What a strange day Friday turned out to be. For economic geeks, the FBI’s announcement about reopening its probe into Hillary Clinton’s emails was only the second biggest surprise. The bigger revelation was that the economy expanded at an estimated 2.9% annualized rate in Q3, far above recent growth estimates and the best quarterly growth reading since Q3 2014. Both announcements made for splashy headlines. While we don’t yet know what is actually included in the emails, we have transparency into the GDP data and it was not as good as it looked. More than half of the 2.9% growth came from two sources that are not likely to be repeated any time soon: a spike in soybean exports and growth in inventory levels. Net of these two factors, GDP growth matched that of Q2 at 1.4%. Moreover, consumption growth (by far the biggest source of economic growth) is trending lower. The current state of the economy and the consumer is covered in detail in the forthcoming “Q3 Economic Review and Outlook”, which will be released within 48 hours.
Equity markets reacted more to the FBI’s announcement than to the GDP print, closing lower for the day. But Friday’s performance was really an extension of the week which saw equities grind lower in 4 of the 5 trading sessions. International markets did not fare much better, with the exception of Japan (+1.4%) and China (+0.4%). The yield on US Government bonds continued to move higher as the market is pricing in a Fed rate hike in December – according to Bloomberg data, the market odds for a December rate hike are 69.2%. Precious metals rose on the week: gold (+0.7%) and silver (+0.7%), while the price of WTI Crude declined 3.3%.
Missing the Mark – The Federal Reserve (aka the “Fed”) is commonly understood to have a dual mandate:
1) maximizing employment; and
2) stabilizing prices
There is a third mandate, moderating long-term interest rates, but that can generally be incorporated into the second mandate. The term “stabilizing prices” has come to be associated with a steady inflation rate of 2%. As has been well documented, achieving inflation of 2% has been extremely difficult in light of tepid domestic and global economic growth. But how difficult? As it turns out, it has been nearly impossible. According to research from FTN Financial, the Fed’s favored measure of inflation (Core Personal Consumption Expenditures) has not exceeded 2% in 70% of the months since the turn of the century, and on a rolling 5-year basis, inflation has been below the target 90% of the time. Granted this century has been beset with major economic events including the Dot.com bust and the Financial Crisis, but the Fed’s actions to raise rates prematurely have prevented inflation from reaching 2% the vast majority of the time. Thus it begs the question, do the hawks on the FOMC view 2% more as a ceiling than as a target? If the answer is ‘yes’ and the hawks win the rate battle, we can look forward to rate increases that are too early and/or too fast. Treating 2% inflation as a ceiling (vs. allowing inflation to fluctuate above that level) will not only keep inflation low, but economic growth low as well.
Core PCE Inflation vs. 2% Target
Sources: Bureau of Economic Analysis and FTN Financial.
Earnings “Beats” vs. Estimates – Aggregate earnings for companies in the S&P 500 have contracted for five consecutive quarters coming into Q3. Yes, the energy sector has played a large role in the contraction, but even when the Energy sector is excluded earnings growth has decelerated rapidly since Q1 2015. Yet, over that same timeframe, aggregate earnings for the S&P 500 have exceeded analysts’ quarterly earnings estimate 100% of the time. How can this be? A research firm called 720 Global has compiled data that they believe explains this phenomenon. The data in the chart below was compiled from the 17 prior quarters ending in Q2 of this year. What the chart shows is that on average management teams begin the year with an optimistic outlook for growth in the coming twelve months, but subsequently “guide” analysts lower throughout the year. In fact, the data shows that on average management teams reduce expectations below what they believe actual earnings will be so that they can “beat” those expectations even as it is a large “miss” relative to their original guidance. As a result, earnings have been declining yet companies are able to beat lowered expectations. There is nothing inherently wrong with this approach, but it does explain why the percentage of corporate earnings that beat expectations is so high, while in the aggregate earnings have been contracting.
Economic Wrap-up: New Home Sales rose to a 593k annual rate in September. Although previous months’ numbers were revised downward, Q3’s home sales averaged 599k – the highest 3-month average since early 2008. Housing remains stable, but tight supply, rising prices, and muted wage growth will limit the overall impact on GDP growth. The September Durable Goods report was mixed – the manufacturing sector still has a pulse, albeit a weak one.
After two consecutive weeks of losses stocks staged a mini recovery, though with the exception of Japan and emerging markets, most indices are down about 1% month-to-date. Interest rates also reversed their recent trend as yields fell modestly; the yields on the UST 10-year and 30-year bonds are now 1.73% and 2.49%, respectively. While low by historical standards, these rates remain high relative to other developed countries, including Germany (0.003%) and Japan (-0.07%). Precious metals rose during the week, but have lost ground month-to-date, while WTI crude is now up 5.6% for the month at $50.92 per barrel. After declining by approximately 5% in the first half of the year, the US Dollar has been in a volatile upward trend gaining more than 3% this month alone and is near the same level it started at this year. This is an unwelcome reality for the struggling domestic manufacturing sector as a higher US Dollar makes American products more expensive compared to their international counterparts.
For a detailed view of weekly, month-to-date and year-to-date asset class performance, please click here.
Hysteresis – It sounds like a medical condition, but it is not. According to the Merriam-Webster dictionary: “hysteresis is a retardation of an effect when the forces acting upon a body are changed (as if from viscosity or internal friction).” I bet a lot of folks joined me in looking up the definition of the word after Janet Yellen recently used it in a speech describing the economy.
If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. – Fed Chairman Janet Yellen, October 14, 2016.
Although Chairman Yellen decided to employ complex “Fed Speak” (a la former Fed Chairman Alan Greenspan), this was an extremely important statement. In plain English, Chairman Yellen said: allowing the economy to run hot for some years could repair the damage done by the Great Recession, including low labor-force participation, too-slow productivity growth, low inflation and stubbornly low interest rates. This may in fact have been a turning point for Fed policy in which Chairman Yellen telegraphed to markets that the Fed will increase rates very, very slowly over the next couple of years even if the economy runs a hot. We will discuss Chairman Yellen’s speech in more detail in our quarterly “Q3 Review & Economic Outlook” (scheduled for distribution in about one week) because of its important impacts on the path for interest rates and future economic conditions.
Unproductive Debt – As the chart below illustrates corporate debt has been rising during the Great Recovery.
Sources: Federal Reserve Board and FTN Financial
Rising corporate debt is not unusual in and of itself. Even the current pace of corporate debt issuance is not unprecedented in comparison to the late 90’s. What is unusual is how the money is being spent. While corporate investment was growing at double-digit rates at the turn of the century, presently business fixed investment is slightly negative and inventory investment is deeply negative. Instead of reinvesting into their respective companies, management teams have directed proceeds from the bond sales to buy back shares and issue special dividends – both of which serve to immediately increase stock prices, but do little for the long-term prospects of a company. Admittedly, it’s difficult to blame management teams for taking advantage of historically low interest rates and their capital allocation decisions in light of a tepid global demand. While this has been instrumental in boosting stock market performance over the last six quarters of declining earnings growth, it is showing signs of slowing. In the absence of share buybacks and special dividends (or additional quantitative easing), corporate earnings will need to improve for the stock market to move a lot higher.
Blame Game – Last week publicly traded Dunkin’ Brands (DNKN) reported quarterly sales of doughnuts and coffee that were below expectations. Dunkin’s management team blamed the belligerent and divisive presidential campaign. Color me jaded, but that seems like a tenuous explanation. That being said, if Trump and Clinton are reducing the number of doughnuts consumed by Americans, one segment of the American populace they will unite is nutritionists.
Economic Wrap-up: The headline Consumer Price Index (CPI) rose 0.3% in September, bringing the year-over-year rate to 1.5% as energy prices have recovered. Core CPI declined a modest 0.1% to 2.2% in September, as housing and medical care costs continue to rise. More of the same in this data set and, outside of transitory pulses, inflationary pressures are not yet in danger of getting away from the Fed on a sustainable basis. Housing data for September was mixed, but generally indicative of a stable market: Housing Starts were down 9% (primarily related to a large drop in Multifamily units) and Permits were up 6.3%. Existing home sales beat expectations and rose 3.2% in September, but high prices and tight supply conditions will likely govern growth in the fourth quarter.
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Following an up and down week, equity markets (for the most part) closed in the red adding to losses from the previous week. Overall, it has been a tepid transition to the fourth quarter. Domestically, the immediate concern seemed to be potentially weak earnings as Alcoa kicked off the Q3 earnings season missing on profits expectations and lowering its revenue forecast (the stock fell 16% on the news). Relatively unimpressive economic data released last for both the U.S. and China did not help matters. Through six consecutive quarters of declining quarterly earnings, the S&P 500 has gained 3.4% (inclusive of dividends) stretching the valuation of the popular benchmark. After such a poor stretch for earnings, the Q3 earnings reports need only be good, not great, to give investors some relief and position the market for further gains. On the other hand, if earnings disappoint already lowered expectations this quarter, equity markets are likely to pullback as investors reassess forward earnings guidance in an economy growing at less than 2% per year.
Meanwhile, interest rates for US Treasuries continue to rise. The yield on the 10-year UST has increased 0.2% (to 1.8%) in just two weeks’ time as the market positions for a Fed rate increase in December. While the market believes the Fed will raise rates, recent economic data does not support such a move. Indeed. Q3 GDP forecasts have been cut by almost half since August from nearly 4% to around 2% today. Yet, after talking so long about doing it, the Fed may “go” whether it is economically warranted or not, in an effort to salvage their waning credibility.
For a more detailed view of weekly, month-to-date and year-to-date asset class performance, please click here.
Big Brains I– Spent a week in NY meeting with a group of the best and brightest in the investment industry. Some are experiencing eye-popping performance, but for most of these big brains the last 18 months have been a grind. In spite of performance being below their high expectations (which are informed by their own long term track records), nobody’s panicking. Are they frustrated? Yes. Some more than others. But these managers take a more enlightened and humble long-term approach (a good reminder for all investors), recognizing that changing their strategy to maximize profitability in the historically unusual environment of the last 18 months would set them up for future failure and, perhaps even, result in becoming a hedge fund blow-up statistic. During the week, the most oft cited feature of today’s markets I heard from managers is that fundamentals are currently being ignored, therein preventing true price discovery as markets are buffeted this way and that by every new utterance from a central banker concerning increasing or decreasing monetary stimulus. In the short-run (even over a multi-year time frame) markets can ignore fundamentals, but over the longer-term fundamentals matter and when fundamentals reassert themselves, these managers expect to profit handsomely by doing what they have always done: in depth research to identify mispriced assets. So they stay calm and research on. Yes, some are tweaking their strategies or adding trading teams focused on complementary markets, but out of 20 odd meetings, not one manager has made any wholesale changes to their proven investment approach. Having traded markets for 15, 20, or 25+ years, they all know inherently and share explicitly that the key to long-term success is investment discipline.
Big Brains II – Having heard from enough managers that price discovery was not occurring in the markets the way that it should, it begged the question: “What will the catalyst be for true price discovery to occur again?” To which one highly experienced manager replied:
With all humility, I don’t know. No one knows. My opinion is that there are significant tail risks around the world, as high as they have ever been. I am reminded of the first quarter of 2007 when no one believed the US could go into a recession, that housing prices could never go down, etc. Complacency was extreme [not unlike now]. Witness the recent travails of Deutsche Bank [DB] – I am very surprised and even wary that DB did not spark more of a reaction. Three years ago there were a lot of concerns around banks, including DB, and potential systemic risk to Greece and Italy that would ripple throughout European banks [a different manager suggested DB has more than 50% downside from today’s price]. Those problems have not gone away, but the level of monetary policy involvement in the global economy is at an all-time high. Monetary policy hasn’t solved these problems; it has merely pushed them below the surface where they continue to fester. When central banks are no longer able to paper over these issues, there will be significant pain for investors who are not positioned correctly.
Economic Wrap-up: The National Federation of Independent Business (NFIB) Uncertainty Index for September remained near a four-decade high as concerns around the election and a weak economic environment weigh on business owners’ outlooks for their companies. A high level of uncertainty makes it difficult for management teams to rationalize investing in their companies, be it human or physical capital. The NFIB’s chief economist Bill Dunkelberg remarked “If you can’t even say if you think things will be better or worse, you don’t do anything. You can’t fire or hire people, allocate or reduce inventory. You just tread water and that’s a recipe for muddling-along growth”. In other words, management teams are effectively paralyzed, which does not bode well for boosting GDP growth. Supporting Mr. Dunkelberg’s comments, the Job Opening and Labor Turnover (JOLT) survey for August showed a marked decline in job openings to 5.4mm (vs. expectations of 5.8mm). In spite of that relatively weak data point, other indicators show that the labor market continues to exhibit steady growth. Retail Sales for September were in line with expectations, revealing stable consumer demand, but lacked acceleration that could meaningfully boost GDP growth above its recent trend line.
Be well and Godspeed,
Equity market performance last week was mixed as international stocks generally finished lower, while domestic stocks moved modestly higher (albeit with some volatility as the S&P 500 finished higher or lower by 0.75% from where it started each day). For the month of September, large cap domestic stock performance was basically flat, while international stocks pushed higher by about 1%. The yield on US Treasuries finished the week slightly higher, thanks to a large move on Friday which saw the yield on the benchmark 10-year bond move up by 3.5 bps to 1.6%. Similar to equities, interest rate volatility was elevated relative to the last couple of months; yet, for all the movement, interest rates across the yield curve finished the month basically where they started. The same cannot be said for the energy complex, which saw the price of WTI Crude increase 7.4% on the month to $47.99 per barrel, while WTI’s international counterpart Brent Crude, increased by 4.3% to $49.06 per barrel. Finally, the US Dollar’s value declined by 0.6% during the month and is now down 3.2% for the year, which is beneficial to US exports since a weakening dollar makes U.S. manufactured products less expensive. However, weak global demand continues to put pressure on the domestic manufacturing base.
For a more detailed view of weekly, month-to-date and year-to-date asset class performance, please click here.
GDP Forecast Update: After what began as a promising rebound for economic growth in the third quarter, recent data releases have been softer. The Atlanta Fed’s “GDPNow” economic model is currently forecasting third quarter annualized real economic growth of 2.4%, after tracking above 3% for most of the quarter.
If third quarter GDP does indeed buck the recent trend of negative growth revisions and hold this level, it would represent a decent bounce from the 1.4% growth rate recorded in Q2. However, following the slow start to the year, we will need to see growth accelerate further in Q4 to match 2015’s good, but not great annual GDP expansion rate of 2.4%.
Politics vs. Policy: With the presidential election about five weeks away, the rhetoric between the two leading candidates is predictably heating up. Each has a plan they believe will cure the ills of America. While voters are certainly listening to these ideas, so are investors who are trying to divine the likelihood of which candidate will become the next President and which financial assets will benefit from his/her election. For example, during the Presidential debate last Monday night the Mexican Peso began to rise and by market close on Tuesday it had gained 2.5% (it’s second largest daily gain this year) as investors gauged Clinton to be the debate winner. Given Trump’s well-known views on the North American Free Trade Agreement (a trading pact with Mexico known as “NAFTA”) and immigration, a Clinton Presidency would be a boon (or at least less negative) for Mexico. Yet history shows that the politics of a Presidential campaign often do not translate into scalable policy changes. The primary reason is the “checks and balances” that the country’s forefathers embedded in the architecture of our government. It’s not easy for a President to push major policy initiatives through the House of Representatives and the Senate, particularly when they are controlled by different political parties. Consequently, the splashy promises made during a campaign oftentimes do not translate into governance as illustrated in the table below.
Source: Goldman Sachs Asset Management
Economic Data Wrap Up: New Home sales for August were ahead of expectations and July’s already strong report was revised higher. Inventory remains tight, but home-builders appear to be reacting to the strong demand and the number of Homes Not Started increased to 45k, a 25% year-over-year increase. Durable goods orders for August were unchanged and the strong July report was revised down to 3.6% (from 4.3%). Just as housing continues to be a source of economic growth, the manufacturing sector continues to struggle in light of weak international demand and a strong US dollar. Personal Income rose by 0.2% in August (in line with expectations, but the slowest growth rate since February) and Personal Consumption increased by 0.1% (vs. expectations of 0.2%). The Core PCE Deflator (the Fed’s preferred measure of inflation) rose to 1.7% year-over-year, in line with expectations. In sum, this week’s data represents more of the same and does not challenge our thesis that real economic growth in the U.S. will likely average between 2% and 2.5% for 2016 (though we expect Q3 annualized growth will be better than 2% ).
Be well and Godspeed,