Is the Soft Patch Over? (excerpt)

The soft patch may be over. The latest batch of economic indicators is certainly more upbeat than previous ones. Most importantly, I am impressed with May’s 0.6% m/m increase in our Earned Income Proxy (EIP), which is highly correlated with wages and salaries in the private sector. It’s also highly correlated with retail sales excluding gasoline, though the two series have diverged so far this year, with the latter lagging the former.

A sharp rebound in May retail sales would confirm that the soft patch is over. May auto sales did rise to 17.8 million units (saar), the highest since July 2005. We still have some concerns that rapidly rising tenant rent and out-of-pocket health care costs may be offsetting some of the positive impact of our rising EIP. May’s retail sales will be reported this Thursday. An upbeat housing-related indicator was April’s Pending Home Sales Index, which rose to the highest level since May 2006. It tends to be a good leading indicator for existing home sales.

And, of course, there was plenty of good news in Friday’s employment report. Most impressively, full-time household employment rose by 630,000 during May, having risen 2.6 million over the past 12 months. While wage gains remain relatively subdued around 2% on a y/y basis, the latest three-month changes are mostly around 3%, on average, at an annual rate.

Today's Morning Briefing: Peter Pan. (1) By the shores of Lake Winnipesaukee. (2) Seven strategists and economists with seven opinions. (3) Consensus vs. contrary scenarios. (4) Kuroda says we can fly if we believe we can. (5) Japanese inflation close to zero again despite all the pixie dust. (6) Draghi plays Captain Hook. (7) Less deflation, more growth in Eurozone. (8) Dudley: On your mark, get set, wait. (9) Fed policy is market dependent too. (10) Is the US soft patch over? (More for subscribers.)

Has Profits' Share of National Income Peaked? (excerpt)

Profits’ share of national income is very volatile over the business cycle because it reflects the volatility of its two determinants that also fluctuate with the business cycle, namely revenues and the profit margin. The latter is the more volatile of the two and is highly correlated with profits’ share of national income. It has the same cyclical pattern as profits’ share of national income. They both rise rapidly during recoveries and expansions when revenues tend to rise faster than costs, which boosts the profit margin. They both tend to peak and fall near the tail end of expansions when costs, including payrolls and capital spending, start to outpace revenues. During recessions, profits plunge on an absolute and relative basis as revenues fall faster than costs, which also depresses profit margins.

The jury is still out on whether the profit margin has peaked, having risen to a record high of 10.4% during Q1 for the S&P 500. That will depend on whether companies will raise wages as they continue to expand their payrolls. It will also depend on whether the pace of capital spending picks up. So far, there’s not much evidence that these costs are taking off.

However, the profit margin can also get squeezed if revenues growth slows, which does seem to be happening. That’s because global economic growth is lackluster. Yesterday, the Organization for Economic Cooperation and Development lowered its forecast for world economic growth to 3.1% this year and 3.8% in 2016, down from its prediction six months ago of 3.6% and 3.9% growth, respectively. Furthermore, revenues growth has been hard hit by the drop in oil prices and the strength in the foreign exchange value of the dollar since last summer.

Today's Morning Briefing: What’s the Trend in Profits? (1) Why profits can’t grow faster (or slower) than GDP. (2) Profits’ share of national income may be peaking. (3) Profits are very pro-cyclical because so are revenues and profit margins. (4) Record high for S&P 500 profit margin. Can it go higher? (5) Two ways to squeeze margins: Higher costs vs. lower revenues. (6) The OECD cuts its estimate for world growth. (7) Profits cycle driving the business cycle. (8) Using the value of world exports as a proxy for global GDP. (9) Beware of false slowdown in world economic indicators measured in dollars. (10) Is 5% rather than 7% the new normal? (More for subscribers.)

China Remains Epicenter of Global Deflation (excerpt)

Monday’s WSJ included an article titled “Glut of Chinese Goods Pinches Global Economy.” The main point is that “China’s excess manufacturing capacity and slowing growth rate are … putting renewed downward pressure on prices.” I have been expounding on this theme for quite some time, so I obviously think the article is worth reading.

When China’s economy was booming, so did its demand for commodities. The result was the commodity super-cycle, which started in late 2001 after China joined the World Trade Organization on December 11 of that year. The super-cycle was briefly interrupted by the financial crisis of 2008. However, the Chinese government responded to it with a major fiscal stimulus program while the PBOC pumped lots of credit into the economy. Other governments and central banks did the same, but the Chinese led the way.

As a result, commodity prices soared again in 2009 through 2010. However, China’s factories turned expensive commodities into lots of cheap manufactured goods thanks to the availability of cheap labor. In other words, the trend in the so-called “China Price” was disinflationary, if not deflationary for the world economy. For the seven countries that report their CPIs by goods and services, durable goods prices have been falling steadily since the start of 2001: Eurozone (-1.7%), US (-12.5), UK (-13.7), Sweden (-21.6), Taiwan (-22.3), Switzerland (-23.9), and Japan (-43.7).

But China’s economic growth peaked during 2010, and labor costs started rising. The commodity super-cycle wasn’t so super, lasting just 10 years rather than 25-50 years. The subsequent drop in commodity prices since 2010 depressed commodity producers. Nevertheless, the China Price continues to fall as Chinese factories replace labor with automation. The 5/5 South China Morning Post included an article titled, “Building work starts on first all-robot manufacturing plant in China’s Dongguan.” A total of 1,000 robots will be installed at the factory, run by Shenzhen Everwin Precision Technology Co, with the aim of reducing the current workforce of 1,800 by 90% to only about 200.

To avert large-scale unemployment, the government continues to provide fiscal and monetary stimulus, which only worsens the excess capacity problem in manufacturing.

The WSJ article cited above reports, “Prices of all goods imported to the U.S. directly from China have fallen in 20 of the past 38 months, by 2.2% in all. For U.S. consumers, that is good news. But for policy makers and corporate executives, declining prices present a real challenge. The declines can sap profitability, deter investment and block wage growth, all of which are needed to help the world break out of its years of underwhelming growth.”

The article notes, as I have on a regular basis, that China’s PPI has declined on a y/y basis for 38 consecutive months. The PBOC has responded by easing credit conditions, which is likely to boost excess capacity by keeping “zombie” companies in business and by spurring even more capacity expansion.

Today's Morning Briefing: Blaming China. (1) No shortage of gluts thanks to China. (2) The epicenter of deflation. (3) Not so super super-cycle. (4) “China Price” remains deflationary as robots replace humans. (5) Deal or no deal? (6) Lots of big deals in healthcare, IT, and telecom. (7) Fed financing M&A mega-boom. (8) The fastest and easiest way to grow. (9) Challenging time for active managers. (10) Dividend-yielding stocks underperforming. (11) Focus on market-weight-rated S&P 500 auto-related industries. (More for subscribers.)

Sorting Out the Statistical Discrepancy in GDP (excerpt)

The US economy may not be booming, but it certainly isn’t doing as badly as suggested by the 0.7% (saar) drop in real GDP during Q1. By now, everyone is aware of the “residual seasonality” problem that has been weighing on Q1 growth rates. That includes the Bureau of Economic Analysis, which announced in a 5/22 blog post that it should fix the problem by the end of July.

Recently, I’ve noted that the problem can be overcome by simply calculating that real GDP rose 2.7% during Q1 on a y/y basis. This automatically eliminates the seasonal adjustment problem and shows that the economy continues to grow at a slow but steady pace. Real nonfarm business output, which excludes government spending, rose 3.5% y/y during Q1.

Furthermore, national income rose faster than GDP during Q1. In theory, these two should be identical. In practice, there is a statistical discrepancy, which rose to a record high of $328 billion (saar) during Q1. In other words, the economy looks better when the BEA adds up all the incomes than when it adds up all the demand data that are used to calculate national output.

Today's Morning Briefing: Neither Boom Nor Bust. (1) Jury is out. (2) Supply-side and demand-side perspectives on slowdown. (3) National and regional business surveys diverged in May. (4) Not much spring in consumer spending. (5) Meet the HENRYs, or high earners not rich yet. (6) Rising rents and health care costs squeezing consumers. (7) Meet the BBADs, or older Baby Boomers with adult dependents. (8) Building lots of new factories, or just a Gigafactory? (9) Record discrepancy between GDP and National Income. (10) Bond market’s latest economic assessment. (11) Lots of mixed PMIs in Asia and Europe. (More for subscribers.)

The Trend in Profits (excerpt)

The growth trend of corporate profits is determined by the growth trend of nominal GDP. My analysis shows that the trend of these variables has been 7% since 1960. Profits growth is much weaker during recessions and much faster during recoveries, but 7% has been the magic number for the trend. That seems to be the best we can expect in the coming years until the next recession. Given that valuation multiples are at their historical highs, 7% may also be the best we can expect in terms of annual capital gains in the stock market for the duration of the current bull market. That’s quite good compared to the bond yield and the inflation rate, which are both historically low.

On a cyclical basis, there is a strong correlation between the y/y growth rates of nominal GDP and S&P 500 revenues in aggregate. The correlation is even better with nominal GDP for goods. The two series do diverge often on a short-term basis, but have the same cyclical pattern. During Q1, revenues fell 2.5% y/y, while nominal GDP with and without services rose 3.6%. The recent plunge in oil prices had a bigger impact on S&P 500 revenues than on nominal GDP.

Over the past four and a half years, nominal GDP has been growing just under 5%, so it’s possible that this may be the new magic number for the trend growth in GDP, and therefore in profits. While there has been some recent chatter about the depressing impact of seasonal adjustment factors on Q1 real GDP, that distortion is eliminated simply by tracking the y/y growth rate, which has been relatively stable around 2.5% since mid-2010. In fact, while real GDP fell 0.7% (saar) during Q1, it was up 2.7% y/y! Meanwhile, inflation continues to decelerate in the GDP accounts. The GDP price deflator was up just 0.9% y/y during Q1, with the core rate also low at 1.1%. Again, put these trends together, and nominal GDP is growing below 5% rather than close to 7%.

Today's Morning Briefing: Probing Profits. (1) Profits measures: Take your pick. (2) We pick forward earnings. (3) Is the 7% trend still our friend for profits growth, or might it be 5%? (4) How much longer can profit margins break records? (5) Cash flow stalled at record high. (6) The government should fill potholes. (7) Assessing the soft patch in the oil patch. (8) Regional surveys add up to weak May. (9) Frightful freight index. (10) Signs of life in Eurozone’s corporate earnings. (More for subscribers.)