Analysis: Q2-2017 Macro Update

Say we throw a ball up in the air and want to predict what will happen next. Newton tells us that transferring kinetic energy to the ball will accelerate it upwards, and the force of gravity will accelerate it downwards. We can confidently say the ball will eventually come back down to earth. Now, try predicting what would happen to the ball if instead, a random survey of the human population decided its movements. If more people felt like the ball should go up it would go up and vice versa.

There is no shortage of forecasters who would take a simplified approach to this problem – just assume the physics bound world and ignore the human element. Eventually, the two should match up. We can think of this as the efficient market camp. Contrast that to the behavioral camp, which focuses primarily on the human element. They note that the fear and greed of a crowd can push the ball to further extremes than the constraints of physics would suggest.

Our goal today is to predict where that economic ball is going. We will borrow from both camps, while not forgetting that this is an exercise in art, not science. We can’t predict where the ball is going nor when it will get there with any certainty, but we can get a decent idea of where the ball is. If the ball is closer to earth, odds are it will begin its journey upward. If the ball is closer to space, odds are it will begin its journey downward. Give or take ten years.

Market Snapshot

snapshot.png

So, where are we in the markets? Technology has been the clear winner this year thanks to the seemingly unconditional faith in the FAANG stocks. These 5 super-stocks plus Microsoft make up about 12% of the S&P 500 index and are responsible for its record-breaking performance. Energy has been the clear loser this year as the commodity bear market enters its 6th year. The relative underperformance of commodities hasn’t been this bad since the Dot-Com bubble.

More globally, we see that the German DAX index has begun to diverge from the rest of the world. The Euro being at a 2-year high against the dollar is probably not helping. The yield curve has been flattening over the year (a sign that investors are less optimistic about the economy), but that has reversed somewhat over the past month.

Market Valuation

So, is the market expensive or cheap? A popular measure of market valuation is the Cyclically Adjusted P/E Ratio (CAPE). The numerator is the real S&P 500 price index and the denominator is the moving average of the preceding 10 years of real reported earnings. The idea is that the 10-year average will control for business cycle effects.

Case-Shiller PE10 (CAPE):

CAPE.png
http://www.econ.yale.edu/~shiller/data.htm

CAPE is currently at 30 versus a historical median of 16. This level has only been exceeded in 1929 and 2000 which is not a great look, but there are some caveats. Firstly, that 10-year average still includes the massive drawdown in earnings from 2008. Secondly, notice what long-term interest rates are doing. Interest rates can be thought of like gravity on market valuations. High rates mean high gravity pulling down valuations and low rates the opposite. Currently, gravity is extremely low and valuations are free to drift upward. Whether this situation persists will be what matters.

Market Capitalization / GDP:

fredgraph
https://fred.stlouisfed.org/graph/?g=exY1

Another valuation method popularized by Warren Buffet is taking the total U.S. stock market capitalization as a percentage of GDP. This is less sensitive to the accounting issues of CAPE but has its own issues in a globalized world. At 1.73x GDP, valuation measures are higher than any point save for 1929 and 2000. Still not a great look.

Tobin’s Q:

fredgraph15
https://fred.stlouisfed.org/graph/?g=exXT

Tobin’s Q was developed by James Tobin and works under the assumption that a firm’s market value should be close to the replacement cost of its assets. If those firms are really good at using their assets, then investors will be willing to pay more than replacement cost (Q > 1). Think of this as the price-book ratio of the market, where the numerator is the value investors are willing to pay for companies and the denominator is the accounting net worth of those companies. Currently, Q is 1.03 versus a median of 0.73. The main issue here is that it is extremely difficult to get an accurate measure of the replacement cost of a company. US GAAP accounting has this asymmetric nature to it where assets can be marked down but not marked up. This leaves companies holding decades-long real estate on their books at depressed levels and leaves intangible assets, like the network effects of Facebook, completely off book.

VIX:

fredgraph16
https://fred.stlouisfed.org/graph/?g=exYe

So far, we looked at market valuations from a physics point of view, now let’s look at it from the behavioral point of view. The CBOE Volatility Index is a measure of market expectations of near term volatility based on stock index option prices. Think of this as looking at how much people are willing to pay for index options, then reverse engineering the implied volatility from that price. Currently, the VIX is sitting at 10.29 versus a 17.63 median – the lowest point in its 27-year history. Investors believe the market will remain calm and this complacency is being priced into option contracts. If investors turn out to be wrong, which tends to happen every decade, those contracts have the potential to blow up in classic Minsky fashion – stability leads to instability; the longer things are stable, the more unstable they will become.

Inflation

Let’s move towards more macroeconomics. We spoke about the importance of interest rates for valuation and nothing influences interest rates more than inflation. Inflation is the rate of increase in prices for goods and services. Keynes explained why a little inflation was necessary to avoid the paradox of thrift – a tendency of consumers to learn to hold off their purchases and wait for prices to fall. That’s not to say runaway inflation is a good thing, look at the 1970s, but today, undershooting is a bigger risk than overshooting.

Inflation Expectations:

fredgraph17
https://fred.stlouisfed.org/graph/?g=ey3f

The 10-Year breakeven inflation rate is a measure of expected inflation derived from the price of inflation-indexed securities. It’s basically what inflation would need to be for inflation protected securities to be worth their cost. It is useful since it gives a glimpse into what investors expectations are for future inflation. The current inflation expectations are 1.83%, down from 1.99% at the beginning of the year. The key here is that expectations remain stable, it is when they break to the upside or downside that markets get screwy.

Core CPI:

fredgraph2
https://fred.stlouisfed.org/graph/?g=ey3u

Core CPI is the actual measured inflation in the economy – excluding food and energy which tend to be more volatile. The most recent reading was 1.70%, down from 2.27% at the beginning of the year. Both expectations and measured inflation have decreased this year, suggesting the FED may run into issues with their planned rate increase. However, the FED isn’t only considering inflation when setting rates.

Taylor Rule:

fredgraph14
https://fred.stlouisfed.org/graph/?g=eyu9

The Taylor Rule is a guideline for how central banks should alter interest rates in response to economic conditions. It takes into account targeted inflation versus actual inflation and real output versus potential output. The Taylor Rule is basically a forecasting model to determine what the FED will do with interest rates going forward. In the chart above, we can see the gap between what the Taylor Rule would predict for interest rates (Blue) and what the FED level is set at (Red). Currently, the Taylor rule is implying that the FED has plenty of room to raise interest rates in the current economic environment. However, like with everything else, there are drawbacks to the Taylor Rule. Firstly, it is unable to account for real-time issues like a stock or housing market crash. Secondly, it loses relevance in a world where the FED funds rate is not the primary tool of monetary policy. See balance sheet activity.

Business Cycle

The whole point of macroeconomic forecasting is to figure out what is going on with the business cycle. As Howard Marks said, “There are two concepts we can hold to with confidence: – Rule No. 1: Most things will prove to be cyclical. – Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” The business cycle can be thought of as the fluctuations in GDP relative to long-term trend growth. A normal cycle goes something like this: initial recovery, early upswing, late upswing, slow down, and recession.

Output Gap:

fredgraph5
https://fred.stlouisfed.org/graph/?g=eyuK

So, where are we now? The output gap is simply the difference between Real GDP and Potential GDP presented here as a percentage. Currently, the output gap is negative suggesting there is room for economic expansion in the current cycle. Historically, the output gap has run positive before all 10 recessions since 1950 except 1981. Of course, the output gap is only as good as the estimate for Real Potential GDP, which is produced by the CBO’s estimate of what the economy would do with a high rate of use of its capital and labor.

Yield Curve:

fredgraph3
https://fred.stlouisfed.org/graph/?g=eyuN

The yield curve is another useful predictor of the business cycle. It gives us the relationship between bonds of differing time horizons. For example, the current difference between the 10-year and 2-year treasury yield is 0.96%. This is important because it reveals what investors expectations are for the future versus today. If investors believe the future holds economic growth and inflation they will sell long-term bonds, steepening the yield curve. If investors expect a recession, they will do the opposite. The yield curve has been flattening over the past couple of years suggesting that investors are becoming more pessimistic about economic prospects. Take note to watch out for an inverted yield curve, which has preceded every recession since the 1980s.

High-Yield Spread:

fredgraph4
https://fred.stlouisfed.org/graph/?g=eyvl

Alongside the business cycle is a credit cycle where investors attempt to discount the risk of bankruptcies. When investors are optimistic, they tend to charge too little of a premium for that risk and when they are pessimistic the opposite. The High-Yield spread measures the difference between what investors are charging for bonds below investment grade (rated BB or below) and the risk-free rate. The spread is currently 3.61%. This is higher than the 2007 low point of 2.41% but lower than the median of 5.14%. It suggests, as did the VIX, that investors are currently complacent when it comes to discounting risks in the market.

Consumer Health

Consumer spending is the most important factor affecting GDP (about 70%) but also the more stable compared to investment and government spending. It is worth checking up on the consumer. Let’s look at consumer’s consumption, employment, savings, debt, and sentiment.

Retail Sales:

fredgraph7
https://fred.stlouisfed.org/graph/?g=eyvF

Retail sales will be our proxy for consumer consumption. We can see that after the large drop off in 2008, retail sales rebounded strongly but the growth rate has since petered out. Looking closer at the numbers since 2016, we see that department store sales have had the largest drop off (-4.2%) while online shopping sales have had the largest gain (10.8%).

Unemployment Rate:

fredgraph8
https://fred.stlouisfed.org/graph/?g=eywt

Turning to consumer employment, we see the current civilian unemployment reading is 4.4% versus a historical median of 5.6%. Looking closer at the numbers for June, we see that education and health services had the largest gain in employment. Nonfarm wages are up 2.5% over the year. However, the labor force participation rate, at 62.8 percent, has changed little over the past year. This seems to be a trend in the economy where jobs are shifting towards low productivity sectors while more people are staying out of the workforce altogether.

Savings Rate:

fredgraph
https://fred.stlouisfed.org/graph/?g=eywL

Turning to consumer savings, we see that the current savings rate is 3.8%. The median since 1960 has been 8.2% and since 2000 it has been 4.9%. We can think of the savings rate as a double-edged sword. As far as the Keynesian multiplier is concerned, the lower the better since every dollar spent gets magnified through the economy. As far as practicality is concerned, low savings reduces the buffer that consumers will have to deal with adverse shocks in the future, magnifying their effects.

Household Debt:

fredgraph11
https://fred.stlouisfed.org/graph/?g=eywZ

Turning to consumer debt, we see that the consumer has gone through a long period of deleveraging since the financial crisis and appears to have reached a point where re-leveraging is a possibility. The current household debt as a percentage of GDP is 78% versus a high of 97% in 2008 and a historical median of 47%. Like the inverse of savings, debt can boost spending, but too much of it leaves the consumer vulnerable to a crisis.

Consumer Confidence:

fredgraph10
https://fred.stlouisfed.org/graph/?g=eyx7

Lastly, let’s check on consumer confidence to get a more behavioral view. The University of Michigan releases a monthly survey of consumer confidence and the annualized percent change can be viewed above. Since January, confidence has declined but it remains higher than any point since 2004. Looking closer at the numbers, we see that largest predictor of expectations has been partisanship. Since the election, Democrats have held steadfast in their pessimism, while Republican optimism has surged. The recent decline can be attributed to Republicans tempering their expectations and Democrats remaining constant.

Business Pulse

We reviewed the health of the consumer, now let’s check up on the health of businesses. We will be looking at profit margins, debt, productivity, and sentiment.

Profit Margins:

fredgraph12
https://fred.stlouisfed.org/graph/?g=eyxy

The current profit margin in the united states is 11% versus a historical median of 9%. We are clearly in a period of business strength. This makes sense since sales have rebounded strongly since the great recession but wage costs remain depressed. The mean-reverting nature of profit margins would suggest that the future doesn’t look as bright as the present. In theory, rising wages and competition will force profits back down.

Corporate Debt:

fredgraph13
https://fred.stlouisfed.org/graph/?g=eyAT

Looking at nonfinancial business debt as a percent of GDP, we see that after the great recession we went through a full deleveraging cycle and have returned to pre-recession highs. Currently, nonfinancial business debt is about 45% of GDP versus a median of 41% since 1990. The main takeaway is that businesses have used the calm markets to raise debt.

Productivity

fredgraph1
https://fred.stlouisfed.org/graph/?g=eyyl

Productivity is the amount of output per labor hours worked in the economy and is the source of nearly all economic growth. The above chart shows the year-over-year percentage change in productivity. This cycle has had one of the lowest productivity growth rates on record. Consider the following chart:

chart.png
https://www.bls.gov/opub/btn/volume-6/below-trend-the-us-productivity-slowdown-since-the-great-recession.htm

It would take a 5.5% GDP growth rate for us to catch up to historic levels of productivity growth. We are currently running at about 2%. So what is going on? Clearly, there is productivity growth in certain areas of the economy. Take media, retail, and financial services for example. Companies like Facebook, Amazon, and Vanguard have learned how to do more with less. But then consider other industries like healthcare, education, and real estate which have had the opposite experience. Prices continue to rise in those sectors and by definition, they become a greater portion of GDP. Over the long-run, it is possible that the productive industries that are reducing their prices will disappear from the calculation, and that GDP will be dominated by the low productivity sectors.

PMI Survey

Lastly, let’s look at the Purchasing Managers Index (PMI). PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. This information is gathered by monthly surveys sent to executives at about 300 companies. In July, the manufacturing index declined by 1.5% but is up 13% from this time last year. Of the five major categories, new orders fell the most at -3.1%. Prices increased by 7%. The non-manufacturing index is up about 4% since last year. This all suggests business health is strong but slowing.

Conclusion

So, in summary:

  • Markets are at historically high valuations.
  • With that caveat that interest rates are low.
  • Technology companies are leading the rally.
  • Investors are complacent when it comes to volatility.
  • Investors are complacent when it comes risk premiums.
  • Inflation is subdued.
  • The yield curve is flattening.
  • Monetary policy is tightening.
  • Consumers are optimistic.
  • Businesses are optimistic.

All of this suggests that we are closer to the end of the cycle than we are to the beginning. However, we could have said almost the same thing one, two, or even five years ago.

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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