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The Extended Cycle: The Economy's Unexpected Shift from Slowing to Growing - December 2016 Market CommentarySubmitted by Faubourg Private Wealth on December 28th, 2016
Jean Paul Lagarde
Portfolio Manager, Faubourg Private Wealth
Portfolio Manager, Faubourg Private Wealth
A fundamental shift has occurred in the market, taking place weeks before the election and aided by the enthusiasm of president-elect Trump's pro-business agenda. The duration of this economic phase transition is difficult to predict for many reasons, particularly because the Trump platform has not been completely flushed out. The ramifications of his fiscal stimulus plans, tax cuts, and proposed regulation reductions, as well as his relatively protectionist, anti-free trade posturing of which the potential negative and positive effects remain to be seen.
Prior to this phase shift, according to many data points that we monitor, the economy was clearly slowing from the cycle's peak in the first quarter of 2015. It was, at this time, that corporate profit margins peaked, and GDP measured on a year-over-year basis reached the cycle high of 3.3% growth. After peaking, corporate profit margins drifted downward, input prices including labor became more expensive, and output prices measured by the Producer Price Index (PPI) turned negative after being strongly positive for much of the cycle, up until the turn. Likewise, year-over-year GDP growth began trending down quarter after quarter, reaching a low of 1.3% in the second quarter of 2016.
Rather than continuing to slow toward zero and eventually turning negative into an economy-wide recession, which has been the historical precedent, certain data points started to indicate growth. While 2Q GDP has been the cycle low thus far, we did experience a sequential acceleration in GDP from 1Q to 2Q 2016 of 1.4%. Sequential acceleration continued from 2Q to 3Q posting growth of 3.2% quarter-to-quarter. This was enough growth to arrest and reverse the steady year-over-year declines in GDP with a surprising year-over-year GDP growth of 1.6% in 3Q. As of today, based on data points that have come in during the current quarter, our current estimate for 4Q GDP, which will not be officially released until January is 1.9% year-over-year growth, continuing the path of acceleration.
Going from slowing to growing, compounded by the Trump victory, caught the market by surprise. Until this occurred the economy was oscillating between two unfavorable conditions - growth slowing paired with inflation, and growth slowing paired with deflation. Both are negative, with the former, stagflation, being the greater evil. For much of 2016, money was flowing out of U.S. equity exposures, particularly active management, in contrast to passive or index-based management, and flowed into fixed-income. The best performing equity exposures were low-volatility asset classes, such as utilities and consumer staples, and companies with better balance sheets outperformed those with higher leverage. In 2016, we experienced a high-yield scare (debt instruments of below investment grade companies) as investors were suspect that the economy would not be able to withstand the 25-basis point increase the FED Funds rate implemented in December 2015.
Following the February 2016 market swoon, the low in GDP, the debt scare in China, the aforementioned high-yield scare, BREXIT, deflation in Europe, and periodic deflation in the U.S., central banks around the world continued to provide unprecedented amounts of liquidity into the markets through asset purchases (quantitative easing) while the U.S. central bankers, having previously implemented three rounds of their own quantitative easing, relied on dovish posturing to reduce forward-looking interest rates expectations.
With the stimulus came systematically declining interest rates for much of the world where at one point there was over $16 trillion of global debt that was negative yielding. This propelled fixed income instruments globally, and lead to yield-seeking behavior by investors who were yield-starved due to the central bank-induced low rates. Investors flocked to longer-duration and lower credit quality (high-yield) instruments in attempts to earn a livable return.
With that said, since what has thus far been the "bottom" of this cycle, rates have climbed from 1.34% to 2.5% on the U.S. 10-year treasury, inflation expectations have turned up sharply, European 10-year yields have turned positive for all countries except Switzerland who is mildly negative. Even Japan is positive which is a complete departure from what had been the case for so long.
With the rapid rise of interest rates and inflation expectations, fund flows have turned negative for fixed-income as holders who were already receiving a relatively paltry return for holding instruments with varying degrees of interest rate risk, have begun eschewing the instruments, heading into equities.
Regarding equities, what was favored before the turn, low-volatility, low-beta ("safer") equities, have been replaced with higher-beta equities with weaker balance sheets for an overall "risk-on" positioning. Financial stocks have gone from one of the worst performing sectors to the best performing sector since the election.
Fueling the fire in part has been the significant change in consumer confidence and business confidence. University of Michigan Consumer Confidence in December climbed to 98 versus 93.8 in November. The Conference Board's Consumer Confidence in November increased to 107.1 versus 98.6 in October, a new cycle high and year-to-date high. The NFIB small business survey was up 5 points, the highest level since 2014; however, the forward-looking component was up 19 points, the biggest increase since stocks turned favorable in 2009.
In addition, economic data continues to improve. The PPI (Producer Price Index), a measurement of output prices for companies, has turned positive after being negative for much of 2015 and the beginning of 2016. This is partially aided by the increase in oil prices, but after being 0% for July and August, PPI readings have increased for September, October, and November to 0.7%, 0.8%, and 1.3%, respectively. The path of PPI improvements we expect to continue into December and most likely January as crude prices remain elevated. Improving PPI positively impacts earnings and GDP.
Industrial production which turned negative in the second half of 2015, continued to be negative for much of the year culminating in a year-over-year decline of -2.32% in December 2015. Since then the declines have become less negative, with October and November being down -0.8% and -0.6%, respectively. Since year-over-year industrial production will be comparing against the low of the industrial cycle, thus easy "comps," the trend in industrial production will likely remain in the "improving" camp.
Durable goods orders for October improved 4.6% sequentially and 1.0% year-over-year which displays a measure of confidence among U.S. consumers. Durable goods orders since they are bigger ticket items are more sensitive to credit conditions and the macro environment. October data showed an increase in revolving credit (credit card) spending which is highly correlated to durable goods orders. This display of confidence, both in surveys and in spending and credit expansion, will likely propel consumer spending which is 70% of the U.S. economy. With increased confidence, comes increased credit growth, which propels durable goods and higher-cost discretionary consumption and increases total household spending.
With all that said, the market seems overly complacent. Volatility, a measure of uncertainty, is quite low, indicating that the market is very bought into the idea of economic growth and the Trump-trade.
The market's low volatility demonstrates a high vote of confidence that all will play out according to plan, and for now the data is supporting it. We do, however, believe there remains significant risks ahead in 2017 but that the market will likely continue in its upswing as long as the fundamental data remains positive, likely until early 2017 at a minimum.
This has indeed been, by many accounts, a very strange economic cycle. One that can be characterized by growth accelerating slowly, and one with growth decelerating slowly. The economic cycle's peak of 3.3% GDP growth in 1Q 2015 pales in comparison to the peaks of former cycles. The prior cycle high was 4.4% growth in 4Q 2003, and the cycle before that experienced peak growth of 5.3% in 2Q 2000. Numerous factors could play into this, including central bank intervention, the massive amount of debt written off during the financial crisis, challenging U.S. demographics with baby boomers retiring and spending less only to be replaced by younger workers who earn less and are, as a generation, less inclined to spend, favoring more experiencing and sharing - think Uber and AirBnB.
Risk lies in the fact that Mr. Trump has promised a great deal to many Americans and particularly business owners. It cannot be ignored that the low interest rates of easy monetary policy and a burdensome regulatory environment with the pinnacle being the Affordable Care Act has systematically suppressed investment and thus lowered productivity, which has been a drag on economic growth.
Following Trump's surprise election, it is logical that businesses and consumers might be more inclined to spend and invest. While we believe the positive upswing may continue for a couple of months, Trump will eventually have to deliver the goods to his constituents. The potential problem is that there are many fiscal conservatives in Congress, and it will be challenging for Mr. Trump to pass sweeping tax reform, embark on $1 trillion in fiscal infrastructure spending, while not cutting programs like Social Security or Medicaid.
With elevated debt levels and an expanding budget deficit, we believe there is risk to Trump getting his agenda passed. We are also concerned that a more protectionist stance on international trade could negatively affect various parts of the economy. Apart from budget issues, 2017 will be filled with uncertainties in China, continued weakness in the Euro Zone, a critical French Presidential election, to name a few.
Some of these risks are systemic, having been in existence for quite some time. These risks coupled with growth slowing captured investors' attention with fears of a looming recession. With the shift to domestic economic growth, investors have been more disposed to ignore these risks until some point in the future - i.e. risk procrastination.
In reality, the current economic cycle is 94 months old, making it the second longest bull market in the history of U.S. stock market, preceded only by the bull run that began in October 1990 which lasted 115 months, ending in the snarls of the technology bubble's extreme valuations that eventually burst in March of 2000. The aforementioned bull run returned investors 417% (J.P. Morgan's 4Q 2016 Guide to the Markets), while the current return, based on the S&P 500 is 235.47% as of the time of this writing (Bloomberg Data: March 9, 2009 - December 27, 2016).
While equity investors are being rewarded for the risk they bear, we urge clients to consider what has been baked into the market's expectations. Much of Trump's agenda is being considered a "done deal" or a forgone conclusion. We see risk in this stance. We also see significant risks abroad in 2017.
What remains to be seen is whether this extended cycle can last long enough to not only structurally revitalize the U.S. economy, long regarded as the cleanest shirt in the world's hamper, but also sustain long enough to cleanse the emerging markets riddled with massive debt, particularly China, and a faltering Euro Zone.
As always, our goal is to help clients stay fully invested through the market cycles by utilizing tools designed to help buffer against market declines, making the journey to financial freedom less bumpy and more confident.
All data is sourced from Bloomberg unless otherwise noted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual or institution. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Stock investing involves risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Beta measures a portfolio's volatility relative to its benchmark. A Beta greater than 1 suggests the portfolio has historically been more volatile than its benchmark. A Bata less than 1 suggests the portfolio has been less volatile than its benchmark.