The Goldilocks Market of 2017
The fourth was another strong quarter for U.S. and global equity markets. Across nearly all economies growth was consistently strong. Market gains were steady and smooth. Yet there is wide concern that a recession and market correction will occur within the next year to 18 months. Ray Dalio, CEO of Bridgewater opined that we have a 70% chance of a recession. Article
Economic growth is the fuel for increasing revenue, profitability and thus market returns in both debt and equity markets. Therefore concerns of a recession need to be taken seriously. At Pangea all of our asset allocation, fund selection and investment recommendations are grounded in what we can discern about the economy in general and the business cycle in particular.
As such, we monitor as many reliable predictors of economic performance as we can. Three in particular have demonstrated capability to indicate turns in direction of the economy. To be sure, we do not engage in forecasts of growth. Rather we monitor direction and particularly changes in direction. Our view is that it is better to be generally correct than precisely wrong. We seek to understand where we are and to look for impending turns in the business cycle.
Where is the Economy now?
The US GDP (Gross Domestic Product) increased 3.2 percent annual real rate in the third quarter of 2017, significantly faster than the 1.2% rate in the first quarter. The Advance Estimate for the fourth quarter is 2.6%. Revisions are typically to the upside, thus we expect the final rate for Q4-17 to be closer to 3% than 2%. This is very robust in contrast with most of the recovery.
Personal Consumption Expenditures, along with Business Capital Investment, Exports, and Federal government spending were the main contributors to GDP growth.
Personal Consumption comprises about 2/3 of US GDP and is thus a key bellwether. Consumers with both the means and motivation to spend augur well for robust growth.
Businesses Capital Investment is occurring in all major categories: structures, equipment and intellectual property. In aggregate, business investing increased at a strong 7.9% in Q3-17 up from 6.7 % in Q2-17. This should boost worker productivity leading to rising real wages and continued strong consumer spending.
Corporate profits increased $90.8 Billion in the third quarter compared with an increase of $14.4 Billion in the second quarter. This will no doubt add to business optimism supporting both business investment and strong stock market performance.
Exports increased a remarkable 6.9% in the fourth quarter the strongest showing since Q2-14 leading 2017 to be the best annual export record in history. Imports also increased resulting in a net drag on GDP. However, the balance of trade has been stabilized since the recession, but remains at a $50 Billion deficit. The weaker dollar relative to the US trading partners’ currencies should help, as will continued global economic growth.
The Rate of Inflation increased to 1.8% in 2017 compared to 1.0% in 2016. This rate is close to the Federal Reserve target of 2.0%, providing impetus for the Fed to continue raising short term rates as well as take steps to increase long term rates. While there is some risk this will dampen equity gains, long term rates closer to long term averages will generally be better for all capital markets and the economy in general.
The International Monetary Fund (IMF) reports:
“Some 120 economies, accounting for three quarters of world GDP, have seen a pickup in growth in year-on-year terms in 2017, the broadest synchronized global growth upsurge since 2010. Among advanced economies, growth in the third quarter of 2017 was higher than projected in the fall, notably in Germany, Japan, Korea, and the United States.”
Global growth for 2017 has been revised upward by 0.1% to 3.7%
These developments have caused the IMF to revise its forecast for 2018 to 3.9%, 0.2% higher than its third quarter forecast. It attributes this to favorable global financial conditions and strong positive sentiment especially for capital expenditures. The IMF points specifically to the US tax policy changes as a key driver of accelerating growth.
The good news is spread across nearly all developed and emerging markets. Moreover, inflation is expected to remain low. Monetary policy normalization is taking place among most central banks following the leadership of the US Federal Reserve.
Structural reforms are continuing in most emerging markets, improving transparency and in turn reducing investor risk. Leaders of emerging market nations have recognized both the political and economic benefits stemming from these reforms. This is reinforcing moves across all regions as emerging nations compete for export business and capital inflows. It is worth noting that this reform movement is embraced by China’s leadership.
Economic Road Signs
- We consult numerous resources to discern changes in the business cycle. Several we will discuss in this post are:
- The Conference Board’s Leading Economic Index (LEI) and its companion the Current Economic Index (CEI),
- The National Federation of Independent Business (NFIB) Small Business Optimism Index,
- The Financial Forecasting Center’s range of forecasts of GDP and GDP growth,
- The University of Michigan’s Consumer Sentiment Survey, in particular, Expectations of Business Conditions.
- Congressional Budget Office (CBO) estimate of Potential GDP v. Actual GDP
- Changes in the Civilian Labor Force and Productivity
Each of these has contributed insight in anticipating turns in the business cycle. A few have demonstrated remarkable accuracy.Conference Board’s Leading Economic Index
Conference Board’s Leading Economic Index
The (LEI) increased in all three months of the fourth quarter with an unusually high 1.3% gain in December. This very strong performance suggests continuing economic growth in 2018. The Coincident Economic Indicator (CEI) trend is also positive reinforcing the current strong growth trend.
We look deeper than just the index, examining its underlying drivers. The ten components comprising the index can also provide clues about impending changes. Observing these components, we have seen them steadily improve over the past five quarters, to the point that all of them indicate continuation of the strong growth trend. We currently enjoy an economy well balanced in growth and with nearly all the fundamentals pointing to continued growth.
NFIB Small Business Optimism Index
The National Federation of Independent Business (NFIB), surveys its members monthly to assess their feelings about the future of small business. Since small business creates the majority of new jobs, the sentiment of business owners says a lot about future employment and wages. While it is a volatile indicator, directional changes can be observed.
The Index has attained pre-recession levels and even shows moderating volatility. Progress on tax reform has clearly boosted small business optimism.
The Financial Forecasting Center (FFC) projection of US GDP Growth Rates
The forecast is presented in three cases, High, Low and Base. The range of predicted outcomes indicates a continuation of moderate economic growth. Since it commenced in 2009, the FFC error of estimate has declined to below 2%.
The Forecast has remained largely unchanged from the two previous quarters. A case for negative growth has not emerged, meaning that a recession is not expected.
That said, we should not be surprised to see the business cycle turn to late stage with lower growth. Any such downturn for now appears to be moderate. Despite this positive outlook, we continue to monitor the forecast for material changes that would indicate a warning sign.
The University of Michigan’s Consumer Sentiment Survey
The Survey section on Expectations of Business Conditions has a remarkably high correlation (0.90) between these expectations and actual changes in GDP.
The results from the latest survey (January, 2018) demonstrate that expectations of improved business conditions are rising steadily as the Tax cut and regulatory reforms increase respondents confidence in the economy.
Overall, expectations of continued or improved growth stand at 75% of survey respondents with 25% expecting worse economic conditions.
CBO Potential GDP
Real GDP compared with the CBO estimates of potential GDP shows an out-put gap of about 3%. By this estimate, the economy still has room to grow to reach current potential let alone future potential. That is to say it is not capacity constrained.
Labor Force and Productivity: Driving Growth
Business Investment mentioned earlier is having a beneficial impact on worker productivity. Since 2000, Real Investment per worker increased 21% yet Real GDP per worker has increased 28%. That suggests capital expenditures have a multiplier effect on worker productivity. That bodes very well for continued economic growth.
The Civilian Labor Force has resumed growing. Rising productivity and a growing labor force indicate that growing GDP should continue.
Capital Market Implications
The pricing history of the S&P 500 since November, 1999 illustrates several implications for the future. Expressed as the Price/Earnings (P/E) ratio Equity Valuation has varied widely from a high of 27 at the start of the period to a low of 10 at the depth of the recession.
Over this 17 year period it has averaged 16.8 represented by the red horizontal line. The 3 month or 1 quarter Moving Average (MA) is illustrated by the red line and the 12 month or 1 year MA is shown by the green line. The vertical blue bars outline the range of +/- 2 standard deviations within which 95 percent of the observed valuations fall.
Several points can be drawn from the graph:
- The very high valuations in the early part of the period, 1999-2003, illustrate the equity valuation “bubble” known as the “dot com boom”, which was followed by the large and long term (3 ½ years) correction, ”dot bomb” where the P/E ratio fell by 37%.
- Current prices are above the long term average, but well within the normal range. This suggests we are not now in an equity price bubble where a correction, perhaps a severe one, could be expected.
- The more recent part of the bull market, now in its seventh year, has continued with reduced volatility, or risk.
- The 1 Quarter MA is diverging above the 1 Year MA, a bullish signal that price momentum is in play.
- The primary risk is that prices climb beyond the normal range which could potentially result in a bubble and subsequent correction. The antidote is continued improvement in corporate earnings. Economic growth globally and US corporate tax reform are key to maintaining P/E ratios in the normal range.
The key theme for fixed income markets is normalization. Chronically low short term rates are being addressed by the Federal Reserve by raising the benchmark Federal Funds Rate. This rate can be adjusted directly by the Fed.
Long term rates are another matter and this is a concern. Normally long term rates bear a premium over short term rates to incent investors to commit for a longer period and as a reward for taking interest rate risk. Expressed as the 10 Year-Federal Funds Spread, this premium has been trending down since the recovery began. Prior to the recession, the trend had been rising, more indicative of normality. While low long term rates stimulate the economy, there is a downside. Long term investment is less attractive and may result in diminished debt for long term capital spending.
The Fed’s option to adjust the spread is less direct and therefore less precise. The mechanism is to reduce its balance sheet by selling some of its enormous inventory of long term assets. Selling these long term instruments will drive down the price and in turn increase their yield. The challenge the Fed faces is the pace at which it reduces its balance sheet. Timing is crucial since too rapid a sell down drains the money supply and could cause growth to slow or even cause a recession. Thus, normalization is likely to be protracted.
Forward View of Capital Markets
The Financial Forecast Center’s forecast of the S&P 500 index along with its history since 2012 illustrates a fairly dramatic turn in the near future. The remarkable point is the algorithm’s prediction of the current increase in volatility and recent correction. While the forecast for GDP and GDP growth rate is a continuation of moderate to higher growth, the S&P 500 forecast calls a correction and sustained bear market commencing in Q2-18 and continuing until Q2-20.
While equity markets are not a direct reflection of the economy, equity asset prices do reflect economic activity and become synchronized in time. Considering the generally positive and consistent economic fundamentals, a sustained bear market is difficult to reconcile. Short term corrections are healthy and necessary to align asset prices with intrinsic value. We should expect that one or more will occur over the next two years.
Is a Recession Imminent?
We now return to Ray Dalio’s prediction of a recession. He is largely on his own as most other asset managers do not see a material risk of a recession. Of note, he offers very little back ground for such a controversial statement. A 70% chance of a recession is fairly definite and there must be some reasoning behind it. Absent providing a fact based rationale, one must consider other possibilities.
What may be revealing is a bit of background information. Bridgewater like most other hedge funds has seen a net outflow of funds into lower cost funds, mainly ETFs. The low volatility of 2017 provided limited opportunity for active hedge funds to find return opportunities. Poor performance induced investors to seek opportunities elsewhere.