Climbing the Wall of Worry: U.S. Economic & Market Outlook
May 15, 2015
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Climbing the Wall of Worry: U.S. Economic and Market Outlook
A few years ago, looking at the fiscal cliff, budget standoff and government shutdown, the recession in Europe, etcetera, I described the outlook as "sunny...with a chance of tornados." By that I meant things would probably work out well, but there were some big risks to the forecast.
Well, none of the things we were worried about destroyed the economy. At the beginning of 2014, it felt like the theme should be that old Bobby McFerrin song 'Don't Worry, Be Happy.' The economy was growing, unemployment was falling, and markets had been kind to us - investors were steadily making money without high volatility or sharp corrections. It felt like Goldilocks.
In mid-2014, the emergence of Ebola and ISIS and the Ukraine conflict looked like the kind of "black swans" or "tornados" which could threaten the global economy. Ebola has, it seems, been contained; ISIS has not, but the risk of a spike in oil prices due to mideast conflict has been replaced by the reality of a decline in oil prices due to increasing production from both OPEC and non-OPEC producers. While the Ukraine conflict has not been decisively ended, a lasting (if not perfect) cease-fire is in place and the conflict has faded from the headlines.
In the first four months of 2015, the U.S. struggled through yet another harsh winter, but employment growth continued, interest rates remained near year-end levels, and stock markets reached new highs.
So...what's the outlook?
Looking Forward at 2015: Solid U.S. Economic Growth is Expected
Our outlook on the U.S. economy remains quite constructive.
The heart of the optimistic case is that employment, incomes, and confidence are continuing to rise. The ability to spend is the fuel for economic activity. These are positive feedback loops that are gaining traction and should drive accelerating growth.
With the 2016 election cycle already underway, fiscal policy is unlikely to be a drag on the economy. To the contrary, with the federal deficit down to pre-crisis levels, the fiscal drag from deficit reduction is easing, removing a headwind from the economy.
Inflation in the real economy, while past its lows, remains muted. While we expect the Fed to begin raising short-term rates in the coming months, monetary policy does not poses a material threat to the economy. The Fed may stay too dovish for too long, but they're unlikely to tighten prematurely. A concern, though, is that the market may not react positively when they act, even if their actions are well-timed with respect to inflation and unemployment.
Similarly, lower oil prices are good for "Main Street" even if they may cause problems on "Wall Street."
Global economic growth projections have been reduced, largely as a result of slowing growth in emerging markets. Still, the developed market outlook is improving, with the European and Japanese economies expected grow in 2015 and China expected to continue to grow, albeit at a slower rate.
That said, no matter how optimistic the outlook, risks remain.
The Global Economic Backdrop is Mixed
Europe is out of recession. The Ukraine situation has depressed sentiment and slowed growth, but growth remains positive, and estimates are being upgraded.
Japan "triple-dipped" - falling back into recession after the April 2014 tax hike. While the tax hike continues to distort year-over-year comparisons, the economy appears to be recovering.
Chinese growth continues to trend lower but - so far, at least, China appears to be pulling off a "soft landing": growth is not collapsing.
Global Growth Still Subdued, With Regional Divergences
Europe: Economy Moving in the Right Direction
Key Insights as of March 2015
For the EU, 2015 opened on a more optimistic note: GDP growth was 0.3% in Q4, with growth stars Germany and Spain as strong as 0.7% QoQ.
The rapid weakening of the euro around year end and the abrupt decline in oil prices over the fourth quarter provided two notable pushes to the European economy. The interaction of these factors with stronger confidence, easier credit conditions for small- and medium-sized enterprises (SMEs) and a neutral-to-slightly-expansionary fiscal policy constitutes a mix that could give growth a boost. Pioneer has revised upward our growth forecasts to 1.6% this year, with Spain growing well in excess of 2%. We have also revised down our forecasts for inflation, which should remain below 0 for most of 2015.
Increased policy responsiveness: while in recent years the ability of European institutions to get ahead of the curve has been severely questioned, this year started on a different footing: the European Central Bank (ECB) surprised the market on the upside, the EU Commission approved and immediately implemented a new, more flexible, approach to fiscal rules and launched the Investment Plan.
Politics and risks: A rich political agenda provides an element of potential volatility. The Greek question has led to a tough confrontation in Europe, and it clearly will take some time before it is fully resolved. Geopolitical risks, in particular the Ukraine-Russia affair and the Islamic State (IS) threat (nearer than previously thought) constitute the main risks.
May 15 update
The "flash" estimate of 2015 Q1 growth was 0.4% (not annualized) and 1.0% y/y
Japan: Mild Recovery Expected
Key Insights as of March 2015
Abenomics: The winter Diet is currently underway (26 Jan ? 24 Jun). The recent resignation of the Farm Minister Nishikawa has put the schedule of the Diet at some risk, starting with a possible delay in approving the Budget Law. Nishikawa is the third Minister to resign since the Cabinet reshuffled last September; the previous Minister Hayashi has been re-appointed. The agriculture sector is in the spotlight because of further developments related to the Trans Pacific Program and the tight conditions that will be required as part of any deal.
Economic Outlook: Japan was technically out of recession in Q4 2014. However, in real terms, the country closed the 2014 Calendar Year with flat economic growth. On the basis of the new data set, we expect a mild recovery going forward: CY 2015/2016 at 0.6% YoY and 1.1% YoY respectively. Between the second and the third quarters of 2015, the core inflation rate will likely touch bottom around zero, before increasing again towards 1.0% in the forecasting horizon. In our view, there is a not negligible probability of seeing some negative figures for inflation in the short term.
Monetary Policy: Our main case is that the Bank of Japan (BoJ) will not intervene further in 2015, as it will look at inflation dynamics over the medium-to-longer term rather than on a short term basis. The risk to our main case of further intervention is not low, at 30% probability, and the timing associated with that risk is towards the end of the year, when the BoJ will reassess a proper economic outlook for 2016.
EM: Champions and Leftovers
Key Insights as of March 2015
China's expansion of credit has been outpacing its economic growth since the global financial crisis. We believe that this is not sustainable, reflecting a deep problem of resource misallocation in China's economy. A large volume of funds has been channeled into unproductive sectors through local government financing vehicles, State Owned Enterprises (SOEs) and property developers, adding to serious overcapacity in certain sectors and unsold properties. China's policymakers seem to be fully aware of the possible risks. They have adopted a gradual approach to addressing these imbalances, by carefully guiding credit growth towards a more sustainable pace while pushing economic reforms ahead.
There is considerable debate in the industry around what will be the end game of China's deleveraging. We think China's policymakers are moving in the right direction to avoid dangerous credit risks. However, this process will have key implications not only for China growth, but also in the rest of the world.
China's economic growth is likely to weaken further in the years ahead, with slowing credit weighing particularly on investment and heavy industry.
That said, we believe that China can still avoid a systematic financial crisis or a hard-landing in its economy, given the state's control over the banking sector and a large part of the economy, relatively low external vulnerabilities and wide range of available policy tools.
One major uncertainty is the property sector, in which around 90% of developers are privately owned. While the most difficult part of adjustment for the sector looks to have been accomplished, in our view only successful structural reforms can allow China to ultimately achieve a smooth adjustment. We have observed positive signs over the past year and expect an acceleration of reform implementations to come.
How the process unfolds will likely have profound implications for Emerging Markets, with potential winners and losers.
OTHER ASIA: It's budget time for India and Indonesia: FY Fiscal Deficit Targets are 3.9% and 1.9% of GDP, respectively. Both countries are aiming to boost economic growth through capital and infrastructure expenditures. The room for fiscal action in Indonesia seems more evident in the numbers, thanks to the savings obtained through subsidies rationalization. India, by contrast, is in need of significant extra-budgetary funding. The divestment of public assets is a process that can take time.
EASTERN EUROPE AND THE MIDDLE EAST: The Ukraine conflict has continued to be at the forefront of investors' concerns. The fragile Minsk I ceasefire agreement was followed by Minsk II in February; however it is not clear if this agreement will hold. Ukraine has announced likely government restructuring as part of the new International Monetary Fund (IMF) program. In Russia, we have revised our growth forecast down to -3.5% in 2015. In Turkey, excessive political pressure on the Central Bank risks the premature closing of the window of opportunity to improve the economy structurally.
LATIN AMERICA: Negative growth has increasingly become the consensus outlook for Brazil, but we remain concerned about political and policy uncertainty into mid-year as economic conditions continue to worsen. President Rousseff has appointed an experienced technocrat, Joaquim Levy, as the new Minister of Finance. His task will be to implement the necessary fiscal adjustments in order to avoid rating agency downgrades. At the same time, the central bank is likely to continue hiking rates, as inflation has surprised to the upside despite the slowing economy.
US: Economy On Track
We Expect 2.5-3.0% US Real GDP Growth in 2015 ...Modestly higher than in 2009-2013
We have been in a "square root" economic recovery/expansion.
After the sharp downturn (the recession officially bottomed in June 2009) and the first bounce in the recovery, we have experienced an extended period of time of low economic growth (around 2%).
We haven't gotten the 4%+ growth that we've had coming out of many past recessions, because this recession was more a "balance sheet" recession than "business cycle" recession. The private sector has been slowly deleveraging. (there's still more to do at the government level).
We expect U.S. economic growth in 2015 to be somewhat faster, in the range of 2.5-3.0%, reflecting:
Less fiscal austerity
Rising employment, incomes, and consumer spending
Higher business capital expenditures and modest growth in residential investment
We do not believe recession risks are material unless there is an external shock. There are few signals that the domestic business cycle is exhausted. Consumer and business balance sheets are relatively healthy, employment, incomes, and aggregate purchasing power are rising, while inflation remains low, and the Fed remains very accommodative.
The Index of Leading Economic Indicators Is (Still) Rising The rate of increase is consistent with continuing GDP growth
The index of leading economic indicators is not a good tool for stock market timing, since, the stock market is, itself, a good leading economic indicator.
The leading economic indicators are designed to forecast recessions. The index is pretty good - there have been very few recessions which were not preceded by a fall in the leading economic indicators and relatively few times the leading economic indicators without a recession ensuing. It's a pretty good signal.
Leading economic indicators are looking quite strong right now, they're not telling us to forecast a recession. In fact, they're consistent with GDP growth over the next year of over 2.5%.
...Suggesting That GDP Growth Should Continue
The LEI is suggesting economic acceleration. We don't expect growth to approach 5% (the LEI has overstated future growth in each of the last two cycles), but see little downside or recession risk.
The ISM Indexes are Still Signaling Growth Services is stronger than Manufacturing
The ISM (Purchasing Manager) manufacturing and non-manufacturing (services) indexes summarize a variety of measures of business conditions, including new orders, backlogs, inventories, supplier lead times, employment, and prices. Readings above 50 signal expansion (improving conditions) while readings below 50 signal deteriorating conditions.
The manufacturing sector has faced a variety of headwinds, most notably weak weather and the impact of a rising dollar and weak global growth, but continues to grow.
Because manufacturing represents a far smaller share of the total economy than services, the non-manufacturing index should get more "share of mind"...and indications here remain very strong.
The new orders sub-indexes are more volatile than the headline indexes but they tend to lead the broad indexes...and they remain in expansion territory.
Recent Economic Data Has Been Weaker Than Expected
The Citigroup Economic Surprise Indices measure how actual economic compares to forecaster survey data. The indices are calculated daily for a rolling three-month window through a very complicated quantitative process. A positive reading of the Economic Surprise Index suggests that economic releases have, on balance, been beating the consensus, and vice versa.
The "summer slowdowns" of 2010, 2011, and 2012 are clearly visible in this series, as are the effects of winter weather in early 2014 and 2015.
With that said, the fact that this indicator has not turned up is a concern...a warning that expectations might be too optimistic.
The Fundamentals Remain Supportive of U.S. Growth
Bottom line, the preponderance of evidence is that the economy will continue to expand through the remainder of 2015.
Quarterly Contribution to Annualized U.S. GDP Growth by Sector
When we break down of the sources of growth of US GDP into six major categories, patterns emerge and forecasts can be constructed bottom-up.
Each of the charts is on the same XY scale, so simply adding them up shows total economic growth...and the relative contribution of each sector of the economy is proportionate to the height of its bars.
Personal consumption expenditures represent almost 70% of US GDP, so changes in spending have a correspondingly large impact on the economy. The 2008-9 recession is clearly visible, for example.
Note: these charts plot nominal (current dollar) GDP, not real (inflation-adjusted) GDP. The use of nominal dollars in this view obscures the impact of inflation. In the first quarter of 2015, for example, falling gasoline prices meant consumers spent less on gasoline...this made the economy look weak even though lower gasoline prices freed up consumer dollars to be spent on other things or saved (which is what happened, mostly).
Still, the focus on consumer spending, rather than consumer income, means that the role of changing rates of consumer borrowing and saving are not reflected in GDP. In the 200-2005 period, for example, increased borrowing fueled an (unsustainable) rise in sending...while in the 2010-15 period, a higher savings rate (reduction in borrowing) understated the strength of the consumer.
Happily, labor market indicators are quite encouraging, as virtually every broad employment indicator is showing constructive trends: employment and incomes are rising. As we will discuss more later, this bodes well for the future.
The trade deficit reflects the balance between exports (good for the economy) and imports (a negative). The decline in the trade deficit in the 2008-9 recession reflects lower spending by U.S. consumers on imported products. (this is one of the mechanisms that gave rise to the phrase "when the U.S. sneezes, the world catches a cold.") It's also the mechanism by which the U.S. can act as "the locomotive of global growth" - higher spending on imports stimulates the economies of countries that export to the U.S.
Exports are sensitive to global growth, but with exports to developed and emerging markets each representing roughly half of exports, and with both raw materials and finished goods contributing to export strength, exports should remain a source of strength in anything other than a severe global economic downturn. Conversely, a falling unemployment rate and rising consumer confidence could lead to accelerated imports, putting downward pressure on the trade deficit.
Residential investment is, in essence homebuilding. Because we are looking at the changes in - not just the level of - GDP, increased homebuilding would appear as a positive bar and vice versa. Homebuilding activity diminished in the aftermath of the overbuilding of the bubble years, and the subsequent recovery shows up as positive bars. While we don't expect activity to return to earlier peak levels (the U.S. doesn't need that many new houses), the risks appear modestly biased to the upside.
Nonresidential investment is, in essence, business capital spending. We expect a continuing trend to "on-shore" manufacturing in response to incrementally more favorable economics (energy costs, labor costs, foreign exchange rates, etc.) and the supply chain vulnerabilities exposed by the 2008 financial crisis and the Japanese and Thai natural disasters. Corporations have money to invest, with profits, free cash flow, and cash positions near record levels, and debt levels moderate. Money is available, as banks are increasing their commercial and industrial loans and bond markets have welcomed issuers. Restraining investment growth has been (and will continue to be) still-moderate levels of capacity utilization and concerns about the macroeconomic outlook.
In general, inventory level changes tend to wash out...changes in inventory are they are mean-reverting in the short-run, more "noise" than "signal" over the longer-term.
Rising government spending is counted, in the GDP calculation, as contributing to growth - even when it is funded by borrowing or printing money. The government sector has not been a meaningful contributor to growth since 2009. It wasn't European-scale austerity, but the federal budget deficit has been reduced from roughly 10% of GDP to roughly 3% via a combination of spending controls (sequester) and higher taxes.
We Expect Consumer Spending To Strengthen in 2015 Supported by rising employment, incomes, confidence, and borrowing
Initial Unemployment Claims Are Remarkably Low Suggesting that business conditions are still broadly improving
One excellent indicator of whether things are getting better or getting worse is initial unemployment claims. That's people being fired or laid off, people losing their job involuntarily (retirement or quitting does not make you eligible for unemployment benefits). Business is good.
Claims have fallen to levels last seen at the turn of the century...below the lowest point they reached in 2005-2006.
Longer term discussion Initial unemployment claims are usually a good leading indicator of trouble in the economy. When you see claims turn up - like in 2008 - it's usually a sign of trouble. We don't expect that. We expect claims to continue trend downward. But this is something we're watching very carefully to see whether we are correct in thinking that we have a slow growth recovery or whether we're wrong and we're entering a recession. The data is noisy on a week-to-week basis (hence our focus on the four-week moving average), but it's timely data with a short lag, worth watching closely.
You can think of the job market as similar to a bucket of water - which leaks. Every time someone is hired, a drop of water is added to the bucket; every time someone is fired or laid off, a drop leaks out of the bucket. The level of the water in the bucket is the number of people with jobs. Even the good times of 2005 to 2007 more than 1 million people a month were laid off or fired in the U.S. - it's a big economy. In the downturn the rate at which people were laid off or fired rose from about 1.5 million to over 2.5 million people per month. If you do that for eight months you end up with 8 million more unemployed people even if there was no decrease in hiring - which of course there was.
Notes: The big transient spikes tend to be caused by natural disasters (e.g. Katrina, Sandy).
The decline in claims even during the weak Q1 strongly suggested that we weren't seeing a real economic downturn.
October-November 2013 data was distorted by IT issues in California...data noise...
The Work Week is Near Cycle Highs - The Demand for Labor is Strong
The Work Week is Near Cycle Highs - The Demand for Labor is Strong
Job Openings Are at New Cycle Highs
There are almost 5 million job openings in the U.S. today, the highest level since early 2000...more than at the peak of the economy in 2006-7.
Businesses are hiring...business must be good.
The surge in job openings this year is a strong indication that the economy is accelerating out of hit a (weather-related) speed bump in Q1.
Employment Growth Has Been Accelerating
The monthly report is noisy data, and says almost nothing about future economic growth (it's a lagging indicator), but it's watched closely by the market.
The trend (rolling 12-month) rate of employment growth remains relatively steady...rising, if anything.
Total Employment Has Never Been Higher
The U.S. economy shed roughly 8 million jobs in the recession, and has added more than 11 million jobs since the bottom of the last recession...roughly 2.5 million in each of the past four years.
Note that there's no weakening of the trend...
Aggregate Consumer Spending Power Has Never Been Higher
More people, working longer hours earning more per hour equals more spending power.
Note: the spike at the end of 2012 was people realizing capital gains before the tax rate went up...
Consumer Confidence Continues to Rise
Because consumer spending represents roughly 70% of US GDP, employment and income levels matter, but so does consumer sentiment and behavior. When consumers are scared they don't spend money. And consumer spending is what drives GDP in the short term.
Consumer confidence tends to be a lagging indicator inasmuch as human beings tend to steer using the rearview mirror: they expect tomorrow be like yesterday. As a result, we have expected that confidence would recover with the economy, but the recovery in confidence has been tepid at best. We expect confidence to continue to improve if (as we expect) economic growth continues and hiring activity remains strong (and wages rise).
Consumer confidence fell to all-time lows in the spring of 2009. There has been improvement, but confidence remains below prior peaks.
Reasons for still-depressed confidence could include: still-elevated unemployment, the European debt crisis, U.S. political discord, the Ukraine and Mideast conflicts, etc. It's also possible that consumers are still traumatized by their experiences in the last recession - the generation that lived through the Great Depression carried those scars the rest of their lives.
Consumers are Able to Service Additional Debt
Consumer deleveraging, whether via default, foreclosure, or savings, has been dramatic: families now commit less of their income to debt service and similar fixed costs than at any time in the past 30 years.
This is very bullish: high debt burdens are unsustainable; low debt burdens are a sign of health.
Working definitions: "A primary measure used by the Federal Reserve to assess the extent of American household indebtedness and to provide a view of the financial health of the overall consumer sector is the quarterly debt service ratio. The debt service ratio measures the share of income committed by households for paying interest and principal on their debt. When the debt service ratio is high, households have less money available to purchase goods or services. In addition, households with a high debt service ratio are more likely to default on their obligations when they suffer adversity, such as job loss or illness.
Of course, debt payments are not the only financial obligations of households and thus the Federal Reserve also calculates a more general financial obligations ratio. This measure incorporates households' other recurring expenses, such as rents, auto leases, homeowners' insurance and property taxes, that might be subtracting from the uncommitted income available to households."
Remarks by Chairman Alan Greenspan, Understanding household debt obligationsAt the Credit Union National Association 2004 Governmental Affairs Conference, Washington, D.C., February 23, 2004
Consumers Remain Reluctant to Borrow to Fund Consumption They have cut back their use of revolving debt
I like to divide consumer debt into two big buckets.
First mortgages, auto loans, and student loans generally finance the purchase of a capital asset (education being human capital)
Credit cards and home equity lines of credit, on the other hand, are more likely to be just "spending next week's paycheck today."
The extent to which this sort of borrowing grew in 2000-2008 and has been declining since then is apparent in this graph.
HELOC balances continue to decline. Crediit card balances have, apparently, stopped falling and may be beginning to rise.
Consumers Remain Cautious, are Saving More Higher savings reduce reported current GDP...but a longer-term positive
Because GDP measures what people spend, rather than what they earn, a change in the savings rate can materially impact GDP.
The 2008 recession reflected, in large part, an increase in the savings rate: people stopped spending money.
The recovery has been sluggish, in large part, because of consumer deleveraging (deleveraging and saving are essentially the same thing).
The spike in the savings rate at the end of 2012 was caused primarily by people realizing capital gains before a new, higher, tax rate too effect at year-end.
2013's savings rate was significantly below 2012's. The cause was not a jump in spending: it was a reduction in take-home pay caused by the tax hikes; savings have generally trended sideways since then.
The rise in the savings rate in early 2015 was probably attributable to the falling price of gasoline - if consumers view an income increase or price decline as transient, they are relatively likely to save the incremental money; if they view it a permanent, they are relatively likely to increase their spending.
Background: Higher savings reduce reported current GDP...but are a longer-term positive. Consumer savings represent future consumption while consumer debt represents future austerity (or default). Think of a battery and a light bulb - with savings being the charge stored in the battery. Draining the battery makes the light bulb burns brighter, but it's unsustainable if the battery isn't recharged. Saving is recharging the consumer's spending battery.
We Expect Auto Sales to Remain Strong
This chart, in conjunction with the charts that show the drop in personal consumption expenditures and the rise in the savings rate, shows how automobile sales contributed to the 2008-9 recession.
When Lehman failed, consumers cut back their spending (saved more). One of the easiest ways to spend less is to 'drive the old car longer.' Sales of automobiles dropped as consumers retrenched. Dealers stopped ordering cars from the factories, then the factories laid off workers. The causality is important: in essence, the change in the savings rate caused the job losses...if the job losses had come first, the savings rate would have fallen when incomes dropped...the rise in the savings rate showed that opposite happened. As Franklin Roosevelt said, "The only thing we have to fear is fear itself."
Cash for Clunkers caused a brief spike in 2009, but little else.
Activity has steadily, gradually, recovered from recession lows.
The average car on the road is quite old--over 10 year, I believe-which should help support replacement demand.
Lower gasoline prices will also help, but we see limited room for substantial future growth from current levels...it's primarily replacement demand, given demographics and levels of car ownership.
Not a concern, but not a driver of growth either.
Lower Gasoline Prices Free Up Consumer Spending Power
The demand for gasoline (transportation) is relatively inelastic in the short run (people don't change the number of miles driven quickly when gasoline prices rise/fall)...so changing gasoline prices add to or subtract from the after-gasoline spending power of the consumer: lower gasoline prices are bullish, and vice versa.
Prices had been in a sideways range for several years. Most families had adapted to that general level of prices, so there's been a major shock to the system.
In big round numbers, the U.S. consumes roughly 100 billion gallons of gasoline a year, so one dollar per gallon (and prices are down roughly that much from mid-2014 levels) frees up $100 billion of U.S. consumer spending for other purposes.
We Expect Residential Investment To Contribute to 2015 Growth Demographics and affordability are supportive
We Expect Residential Investment (Homebuilding) to Increase
Historically, homebuilding has been very cyclical and very sensitive to changes in interest rates. As rates rise, homebuilding has slowed; when rates fall, it has recovered. This has been one of the primary channels through which the Fed's interest rate policy has accelerated and slowed the economy in prior cycles.
Homebuilding had a delayed recovery in this cycle. That's one of the primary reasons we've had slow economic growth and the square-root recovery. The problem was simple: we built far too many houses during the bubble years. It took time for the population to catch up, but demographics (and job gains among the 30-ish demographic) have resulted in enough household formation to absorb a lot of that inventory overhang, permitting homebuilding to recover.
As the vacancy rate and the inventory of unsold new houses declined, home building began to recover...but largely plateaued in 2014.
Modest further growth in residential construction activity seems likely, but only modest growth: both builders and buyers are likely to remain cautious.
Still, downside risk to GDP from homebuilding market appear to be minimal (the greater risk is underestimating strength).
The largest risk to homebuilding probably comes from interest rates: higher mortgage rates push up the cost of home ownership. Affordability now is reasonably good...but higher rates will not help.
Home Prices Appreciation Continues, But Has Been Slowing
Breaking the Case-Shiller home price data into smaller clusters gives us some insights into house price dynamics.
Detroit is a special case, given its sensitivity to the auto business. It never had a bubble since, during the bubble years, the city was losing jobs and house prices followed. The red line at the top is California, Florida, Las Vegas, and Phoenix. This is where there were big bubbles and big busts. The blue line in the middle is everybody else.
All three lines paint the same general picture: rise, fall, bottoming, rise. The rate of price appreciation appears to be slowing, however.
We see no reason for house prices to rise dramatically (another bubble), either, given the "shadow inventory" overhang, more conservative lending standards, and the likelihood that interest rates will rise. An extended period of relatively stagnant pricing after the initial recovery seems most likely.
The Trade Deficit is Subject to Conflicting Forces We expect the overall impact on 2015 GDP growth to be limited\
Despite Recent Appreciation, the U.S. Dollar is not "Too High" for the U.S. Economy
While the dollar has rallied off its lows, it remains at levels at which many US firms remain globally competitive.
Business Capital Spending is Likely to be a Modest Contributor Demand is not strong enough justify expansion
Capacity Utilization Remains Below 80% Below levels which typically spark a rise in capital spending
Capacity utilization remains below 80%...which is currently considered the level at which business capital spending is likely to accelerate.
Inventory/Sales Ratios Are Sounding a Warning Signal
Retail inventory: sales ratios are a key leading indicator.
At the start of the 2008-2009 downturn, inventories and inventory:sales ratios did not look extended. When sales dropped however (higher savings rate), the I:S ratio spiked.
This led to production cutbacks (job losses) as excess inventories were worked off.
As sales recovered, inventories rose again.
In recent months, the I:S ratio has risen sharply. Some of the rise may be attributable to rising crude oil inventories and some to weather disruptions-related sales declines, but - either way - either sales must pick up or production must slow down.
Fiscal Policy is Expected to Contribute to 2015 Growth Austerity is not the watchword in 2015-2016.
The Drag from Fiscal Austerity is Gone
The run-off of the stimulus spending enacted to fight the last recession, the "sequesters," and fiscal austerity at the state and local levels have resulted in the government contribution to GDP turning negative - government was shrinking.
A corollary of this is that the "private sector" (non-government) segment of GDP must have been growing somewhat faster than total GDP...and that is exactly what has been happening.
The period of fiscal austerity is ending: with an election looming, neither party in Congress is likely to press for big tax increases or spending cuts.
Reduced government austerity removes a headwind from the economy.
We Expect Solid U.S. Economic Growth in 2015 Recession risks appear low unless there is an external shock
On Balance, Lower Oil Prices are a Positive for the U.S. Economy
Oil Prices Have Collapsed as Production has Outrun Demand
The energy business is in the midst of an industrial revolution. 3D seismic imaging, horizontal drilling, and fracking have permitted U.S.-based oil producers to increase production by roughly 4 million barrels/day in the past 5 years. Oil imports have fallen by roughly 3 million barrels/day as domestic producers took share from non-U.S. producers (primarily OPEC).
In November, OPEC effectively abandoned its efforts to keep oil prices high by cutting back their production, opting instead to compete for market share by increasing output and cutting prices.
The result is that oil prices have fallen dramatically.
The U.S. Rig Count Has Declined Rapidly
With prices falling over 50% from their peak (before rebounding), companies have dramatically reduced drilling activity.
This is showing up in the economy as job losses, reduced capital spending, and lower industrial production (drilling activity)...though the job losses haven't been large enough to "move the needle" at the national level and the drags from reduced capital spending/industrial production are being offset by lower energy costs in the rest of the economy..
...But Production and Inventory Growth Have Not Yet Reversed
While the rig count has dropped, production has not yet fallen materially.
Since production has exceeded demand, inventories have risen to very high levels.
This is clearly not yet a market in equilibrium.
A Closer Look at Production and Inventory Levels in 2015
In recent weeks, production and inventory have peaked...but remain at high levels.
Sudden Increases in Oil Prices Cause Recessions...Declines Don't
Discussion of the downside risk from price spikes
One of the biggest threats to the economy is always rising oil prices.
Think about it from your family's perspective. Once you've heated your house, fed the family, paid your utilities bills, and put gasoline in the car, then you know how much money you have left over for other things. And so rising commodity prices crimp the amount of income that's available for everything else and they can drive the economy into recession.
This graph is a simple model of oil prices and recessions. When today's oil price gets to twice its trailing five-year average - as it did in 1973, 1979, 1990 and 2008 - a recession is likely.
Right now that ratio is about 0.5. This is stimulus for the economy, not a drag on the economy.
The situation is most analogous - though not quite the same - as that of the 1980s. After the Iranian revolution and "Volcker recession," energy conservation became a high priority, limiting demand at a time when global production exceeded demand. The resulting "oil glut" led to a price crash in 1986 and an economic expansion that (despite the stock market crash of 1987 - caused by a different set of factors) lasted until Iraqis invasion of Kuwait led to another recession-inducing oil price spike.
NOTE: FOR TECHNICAL REASONS, THIS GRAPH IS ONLY UPDATED THROUGH APRIL 6. PRICES ARE UP SOMEWHAT SINCE THEN< BUT NOT ENOUGH TO MATERIALLY CHANGE THE STORY.
Inflation is Low...but Cyclical
Headline Inflation has Been Pulled Down by Energy Prices Core CPI Remains Close To But Below 2%
Energy prices have pulled headline inflation down, but the effect will be transient. Core inflation, which is largely driven by shelter and labor costs, is more likely to rise than to decline as the economy approaches full employment and house prices and interest rates rise.
Longer-term discussion It is important to understand is the distinction between headline inflation and core inflation. Headline inflation includes food and energy, core inflation does not. We need food and energy to live, let's make no mistake about that. But core inflation is helpful to economists because - especially in the last 10 or 15 years or so - core inflation is much more stable than headline inflation. In addition, food and energy prices are largely outside the control of the Fed: raising and lowering interest rates doesn't change the weather, the harvest or, generally, the price of coal, oil, or gas.
The situation now is different from 30+ years ago (pre-Reagan). Back in the 1970s, something like 25% of the workforce was unionized with contracts that included cost-of-living adjustments, or COLAs, that boosted wages when energy prices went up. Now if we look at the US economy in the aggregate, energy represents something like 5 or 10% of the cost of goods sold. Labor represents something like 70% of the cost of goods sold. A business might be able to absorb higher energy costs without raising prices but when labor costs go up across an industry, businesses will pass along those higher energy/labor costs in the form of higher prices. If there are no COLAs, energy prices don't get passed into wages in the same way, and don't trigger a wage-price spiral.
What we've seen in the last 10 years is that headline inflation has been very volatile because food and energy prices have been very volatile, but because it's not being passed through to wages by COLAS, core inflation is not following headline inflation: it's much more stable. For this reason, core inflation is the trend that we want to look at: we shouldn't extrapolate trends in headline inflation.
If you see a dog walking down the street, wagging its tail, there are a few things you can conclude. First: the tail will never get very far from the dog; second: the tail will follow the dog. If you want to know where the tail is going, you should not extrapolate the direction of the tail, you should extrapolate the direction of the dog.
How Long Can the Expansion Last? What is Full Employment? When Will We Get There?
The unemployment rate has been falling at roughly one percentage point per year. At this rate, it will be below 5% by the end of 2015.
How low can it go?
How can a business grow if to can't hire additional employees? How can an economy?
A classic wage-price spiral is triggered when a tight labor market put upward pressure on wages while full employment and rising wages boost aggregate demand. We saw clearly it in 1968-71 and at the end of the 1990s.
While this hasn't happened yet, the economy hasn't hit full employment yet. There's no reason to assume that it will be different the next time the demand for labor outstrips the supply.
It's important to understand that inflation is not dead...it's just dormant.
When unemployment is high, labor doesn't have much bargaining power (it isn't scarce) and inflation pressures remain subdued.
As the unemployment rate comes down and labor regains bargaining power, wages will rise.
Inflation happens in good times - it's a cyclical phenomenon.
Analogy: you probably don't need to put gas in the snow blower in July, but you shouldn't sell your snow blower just because it's summer.
A Rising Quit Rate Suggests Diminishing Labor Market Slack
There may be 50 ways to leave your lover, but there are really only four ways to leave your job: die, retire, be involuntarily terminated (in which case you qualify for unemployment insurance), or quit.
In a recession, the quit rate tends to fall for three reasons:
Businesses aren't hiring
Employed people are loathe to give up a safe job. The grass may look greener, but...
Unemployed but competent people are available...usually at lower wages than workers who have to be lured out of their current job.
The rate at which people voluntarily QUIT their jobs is rising. That's important because people generally don't quit their jobs unless they have something better lined up.
One signal that the economy is beginning to overheat will be when the Quit rate becomes elevated....because when people quit their jobs, it's usually to take a different job that pays more. That, in turn, is a signal that there's less "slack" in labor markets and employers are having to "pay up" to add workers...a signal that rising labor costs (and the wage-price spiral) are putting upward pressure on inflation.
When a pot boils, little bubbles come up the edges before the big bubbles come up in the center. Quits are little bubbles...and they're rising faster and faster.
Monetary Policy Outlook
U.S. Monetary Policy Remains Very Accommodative The fed funds rate will probably remain below inflation for several more years
U.S. monetary policy has been very accommodative.
Think of the Fed Funds Rate as the Federal Reserve Board's gas pedal and brake pedal for the US economy.
When interest rates are above inflation, the incentive is to defer purchases until the last minute
When interest rates are below inflation, the incentive is to make purchases as soon as possible
High real interest rates tend to push demand from the present into the future, slowing the economy
Low real interest rates tend to pull demand from the future to the present, accelerating the economy
With inflation still moderate, and the Fed Funds Rate near zero, inflation-adjusted interest rates remain negative, which is a very powerful tailwind for the economy...and the Fed's foot won't be touching the brake pedal until the Fed Funds rate is above the inflation rate.
Nominal and Real Treasury Yields Are Still Near Historic Lows
Last year, with the 10-year Treasury below 2%, I wrote:
It's not a bond bubble, although bonds are very expensive.
How do you define "bubble? I'd define it as taking the risk of losing half your investment quickly and having no reasonable prospect of getting the money back
Paying 100X earnings for a dot-com
Using high leverage to buy a house at the top of the market
Treasury bonds will mature at par...and the government won't default
Still, Treasury bonds are extremely expensive relative to other financial assets (and maybe hard assets as well).
That is still the case. Bond yields are offer minimal yield above current inflation...and offer little compensation for the risk of higher inflation down the road.
U.S. TIPS Yields Remain Below Historical Average Levels
Investors seeking some protection from inflation as well as default often consider TIPS - treasury inflation protected securities, whose par value adjusts according to inflation.
The question is: do TIPS offer an attractive after-inflation yield?
Over the long term (the last 90 years or so) long-term bonds have returned something like inflation +2%.
When TIPs yields fell into negative territory in 2011-2013, we interpreted it as a sign that fear was dominating investor sentiment - that TIPs were very overpriced.
TIPS yields have risen since then, but remain quite low.
U.S. Treasury Yield Curve
The Fed Funds rate has been pegged at virtually zero for years...so movement in the yield curve has mostly consisted of rising and falling long bond yields.
This is what people have become accustomed to...but it is not the normal behavior of the yield curve.
Normally the 30-year rate is relatively stable and short rates relatively volatile. Long-bond investors know that there will be multiple recessions and expansions and periods of Fed tightening and easing over the next thirty years.
The Fed funds rate is normally volatile, since it's the traditional rate the fed has manipulated.
Treasury Yield Curves in Previous Fed Tightening Cycles Beware the belly of the curve
Note that long bond yields have tend to be relatively stable even when the Fed is raising rates; they can outperform intermediate-term bonds despite their longer durations.
Short-dated bonds, on the other hand, have always seen their yields rise when the Fed raises rates. There is no reason to expect it to be different this time.
Corporate Earnings are Strong, but Growth has Paused/Stalled The energy sector and FX effects are the largest detractors
Corporate earnings growth has slowed in recent quarters for three reasons.
As slack in the labor force has been worked off, labor had become less plentiful...and the cost of something rises when it becomes scarce.
The rising dollar hurts profits in two ways.
Companies (I use Coca Cola as an example) that generate sales and profits outside the U.S. by producing and selling products outside the U.S. (e.g. not exporting) see downward pressure on their earnings when their Yen/Peso/Euro earnings are translated back into US$...but it doesn't cause job losses in the U.S.
Companies that export (e.g. Boeing) and domestic companies that compete with imported goods (e.g. California winemakers) find themselves at a a competitive disadvantage with foreign manufacturers (e.g. Airbus and French winemakers). This can cause job losses as well as profit pressures.
Pioneer's focus is more on bottom-up security selection than on predicting aggregate corporate profits...but we don't disagree with the "consensus view" that we will see continuing modest profit growth.
Equity Valuations, While not Cheap in Absolute Terms, Remain Attractive Relative to Bonds
The so-called "Fed Model" suggests that equities are very cheap relative to government and corporate bonds.
On a trailing 12-month basis (and remember, earnings are growing), the P/E ratio of the S&P 500 is somewhere around 16-20 times trailing earnings.
If you invert the P/E ratio, so it's E/P, it's earnings yield
The current earnings yield of the S&P 500 is therefore something like 5-6%, compared to roughly 2% for treasury bonds.
Alternatively you could argue that the P/E ratio for government bonds is 50 times.
It's hard to make a strong case that stocks are expensive here... unless the economy goes into a recession, or unless you forecast that the government will try to balance the budget by taxing away all those profits.
A "square root recovery" scenario is also good for corporate bonds, since economic growth should help keep defaults lower than the yield spread between treasuries and corporates.
A square root recovery is not a terrible thing for treasuries: inflation and interest rates should stay low.
With that said, this model has never been a good short-term market timing or tactical asset allocation tool...it only really adds value over long time horizons.
Compare, for example, where we are today with where we were fifteen years ago...the model then said stocks were expensive and bonds were cheap. Over the next 10 years, stocks underperformed bonds. Now it says treasuries are expensive and stocks are cheap...if you're a long-term investor.
The "Misery" Index is at a 55-Year Low Both unemployment and inflation are low
In the 1970s, the "Misery Index" became popular...put simply, it was just the sum of the inflation rate and the unemployment rate.
It hasn't been this low since Eisenhower was president.
Investment Suitability Is Important
Sudden swings in the markets are always to be expected. Staying diversified is always important, as is paying attention to asset allocation. As always, we encourage investors to work closely with their financial advisors to find the mix of stocks, bonds and money market assets that is appropriate for their risk tolerance, time horizon, and investment objective.