Without a press conference with this Fed Meeting, TD Ameritrade turned to Tematica Chief Macro Strategist Lenore Hawkins for some insights into what we might see with regards to interest rate hikes. Click below to watch the video:
Friday’s GDP report saw stronger growth than was expected, coming in at 2.3% versus expectations for 2.0%, but below the 2.9% rate from the prior quarter. Growth has now slowed from a 3.2% rate in the third quarter to 2.9% in the fourth and 2.3% in first quarter – not seeing the acceleration, are we? The biggest drag on GDP growth this quarter came from Personal Consumption Expenditures, which slowed to just 0.73%, the slowest rate since Q2 2012. This decline came from the goods purchased category – mainly durable goods, especially automobiles and in the non-durable category – clothing and shoes. This rather dramatic decline is likely a function of two things: first the rising ratio of consumer debt to disposable income and second, the base-effects of the forced spending in Q4 due to the damage caused by the twin hurricanes in the east and fires in the west.
The biggest contributor to growth came from Gross Domestic Investment, which was primarily from non-residential construction and an increase in non-farm inventories. The spike in non-residential construction was to be expected given the damage from the hurricanes and fires.
On the other hand, government investment in fixed asset investment (infrastructure) is at historical lows. The chart below, from Topdown Charts, illustrates this quite clearly.
“The points to note on US government investment and long-term GDP growth trends are: -US government fixed asset investment remains around record lows as a percentage of GDP.-The decline in government investment seems to mirror the long-term decline in US economic growth.-More recently the decline in long-term GDP growth rates looks to have bottomed, and this lines up with the bottom in US government bond yields.-Private investor interest in infrastructure assets appears to be growing, which is important given the decline in government investment spending.”
As we discuss regularly here at Tematica, the growth of an economy is a function of just two things:
- Growth in the Labor Pool
- Growth in Productivity
Crumbling highways, bridges, and roads and outdated airports (just to name a few) reduce productivity and increase costs. For more robust economic growth, these investments – be they through tax and debt-funded public coffers, or the private sector – must be made to keep America competitive.
As Topdown Charts points out, this is an area to which investors ought to pay attention –
“Thinking about trends in US government fixed asset investment, and the need for infrastructure upgrades and modernization, and what was an initial false start for an infrastructure spending plan (which now seems likely to be tabled for serious discussion after the US mid-term elections later this year), it’s interesting to note the rise in popularity of infrastructure ETFs.”
While U.S. Consumer credit increased less than expected in January, we are concerned with what we are seeing in consumer loans and debt in general across the world.
With our Cash-Strapped Consumer investing theme, the average amount financed and the duration of new auto loans continues to rise – same car, bigger loan and for longer means a more highly leveraged car owner.
We also see warnings sign with credit card debt as our Cash-Strapped Consumers struggle to make ends meet. At small banks, the share of outstanding card balances written off as a loss after consumers failed to pay hit 7.2% in the fourth quarter of 2017, up from 4.5% a year ago, according to Federal Reserve data. While overall card losses across all banks remain below the historical average of the last 30 years, they’ve been slowly climbing in the last two years. We believe these smaller banks are canaries in the coal mine as the average charge-off rate at those smaller banks is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010.
If an effort to compete with the large and increasingly larger banks, some smaller banks have taken to lowering lending standards, which means their credit cards are held by those that are first to feel economic angst. The subprime borrower is always the first to get hit when the economy weakens. For years, wage growth has been slower than the growth in expenditures, forcing many families to take on credit card debt just to pay for necessities. The rising charge-off rates indicate that these folks are in a perilous economic condition if wage growth doesn’t accelerate sufficiently and soon.
Education debt swelled to nearly $1.38 trillion at the end of 2017, with 11% of borrowers 90 days or more delinquent, according to the New York Fed. The U.S. federal government now owns over 30% of total consumer debt in the U.S., thanks to its utter dominance of the enormous student loan industry. Prior to the financial crisis, that number was less than 5%. Think about what that means concerning the reduced firepower of the federal government in the case of another financial crisis.
This area of lending reminds us of the dynamics in the housing market that led to the subprime mortgage disaster. The problem in subprime was that too many players had no real skin in the game. Thanks to various legislative acts, the banks issuing mortgages were incentivized to immediately turn around and sell them to Fannie Mae or Freddie Mac – particularly the subprime loans. This meant the issuing bank had no real interest in the quality of the loan.
With student loans, the student or prospective student has little ability to estimate the relative earnings advantage potential for any particular education. The seller of the education, the college or university, is financially indifferent as to whether the student will ever be able to pay off the loans and with the way student loans work, has no incentive to tie the cost of tuition to the improvement in future earnings it provides through its curriculum. This creates an entirely new generation of Cash-Strapped Consumers that start off their young lives already saddled with brutal debt levels, which often postpones the traditional cycle of car and home purchases as well as starting a family.
Emerging Market Debt
It isn’t just domestic debt that has us concerned. Another area of concern that we are watching has been in emerging market debt which has helped generate the Rise of the Middle Class investing theme in these economies. The 26 largest emerging markets monitored by the Institute of International Finance have seen their sovereign debt load rise from 148% at the end of 2008 to 211% of GDP at the end of the third quarter of 2017. Couple that with the pricing perversions driven by investors’ search for yield that have the 10-year Kenyan bond trading at 7.5% and the Dominican Republic 30-year at 6.5% while the 10-year and 30-year U.S. Treasury bonds trade at 2.87% and 3.15% respectively. Really? Not a whole lot of risk premium priced in there.
Then there is the incredible size of China’s financial system. As of the end of last year, assets in Chinese commercial banks were approximately $40 trillion, which is around 51% of global GDP. The highest the U.S. every reached was 32% of global GDP in 1985 and Japan at 27% in 1994. For additional perspective, at the end of last year, in the United States, that number was $17.4 trillion versus U.S. GDP of $19.4 trillion while China’s GDP is around $13.1 trillion. This is wholly unprecedented in the history of global finance.
Let’s not forget that over the weekend China removed term limits for Xi Jinping, allowing him to possibly rule for life. History tells us that a nation, controlled by a single leader, who is no longer bound by any sort of accountability thanks to his/her ability to rule for life, rarely experiences increasing individual freedoms, increased open trade and responsible debt management – yet another geopolitical concern to add to the pile.
The bottom line is the world has been awash in a whole heck of a lot of liquidity thanks to the concerted efforts of the world’s major central bankers. The intention was to suppress interest rates, thus induce borrowing. Well, it worked. The secondary effect, which was also intentional, was to inflate assets prices so as to induce the so-called wealth effect.
Done! Thanks to stock prices rising at a much faster rate than the economy, household wealth as a percentage of disposable income has reached a new record high.
The Federal Reserve is now attempting to increase interest rates and take away that liquidity and asset-price-inflating punchbowl without any major disruptions. The European Central Bank may join in here soon too as all are concerning that this post-financial crisis party may shift into inflation-mode, which no one wants. This too is wholly unprecedented in human history. While the mainstream financial media is all about the Goldilocks outcome, we remain skeptical and wary of highly leverage assets or those whose risks are significantly underpriced.
The results of the election last weekend in Italy continue the international trend of angry and frustrated voters dumping those in power, desperately seeking some way to improve their conditions. While many continue to trumpet an improving global economy, and there are some improvements to be sure, many nations have not yet recovered from the damage of the financial crisis. The Brexit vote, Trump vote, weakened Angela Merkel in Germany and this weekend’s vote in Italy are all signs that voters in those nations want to see significant changes. Voters don’t do that when they are satisfied with their pocketbooks today and opportunities for tomorrow.
Sunday, March 4th Italians headed to the polls amidst and economic backdrop that has become increasingly frustrating. Economic growth in the nation has been weaker than many other European Area Nations.
Even more telling is the weakening trend in per capita GDP.
Italy’s unemployment rate remains well above historical norms and well above that of Germany.
Youth unemployment has been even more grim, peaking at 43.40 in March 2014 after having been as low as 19.40% in 2007. This high level of youth unemployment has meant that the best and the brightest are much more likely to leave the struggling nation than to stay and fight an uphill battle.
Wage growth (year-over-year) has been weakening for decades but has been sitting at record lows post-financial crisis, below 2% since 2011 and below 1% since 2016.
The bottom line is while the markets have been priced for sunshine and roses, we continue to see voters around the world frustrated with weak economies, poor wage growth and the lack of opportunities to improve their circumstances. While the 2017 markets may have been a bit like watching a sunny summer afternoon PGA tournament, 2018 looks to be more like the latest reality TV drama.
This week the markets shrugged off last week’s fears and went back to the slow and steady melt up, despite economic news that looked likely to once again rock the boat. By Thursday’s close, the S&P 500 had gained 5.8% from the prior Friday’s open, putting it and the rest of the major market indices back in the green for 2018. While next week will be a lite one on the economic data side, it will contain a few data pieces that we’ll be watching to gauge the vector and velocity of the global economy and inflation. Those results will tell us if we’re in for more weeks like this one or the prior one when it comes to the stock market.
Now let’s recap this week’s happenings and share my observations on it all…
Monday the S&P 500 soared 1.4% in the first half hour of trading only to then drop 1.3% from that high, then back up again to close up 1.4%. Tuesday and Wednesday were both basically days of further upward movement for the market. Thursday there was a slight wobble at the open — falling -0.3% in the second hour of trading — but then moved back up again to close up 1.2%. Having briefly dipped below its 200-day moving average last week, the S&P 500 closed Thursday all the way back up above its 50-day moving average and down just 4.9% from the January 26 all-time high, retracing roughly half of the decline from the January 26th peak.
Investors appear to still be rather skeptical when we look at fund flows. For the 8 days through Tuesday, equity ETFs saw the largest outflows of the past 5 years when converted to a monthly rate. Then again… Monday inflows were the largest year-to-date so perhaps after the Xanax and Zantac kicked in over the weekend, folks were feeling better. Perhaps some of the concerns are coming from the record high 24% of investors surveyed in the BofA Merrill Lunch Global Fund Manager Survey who think corporate balance sheets are overleveraged – problematic with rates rising as bonds need to be rolled over at a higher rate, leading to higher interest costs that weigh on earnings. That brings us to fixed income ETFs, which are still not feeling the love, having seen positive inflow days only 8 times this year as of Tuesday and have hit new cumulative outflow lows.
Looking at sector performance, since the opening on Friday 9th, the technology sector has gained an incredible 8.5% and financials rose 6.9% and we’ve seen a sharp rebound in the Connected Society and Disruptive Technologies positions on the Tematica Investing Select List. The weakest performing sector has been energy, which gained a comparatively weak 2.4%, and isn’t surprising given the continued fall-off in oil prices as more US capacity comes on stream.
Here’s the thing, technology is still 2.8% below its all-time high, while financials are 4.5% below their highs, whilst energy is 12.5% below its all-time high – again the weakest sector in terms of recovery. The performance in financials has been related to the changes in the yield curve – something I’ve talked about on our Cocktail Investing Podcast. The decline in the spread between the 10-year and the 2-year Treasury bond since December 2016 sharply reversed course back in early January and has continued to widen. The spread between the 30-year and 5-year Treasury bond yield had been declining since November 2013 has given signs of possibly starting to widen as of the beginning of the month, but nothing definitive yet. Financials perform better with wider spreads given that they borrow short and lend long, so the wider the spread, the greater the potential profit margin.
On the economic front this week we saw a meaningful increase in consumer credit, wage growth that was weaker than the headlines indicated, CPI and PPI numbers that gave further support to a Federal Reserve that is looking increasingly more hawkish and retail sales that came in below expectations with the biggest drop in nearly a year. That’s the quick summary now for the details and my observations:
In the fourth quarter consumer debt, (excluding mortgages and other home loans), increased 5.5% year-over-year to a record high $3.8 trillion. Non-housing debts also hit a record high of 29% of the overall debt load. Roughly 5.8% of disposable income is going to keep households current on their nonmortgage debt, which is the highest percentage since the end of 2008. For context, the lowest percentage reached was 4.9% in 2012. This is a potentially worrisome sign as this type of debt is more sensitive to rising interest rates. It is worth noting that the average repayment period for new car loans has hit an all-time high of 69 months as of Q3 2017, according to data from Experian. Personal loans to consumers during 1H 2017 were 7.8% higher than 2016.
The dangers here become apparent when we look at the Real Earnings report from the Bureau of Labor Statistics, which was also released this week, and showed that for the roughly 82% of workers in the Production and Nonsupervisory category real average hourly earnings have fallen in 5 of the past 6 months. Year-over-year their average weekly earnings have grown a meager 0.2% – further support for our Cash-Strapped Consumer investing theme. You can read more about that here. Rising credit card balances combined with income that for many people has been basically unchanged in a year is a coming headwind for consumer spending and the economy even before we factor in three to maybe four Fed rate hikes this year. As for all that talk of the economy heating up, the aggregate weekly hours for this group fell dramatically in January as the chart below shows.
Aggregate Weekly Hours of Production and Nonsupervisory Employees
We are cognizant that this decline could be misleading due to the exceptionally cold weather for parts of the country in January and one month certainly doesn’t make a trend, but this is an area we will be watching in the coming months.
This week also saw inflation data that is cause for concern with the headline Consumer Price Index rising more than expected, which you can read more about here. Core CPI is now rising at the fastest 3-month pace since 2011 and the fastest six-month pace since 2008, but year-over-year core CPI is still below 2% and is little changed compared to the last few months. Taking a step back we can also see that during the summer of 2017, the 3 and 6-month rates were at the lowest levels since the last recession, so base effects are making the increase look outsized. There has been some talk about the 1.7% increase in apparel prices, which was the largest since 1990. Again, we suspect that the fact that Floridians had to go buy parkas played a role here and in the bigger picture, and the reality is that apparel prices have fallen in 3 of the past 4 months and declined or were flat in 5 of the last 7 months. As we said above, one month does not make a trend people!
The 3-month annualized median CPI is up nearly 3.2% while the 6-month annualized is up 3% and year-over-year median CPI is up 2.4%, indicating that inflation overall is on the rise. We believe that this means the Federal Reserve’s plan to hike 3 times in 2018 is (at least as of now) essentially a done deal with the probability of a fourth hike rising. The Producer Price Index came out after CPI and also pointed towards inflationary pressures.
Thursday’s report on retail sales reasonably should have given the market at least some pause, but we are back to bad-news-is-good-news and good-news-is-great-news. The Commerce Department reported that retail sales in January fell -0.3%, the biggest decline since February 2017 versus expectations for a 0.2% increase and to really rub it in, December was revised down to unchanged from a gain of 0.4%. The market ignored the disappointing numbers and kept moving on up. From our perspective, nonstore retail sales – code words for digital commerce – rose 10% year on year, still taking consumer wallet share and boding very well for the thematic investing poster child better known as Amazon (AMZN).
The bottom line for the week is equities appear to have shrugged off the concerns from earlier in the month, 3-4 Fed hikes are increasingly likely and wage growth for much of the country remains stubbornly elusive despite the tightening labor market. We believe we have a decent grasp on what is behind the wage conundrum, but that is a topic for another day. As for what to expect from the markets in the coming weeks, we suspect that we are not out of the woods and that another retest of the recent lows is likely before moving on to make new highs.
Longer term we are in store for a fascinating battle between the impact of Fed tightening and fiscal stimulus (tax reforms and increased spending) on the economy and portfolio returns. Driving with one foot on the accelerator and one on the brakes comes to mind. The coming months and year are likely to be more challenging for investors than 2017, which is all the more reason to have solid investment strategies based on long-term themes.
With U.S. equity markets closed on Monday in observance of President’s Day, the weekly Monday Morning Kickoff penned by Tematica’s Chief Investment Officer, Chris Versace, will not be published. While that may disappoint more than a few folks, Chris and I will have no shortage of commentary next week due in part to the monthly Flash PMI data to be published by IHS Markit. While we will dig into those reports to gauge the velocity of the economy, we expect the comments on input prices will be of keen focus following the January inflation reports we received this week.
Enjoy the long weekend and be sure to look for our comments at TematicaResearch.com next week.!
Holy hump day – markets look to be rockin’ and rollin’ again today after this morning’s data releases from the Bureau of Labor Statistics.
First on the dance floor is the U.S. Consumer Price Index (CPI), which rose more than expected. Headline figure increased 0.5% seasonally adjusted, over the prior month versus expectations for 0.3% increase and 2.1% over the last 12 months, not seasonally adjusted, versus expectations for an increase of 1.9%. Excluding food and energy, rose 1.8% nsa, versus expectations for 1.7%. The recent market fears that the Federal Reserve is going to get more aggressive in how quickly it takes away its loose policy punchbowl are only going to get worse after this report. Hello volatility, we didn’t think you were done with us!
Most areas saw price increases over the past year, with the exception of commodities less food and energy, declining -0.7%, new vehicles -1.2%, used cars and trucks, -0.6%, and apparel -0.7%. These declines reveal the lack of retail pricing power, even on the auto lot, reinforcing our Cash-Strapped Consumer investing theme as well as the deflationary power of our Connected Society theme whereby consumers are able to quickly compare prices without incurring any meaningful costs.
Next up is the Real Earnings Summary, also from the Bureau of Labor Statistics, which found that real average hourly earnings for all employees actually declined -0.2% from December to January, seasonally adjusted. Nominal earnings rose 0.3%, but the 0.5% increase in CPI wiped out that gain. What is even more disconcerting is that the over 80% of the population in the Production and Nonsupervisory Employees category saw their real average weekly earnings declined by 0.8% over the month thanks to both a decrease in real average hourly earnings and a 0.3% decline in average weekly hours. Year-over-year this group saw real average weekly earnings rise a meager 0.2% – again reinforcing our Cash-Strapped Consumer investing theme. Who can possibly feel better off when their weekly take home is basically the same as it was last year?
For all the talk of an accelerating economy, the over 80% of workers in the production and nonsupervisory category have now seen their real average hourly earnings decline in 5 of the past 6 months! Remember this when you read about how high Consumer Confidence has reached.
Roughly 70% of the economy is dependent on Consumer Spending. Over 80% have seen their earnings decline in 5 of the past 6 months while Consumer Credit has been rising. How much more can they spend?
It is no wonder the stock market has been having fits given we have fiscal policy stepping on the accelerator while monetary policy looks to be putting both feet squarely on the breaks. On the fiscal side, we have a roughly $1.5 trillion tax cut with an additional $300 billion spending plan which is looking to take the deficit to $1.2 trillion or about 5.4% of GDP. President Trump proposed today a $4.4 trillion budget that would widen the federal deficit to $984 billion in the next fiscal year, which begins September 30th. Analysts estimate that after tax cuts and the two-year budget deal, the deficit will be above $1 trillion next year.
On the monetary policy side, in December the market was pricing in 3 hikes during 2018 at just 30%. That’s increased to about 70%. The Federal Reserve is unwinding its massive balance sheet on top of those rate hikes, which means not only will Fed rates be higher, but the supply of bonds in the marketplace will be increasing both from the deficit spending as well as the Fed’s balance sheet unwind. The new Federal Reserve Chair Powell is giving signals that he is unlikely to provide quite the safety blanket that Chair Yellen did for asset prices.
The monetary brakes aren’t just here in the U.S. The Bank of England is set to increase rates at a less gradual pace with the European Central Bank not to far behind and shortly to be (most likely) run by a German instead of an Italian – a meaningful difference. In Japan the economy appears to have escaped deflation and is expanding, making the 10-year Japanese bond yield at zero difficult to maintain for much longer.
(Hat tip to WSJ The Daily Shot for chart below)
Add in that we’ve seen record flows into equity ETFs recently, many in the markets today have never experienced a real downturn and the market has been trained, for nearly a decade, to buy the dips as central bankers will always step in to push asset prices back up, and it is no wonder the 14-day change in the 14-day RSI was the biggest in recorded history. Volatility is coming back to play!
Well, this past week was something different as equities took it on the chin! By Friday morning every major equity index in the U.S. was on track to experience its worst week in two years as the U.S. 10-year Treasury yield moved over 2.8%, hitting the highest level we’ve seen in over four years, while the 30-year broke through 3%. The dollar made new lows during the week, dropping to December 2014 levels. The rout was also seen in the cryptocurrency world as Bitcoin, which had reached over $19,000 in December, dropped below $8,000.
The week started off on a negative tone on Monday as the S&P 500 broke its streak of 99 consecutive trading days without a 0.6% decline. Tuesday the index broke another streak, this one was a whopping 310 trading days without back-to-back declines of 0.5% or more. As of early Friday afternoon, the index was on track to end the 449 calendar day streak without dropping 3% from a closing high.
On the political front, President Trump gave his first State of the Union address and Fed Chairwoman Janet Yellen conducted her final committee meeting as the head of the Fed. The following FOMC statement, which described employment and household spending as “solid” and asserted that “market-based measures of inflation compensation have increased in recent months” combined with former chair Alan Greenspan’s “bubble” comments unnerved markets increasing the possibility for four rate hikes in 2018. With this concern, we’ve seen bond yields rise substantially not just at home, but on a global basis, with the German and Canadian 10-years hitting a multi-year high, while European investment-grand bond spreads have narrowed to the tightest level in over 10 years.
Mid-week, the ADP Employment report hinted that we might see stronger than expected payroll numbers on Friday, with a gain of 245k jobs in January versus expectations for 185k. Friday’s report from the Bureau of Labor Statistics did surprise to the upside, reporting 200k new jobs in January with the unemployment rate unchanged at 4.1%. The unemployment rate has now been below the Fed’s official NAIRU (non-accelerating inflation rate of unemployment aka full employment) for eleven consecutive months. The headline for the BLS reported looked solid, but the details paint a different picture, which you can read about here.
Thursday’s auto sales came in below expectations and were the weakest since August 2017 as the aftermath of 2017’s horrific natural disasters fades, coming in at 17.04 million units on a seasonally adjusted annual rate (SAAR) versus the expected 17.2 million and well below December’s 17.76 million. Ford, Fiat-Chrysler and Hyundai were quite weak, while Toyota, GM, Audi, Mazda and Nissan managed to put up decent numbers. Truck sales, which provide a good read on the overall health of the small business sector, slowed in January, following a blowout December that featured the fifth strongest units since 1996.Now for the perspective, despite that “blowout” December’s figure was an increase of just 1.6% on a year-over-year basis.
Manufacturing saw a slight decline in January, according to the ISM Manufacturing Index report, but came in above expectations at 59.1 versus 58.6 expected and 59.3 in December. Despite the decline, the number was the fifth highest monthly print in the current business cycle.
While many in the markets are today worried the Fed may raise rates more than was previously expected, we’d like to point out a few realities. These may or may not affect the Fed’s decisions, but in our view, they deserve some attention.
On February 1st we learned that nonfarm labor productivity in the fourth quarter actually declined -0.1% on an annual basis versus expectations for an increase of 0.7%. In addition, Q3’s increase of 3% was revised down to 2.7%. Recall that the growth of an economy is a function of the growth in the workforce and the growth in productivity. Today the 12-month moving average for the growth in the labor force is just 0.7%. Putting the two together doesn’t give an exactly robust picture and yes, a picture is indeed worth a thousand words.
The bottom line this week is richly priced equities are taking a serious punch from rising interest rates, which increase borrowing costs in an economy that is once again heavily indebted across the board. This week the Wall Street Journal reported that government borrowing in the first quarter of 2018 is set to hit the highest level since 2010 when the unemployment rate was 10% versus the 4% we have today. Here’s a quick look at the estimated federal debt issuance:
- 2017 $519 billion
- 2018 915 billion
- 2019 $1.08 trillion
- 2020 $1.128 trillion
This ballooning level of borrowing is coming at a time when the Fed is reducing its balance sheet, thus hitting the bond market from both sides – weaker demand and extra supply. Add this to record high corporate debt and ballooning consumer credit card debt and you have yourself one painful debt-fueled headwind. Odds are all of this is going to make the next round of Federal government funding talks even more fiery in D.C.
This morning we got the advanced Q4 GDP estimate, which saw the growth rate for Gross Domestic Product come in weaker than consensus estimates, a surprise to no one who regularly reads our work. Yesterday, the Atlanta Fed’s GDPNow model forecast was for 3.4% in Q4 while the Wall Street Journal survey of economists pinned the number at 2.9%. The reality was 2.6% is a solid number, but a decline from the 3.2% in Q3 and 3.1% in Q2. Overall 2017 saw the strongest growth rate since 2014, when GDP rose 2.7%.
Looking into the details here is what I found:
- The biggest driver of growth was consumption, adding 2.6% to GDP, versus adding 1.5% in Q3. Durable goods demand was quite strong, but some of that is a result of the string of brutal natural disasters which damaged/destroyed homes and autos. We also saw stronger spending on clothes and restaurants.
- Investment added just 0.6% to GDP versus 1.2% in Q3. The rate of fixed investment growth nearly tripled from Q3 but inventory dropped from adding 0.8% in Q3 to subtracting -0.7% in Q4.
- Trade was the big whopper here, removing 1.1% from GDP versus adding 0.4% in Q3. The export of goods was strong, rising to 1% in Q4 from 0.2% in Q3, but Imports detracted 2% from GDP, despite those stronger exports. The goods trade deficit made a new high, the largest since Q3 2008.
- Finally, government spending added 0.5% to GDP versus just 0.1% in Q3. The growth was at both the state/local and the federal level.
The bottom line is that growth in the fourth quarter was utterly consumer-dependent and the average consumer is financially stressed. The year over year growth in real earnings for roughly 80% of the population has been less than 1% over the past year, the personal savings rate has dropped to a decade low of 2.9%, and credit card debt has again reached record highs. Without material gains in wages, the current rate of spending growth cannot be maintained.
While the calendar has turned, the beat remains the same as the market rips higher and consumers go deeper into debt
While Mother Nature is once again having her way with part of the U.S., the Dow ripped past 25,000, the S&P 500 hit 2,700 for the first time and the Nasdaq broke 7,000 for the first time. We are in this bizarre world where three record highs in a week are yawnsville, but then again, we have to remember the S&P 500 has closed in the green for 14 consecutive months, an unprecedented record. The Dow is no slouch either, as it has crossed a new 1,000 point mark a whopping six times in the past twelve months.
While stocks make new highs, the short-term yields on Treasuries continue to climb, with the 2-year hitting a multi-year high. Longer-dated yields haven’t budged much, which has led to the spread between the 10-year Treasury and the 2-year to hit the lowest level since 2007. The same goes for the spread between the 30-year and the 10-year.
Stocks are partying like its 1999 but the 10-year Treasury and the DXY Amex U.S. dollar index are singing a very different tune with the 10-year rate having fallen rather consistently since late 2016 and the DXY near 3-year lows. The dollar has just concluded its worst annual performance in a decade! These mixed signals are meaningful.
The driving narrative for stocks as we kick off the first week of 2018 is the impact of tax reform on earnings and the overall economy. According to FedEx (FDX), the Tax Cuts and Jobs Act is estimated to increase earnings per share by $4.40 to $5.50 per diluted share for FY 2018 before adjustments. Looking at the broader market, Bank of America (BAC) boosted its 2018 EPS estimates for the entire S&P 500 by a full 10% (about $14) to $153 a share. That estimate reflects an increase of $10 from the lowering of the federal tax rate from 35% to 21% and another $3 increase from incremental buybacks induced by the tax reform.
Looking back at 2017, earnings in the U.S. improved by around 10% while stocks gained roughly 20%, so we’ve already seen some significant multiple expansion in multiples and over the last three months of last year the multiple on the S&P 500 rose to over 20x on expected 2017 earnings. On a forward basis, the market is currently trading near 18.6x expected 2018 earnings. With the impact of tax cuts already backed in, the forward multiples for the S&P 500 are already ahead of the multi-decade high of 17.5x – so we are dealing with a whole lot of optimism. Who doesn’t like to pay less, rather than more in taxes? We are all for reducing the burden, but we have to be realistic when thinking through the potential impact of these cuts.
The trailing 12-month P/E ratio for the S&P 500 is today just shy of 23, a level rarely seen over the past four decades. This level wasn’t reached once in the last bull market ending in 2007. It was consistently above 23 during the last couple of years prior to the dotcom bubble bust, so we do have room to run, but let’s be clear – we are in rather heady territory.
This week’s sentiment survey from the American Association of Individual Investors found that bullish sentiment has increased to 59.75%, which is the second highest reading for bullishness of this bull market and marks the third consecutive week with sentiment over 50%. The bears are disappearing, with bearish sentiment down to 15.6% – the only week this level was lower was back in November of 2014 when it hit 15.1%.
The overwhelming optimism pushing share prices higher appears to be indifferent to the reality of a capacity utilization rate sitting at 77.1%, well below the 80%+ level from 2005 to 2008 and the 80%-85% range in the 1990s. While it may not be popular to say, the reality of the situation is with low utilization rates, the expected bump in capital spending is likely overstated no matter how much capital is freed up by tax reform.
Corporate America today is already flush with a historically high level of $2.4 trillion in liquid assets. Realistically, just what will be the marginal impact of that extra cash generated by tax reform? This was a topic we discussed at length on our Cocktail Investing podcast this week.
We aren’t alone in our thinking as this week’s release of the December Federal Open Market Committee (FOMC) policy meeting notes reveals that, (emphasis mine) “Many participants judged that the proposed changes in business taxes, if enacted, would likely provide a modest boost to capital spending, although the magnitude of the effects was uncertain…. However, some business contacts and respondents to business surveys suggested that firms were cautious about expanding capital spending in response to the proposed tax changes or noted that the increase in cash flow that would result from corporate tax cuts was more likely to be used for mergers and acquisitions or for debt reduction and stock buybacks.” This helps explain the Fed’s arguably muted GDP forecasts bumps for 2018 and 2019, and let’s remember the Fed tend to be cheerleaders for this kind of thing.
Speaking of the Federal Reserve, let us not forget that the Fed is expected to unwind about $420 billion of monetary stimulus in 2018 and another $600 billion in 2019. This means that by the end of 2018, about two-thirds of QE1 will have been siphoned out of the punchbowl. Obviously, those chosen to serve on the Fed aren’t exactly uneducated fools, but this is the most inexperienced Fed in decades with a decidedly hawkish bent. There are an unprecedented 4 of the 7 FOMC seats vacant, which means only 3 will have been around during the various rounds of quantitative easing.
The wild optimism has also had some rather interesting effects on asset classes, (a hat tip to David Rosenberg of Gluskin Sheff for calling this one out). The U.S. Utility ETF (XLU) is lost about 9.8% from its mid-November levels while the S&P 500 has gained 6.3%, leaving XLU with a 16.1% relative underperforming even as new record temperature lows are gripping much of the country causing energy prices to soar. The last time we saw this was in 2015, right before the mid-year correction. Prior to that was in 1999/2000 and many of us recall how things went after that.
On the economic front, this has been a great week with an ISM manufacturing report that was rock solid with 16 of the 18 industries on the rise versus 14 back in December. New Orders hit their best level since January 2004 with production rising to its highest point since May 2010 and the aforementioned weak dollar boosted exports to 58.5 from 56.
Jobless claims rose for the third consecutive week, up 250k from last week’s 247k and 10k above expectations. Claims remain low by historical standards, but we are above the cycle low from last November.
Auto sales came in better than expected at the end of 2017, as did Personal Consumptions, rising 4.5% year-over-year. But those auto sales included dealer incentives amounting to over 11% of the list priced, versus the historical norm of 7%. That holiday spending came at a price with the average American accumulating an average of over $1,000 in debt, about 5% more than last year according to MagnifyMoney’s annual post-holiday survey. That debt was primarily added to high-interest rate credit cards. Spending may be up, but wage growth remains elusive for most, the savings rate is at decade lows and with home prices rising roughly 2 times faster than income levels, home sweet home is becoming further out of reach for many. As we joked on this week’s podcast, before too long we could very well see housing land in our Affordable Luxury investing theme.
The bottom line is the economic data isn’t showing signs of rolling over, but the markets have priced in a whole lot of perfection while the consumer is giving very classic late cycle signals, which we described and discussed in this week’s podcast. We don’t see any immediate signs that market direction is likely to shift, but with volatility remaining incredibly low, portfolio protection is cheap while warning signs are aplenty.