median stock is at the 97th percentile” (Wersthorn, “Valuations Slip as Stocks Near Records,” p. B12). Markets can and do remain irrational for extended periods, but sooner or later, they must mirror the underlying economic, financial, and political conditions.
Political Issues
Stocks don’t normally do well when there is significant political instability. And, lately, a lot of political churn has developed:
• Tariffs and Trade Wars: While the ultimate objective appears to be “free” or “fair” trade, the use of tariffs to achieve those goals causes retaliations and economic disruptions including rising consumer prices;
• Sanctions on Turkey, Russia, Iran: The economies in those countries are tanking which is likely to have spillover impacts on trade. The Turkish lira is down more than 45% this year, 17% alone on Friday, August 10th, the day the sanctions were announced. It looks like Turkey will need a Greek style bailout, and we may yet see financial contagion from weak Emerging Market (EM) countries with high dollar denominated debt, falling currency values, and low foreign exchange reserves (Turkey, Argentina, South Africa, Brazil, Indonesia, Mexico, and Russia). The Russian ruble is down 17% year to date, and it fell 6% on August 10th. Iran’s economy is near economic meltdown with reports of widespread social unrest and a renewed lash out by the ayatollahs against Christianity;
• There is also the non-trivial probability that the U.K. exits the EU without a trade deal, in which case the U.K.’s economy is likely headed for a hard landing;
• Italy, too, is likely to re-emerge as a political issue later this fall as the anti-EU coalition government moves to pass a budget that will greatly trouble the bureaucrats in Brussels.
Slowing World Growth
While the data don’t yet inspire worries about the imminent onset of a recession, they definitely show that economic growth in the U.S. and the rest of the world is decelerating. Wall Street economist David Rosenberg has calculated that while 82% of the world’s economies are still growing, only 21% are showing acceleration. New Zealand’s central bank, for example, just moved it forecast for its first rate increase to Q3/20, a full year later than their May forecast. Talk about deceleration! Furthermore, the significant slowdown in China’s growth should be a major concern for equities, as should a continuing strong dollar which erodes the profits of multinational corporations.
In the U.S., Wall Street is still talking about Q2’s 4.1% GDP growth rate, as if the economy is going to eclipse that rate in Q3. When dissected, however, that 4.1% growth is less than meets the eye:
• Of the 4.1 percentage points, 1.1 was caused by a surge in exports to beat impending tariffs (soybeans). Truth be known, exports actually fell 12.8% in June, making the likelihood of a positive contribution to GDP growth in Q3 nearly impossible;
• The consumer credit boom in Q2 was aided and abetted by the tax cuts. Most of the impact on accelerating growth from those cuts has passed (but not the future interest payments on the resulting federal debt!);
• Q3’s consumption growth is likely to be much lower than Q2’s 4%; the growth in real disposable income was non-existent in July, as inflation outpaced wage growth.
U.S. Employment
The latest U.S. employment data leaves one wondering how anyone sees economic acceleration:
• The 157,000 growth in the headline (Establishment Survey) jobs number was significantly below the consensus estimate. Everyone grasped on to the upward revisions of the two prior months, which, because of the way BLS calculates seasonal factors, could have been borrowed from prior months (BLS recalculates all the seasonal factors back to January every month, but only shows the public the results of the prior two months);
• Half of the 157,000 came from the birth-death model, a number generated by a computer algorithm to account for small businesses that are not actually surveyed or measured;
• The Household Survey (which is a telephone survey of 60,000+ households each month) showed that the workweek fell (0.2%), the equivalent of 360,000 jobs;
• Multiple job holders rose to 5.2% of those employed from 4.9% in June and 4.8% in May, tied for the highest level in the post-recession period, and usually an indicator of some consumer stress;
• The Household Survey also noted that the number of self-employed rose 199,000; again, a negative for the employment market;
• The biggest issue in the labor market remains the lack of qualified applicants. The phenomenon of more jobs available than unemployed people is new this cycle with the skills mismatch being the biggest issue. Accelerating growth is difficult when new hires lack the requisite skills and jobs go unfilled because of the skills mismatch;
• In July, both average hourly earnings and average hours worked were down.
Housing
Housing has always been one of the best leading indicators of the economy. It is not only a leading indicator, but a sustaining one. This data clearly shows deceleration:
• Building Permits show a steady downtrend from March (down 6.2%);
• Housing starts fell 12.3% in June from May’s level;
• New and existing home sales are trending lower;
• Construction spending is sliding;
• Mortgage applications have been in a downtrend all year as mortgage rates and home prices have risen;
• When rents in Manhattan decline (1.3% in July vs. a year earlier), it’s time to worry!
Auto Sales and Sentiment
Auto sales, always a good barometer of the consumer’s pocketbook, fell below the 17 million annual rate in July (to 16.68 million) from 17.21 million in June. No acceleration here! Both ISM sentiment indexes (Manufacturing (-2.1 points) and Non-Manufacturing (-3.4 points) showed unusually large declines in July. While both remain above 50 (meaning expansion), both indicate deceleration.
The Bond Market, The Fed, and Inflation
My last blog described how the underlying inflation indicators were poised to show upside surprise. As described earlier, July’s inflation rate eroded the scant wage gains that did occur (see WSJ, “Rising Consumer Prices Are Eroding Wage Gains,” Mitchell, 8/10/18). The Consumer Price Index (CPI) rose at a 2.9% clip over the 12 months ended in July. That level of inflation was last exceeded in late 2011.
As a result of the rising inflation tide, the Fed will have little choice but to continue to raise short-term rates. Long-term rates, as represented by the 10 Year Treasury yield briefly touched 3% again in early August but have not remained above that magic number even despite huge increases in Treasury borrowings due to a lower federal tax take. As of this writing, that rate has fallen back below 2.90% with much of the downward pressure due to the political chaos and sanctions discussed above.
But really, one must wonder why the 10 Year Treasury yield didn’t move higher prior to the recent politically induced flight to quality. Does the bond market smell an economic slowdown? With the 2-10 year spread currently at 29 basis points (0.29 percentage points)(the “spread” is the difference between the yield on the 10 year and the yield on the 2 year), one more Fed rate hike (likely in September) will virtually close this gap. And with the Fed’s “dot plot” (the forecast of the Fed Fund Rate by each voting Fed member) forecasting four to six more rate hikes before the end of next year, an inverted yield curve (short rates higher than long rates) appears inevitable.
So, why is an “inverted yield curve” such a big deal? In March of this year, the Fed’s own researchers in the San Francisco Fed published a study entitled ”Economic Forecasts With The Yield Curve” (Bauer and Mertens). Their conclusions: “…the term spread has a strikingly accurate record for forecasting recessions. Periods with an inverted curve are reliably followed by economic slowdowns and almost always by a recession.” These are the conclusions of the Fed’s own researchers!
Conclusions
• No recession yet in sight; the economy is still expanding. But it clearly isn’t accelerating. In fact, it appears to be decelerating with housing leading the way. In this kind of economic environment, a policy mistake, like too may Fed rate hikes, may cause a recession; something to worry about over the next several quarters;
• Today’s U.S. equity market is priced for an accelerating economy. But the facts say that economic growth is slowing. Just to be clear, it is possible to have a significant market correction without a recession, as is currently happening in China where growth is slowing (no recession) and the market has corrected more than 25% from its nearby high;
• So when Q3 GDP growth comes in sub-3% and the stock market is surprised, you shouldn’t be.
Why Stock Prices Are High
As a sidebar, there is a possible explanation as to why U.S. stocks are still flying so high in the face of this clear growth deceleration. When the tax law was passed, there was the belief that the changes to the corporate tax law would boost business investment (capex). Remember the excitement when a few companies made the headlines by promising to build new plants in the U.S. in the wake of the tax cut? Except for the oil and gas industry, there is no evidence, today, to suggest that large increases in capex have occurred. When one thinks about it, corporate balance sheets were already flush with cash prior to the tax cuts, and if there was little capex growth then, why would additional cash make a difference? With little “organic” growth in sight, it appears that most of the windfall cash has been used for stock buybacks, increased dividends, or acquisitions. Buybacks are at a record level, and that appears to be a driving force behind the high PE levels of U.S. stocks.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.
