Wednesday, April 19, 2017

Driving in the Slow Lane

Following the latest reports on housing starts (down 6.8% m/m during March) and manufacturing output (down 0.4% last month), the Atlanta Fed’s GDPNow model showed an increase of just 0.5% (saar) in Q1’s real GDP. As I noted recently, the auto industry is a major soft patch in the economy. Sure enough, auto output fell 3.6% during March. Auto assemblies are down 7.3% over the past five months to 11.1 million units (saar) from last year’s peak of 12.0mu. The weather can be blamed for the drop in housing starts, but not for the weakness in auto sales and production.

There are other soft patches in the economy. For example, the ATA Truck Tonnage Index dipped 1.0% m/m in March, and is up by only 0.7% y/y. In other words, it has stalled at a record high over the past year. Sales of medium-weight and heavy trucks dropped 8.0% m/m in March and 19.0% y/y.

So it comes as no surprise that the Citigroup Economic Surprise Index (CESI) has plunged from a recent high of 57.9 on March 15 to 6.6 on Tuesday. These developments are likely to put pressure on the Fed to hold off on another rate hike for now, and on the Trump administration to move forward with its fiscal stimulus agenda. Treasury Security Steve Mnuchin said on Monday that tax reform might not happen until after the summer. I think the weakness in the economy will prompt a faster response by Washington.

By the way, there is a reasonably good fit between the CESI and the 13-week change in the US Treasury 10-year bond yield. The actual yield has dropped from a recent peak of 2.62% on March 13 to 2.17% yesterday. It seems to be heading toward the bottom end of my predicted trading range of 2.00%-2.50% for the first half of this year.

Wednesday, April 12, 2017

Back to Slower, Longer Economic Growth?

In my meetings with some of our accounts recently, many were skeptical that the strength in the soft data in the US will trickle down to the hard data until the Trump administration actually succeeds in cutting taxes and in boosting infrastructure spending. The soft data consist mostly of surveys of consumers, CEOs, purchasing managers, small business owners, industry analysts, and investors. They all turned remarkably upbeat after Election Day, as I have been monitoring in our new Animal Spirits chart publication.

On the other hand, a few hard-data indicators are downright downbeat. Auto sales totaled 16.6 million units (saar) during March, down from a recent high of 18.4 million units at the end of last year. Payrolls in general merchandise stores have dropped 89,300 over the past five months through March as a result of widespread store closings due to competition from Amazon. Then again, employment in construction, manufacturing, and natural resources rose 175,000 during the first three months of this year. The sum of commercial and industrial bank loans and nonfinancial commercial paper has been flat since the start of the year.

A bigger question is whether there has been a structural decline in the potential growth of the economy that may defy both the animal spirits that seem to have been unleashed by Trump’s election as well as his “Make America Great Again” (MAGA) fiscal policies, assuming they get fully implemented. If so, then the long-term trend of growth for both the real economy and corporate earnings may be lower than in the past. The good news in this scenario is that it might mean that a boom is less likely, which obviously would reduce the risk of a bust.

While much has changed since Election Day, some things have not. Demography hasn’t changed. Neither has technology. Globalization might change, but for now the world remains very competitive as a result of relatively free (though not necessarily fair) trade. Productivity growth remains abysmal, and might improve as a result of MAGA policies, or might not. Consider the following:

(1) Potential output. The Congressional Budget Office (CBO) calculates a quarterly series for potential real GDP growth that starts in 1952 and is available through 2027. The outlook for this year and beyond is based on demographic projections used to estimate labor force growth and assumptions about productivity. From 1952 through 2001, potential real GDP grew in a range mostly between 2.5% and 4.0%, averaging 3.5%. Since then, growth has consistently been below 3.0%, and actually below 2.0% since Q1-2007.

(2) Real GDP. I constructed a series for the underlying growth in real GDP simply as the 40-quarter percent change in real GDP annualized. It tells more or less the same story as the CBO’s estimate for potential output. From 1960 through 1975, growth averaged 4.7%. From 1975 through 2007, it averaged 3.7%. It plunged during the Great Recession, and has remained consistently below 2.0% since Q3-2009.

(3) Labor force. Trump may or may not succeed with his MAGA plans. However, he certainly can’t Make America Young Again (MAYA). He can’t bring back the Baby Boom. There has been a dramatic slowing in the growth of the working-age population and the labor force, particularly of the 16- to 64-year-olds. The actual growth rates of this age segment of the working-age population and the labor force are down to only 0.5% and 0.3% over the past 10 years at annual rates.

(4) Productivity. The big unknown is whether Trump’s MAGA policies can revive productivity growth. That’s the only way that real GDP growth might finally exceed 2.0%. Getting it up to Trump’s 4.0% goal seems very unlikely. Nonfarm productivity growth has been below 1.0% since Q4-2014, based on the five-year percent change at an annual rate. Surprisingly, manufacturing has contributed greatly to this weakness, also rising less than 1.0% since Q4-2015.

Wednesday, April 5, 2017

Bull by the Tail

Stock market valuation measures are elevated across the board, for sure. The forward P/E of the S&P 500 is currently 17.7. It is highly correlated with the forward price-to-sales ratio (P/S) of the same stock market index. This valuation metric closely tracks the Buffett Ratio, which is equal to the market capitalization of the entire US equity market (excluding foreign issues) divided by nominal GNP. During Q4-2016, the Buffett Ratio was 1.67, not far below the record high of 1.80 during Q3-2000. The forward P/S rose from 1.58 in early 2016 to a record high of 1.93 in March.

These all are nose-bleed levels. However, they may be justified if Trump proceeds with deregulation and succeeds in implementing tax cuts. His policies may or may not do much to boost GDP growth and S&P 500 sales (a.k.a. revenues). Nevertheless, they could certainly boost earnings.

The risk is that Trump’s victory activated a melt-up mechanism that has nothing to do with sensible assessments of the fundamentals or valuation. Instead, structural market flows may be driving the market’s animal spirits. Consider the following:

(1) Lots of corporate cash is still buying equites. At the end of last week, we updated our chart publications with Q4-2016 data for S&P 500 buybacks. They remained very high at a $541 billion annualized rate. For all of last year, buybacks totaled $536 billion, a slight decline from the previous year’s cyclical high of $572 billion. S&P 500 dividends rose to a record high of $396 billion last year. Since the start of the bull market during Q1-2009 through the end of last year, buybacks totaled $3.4 trillion, while dividends added up to $2.4 trillion. Combined, they pumped $5.7 trillion into the bull market, driving stock prices higher without much, if any, help from households, mutual funds, institutional investors, or foreign investors.

(2) Passive is the new active. On the other hand, equity ETFs have been increasingly consistent net buyers of equities during the current bull market. Their net inflows totaled a record $281 billion over the past 12 months through February. Since the start of the bull market during March 2009, their cumulative net inflows equaled $1,167 billion, well exceeding the $179 billion trickle into equity mutual funds.

So there you have it: The bull may be chasing its own tail. I know that image doesn’t quite jibe with the bull charging ahead, but work with me here. The bull has been on steroids from share buybacks by corporate managers, who have been motivated by somewhat different and more bullish valuation parameters than those that motivate institutional investors, as we have discussed many times before. Most individual investors seemingly swore that they would never return to the stock market after it crashed in 2008 and early 2009. But time heals all wounds, and suddenly some of them may have turned belatedly bullish on stocks after Election Day. Add a buying panic of equity ETFs by individual investors to corporations’ consistent buying of their own shares, and the result may very well be a melt-up.