Friday marked the end of Q2 and the first half of the year is now officially in the books. It was a strong start. At the midway point, global equities are up +11.8% and the S&P 500 gained +9.3%, with Q2 representing its seventh consecutive positive quarter. Emerging Market equities rallied +18.9%, while their less economically-developed cousins in the Frontier Markets gained 13.4%. Traditional fixed income investments and hedge funds also moved higher, though less so than equities as would be expected. The metals complex also participated in the broad rally: Gold (+8.2%), Silver (+4.4%) and Copper (+7.7%). There was a lot to cheer about in the first half of 2017, even as the energy complex stumbled on oversupply concerns as WTI Crude declined -14.3% (though it has rallied nicely of late).
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Growth, But No Progress – Much ink (or electrons, as the case may be) has been spilled of late writing about rising wages and how they are bound to place upward pressure on inflation in the near future. While actual inflation data has contradicted these claims, the rallying cry has been “just wait…it’s coming”. What the proponents of wage-push inflation may be missing is that demographic trends are placing downward pressure on aggregate wage growth, even as individual wage growth has accelerated. Per data from the Atlanta Fed, annual wage growth for individual workers has increased from 1.6% to 3.4% since the middle of 2009. Over that same period, aggregate wage growth (i.e. wage growth of the collective domestic labor force) declined from 2.6% to 2.4%.
Sources: Atlanta Fed, Bureau of Labor Statistics and FTN Financial.
The reason for the apparently contradictory data can be found in the shifting composition of the labor force, namely the handoff from Baby Boomers to Millennials according to research from FTN Financial. Although those 55-years and older are working longer (the Labor Force Participation Rate for this cohort has held relatively steady at 40% since the Financial Crisis), there does come a day when even the mighty Boomers stop working. On the other side of the age spectrum, the labor force participation rate of Millennials has grown substantially, such that the unemployment rate amongst 20-24 year old’s has declined from 16% at the peak of the Financial Crisis to approximately 7%. Given their extensive work experience, Boomers tend to have high paying jobs relative to the less-experienced Millennial workers. As such, giving Millennials pay raises (off a lower salary base) has a less pronounced impact on aggregate wage growth than if the same pay percentage raises were going to higher paid Boomers. Hence, the demographic shift from an older work force to a younger work force results in higher individual wage growth, but relatively stable wage growth in the aggregate.
What does this generational shift mean for the economy? All else being equal, stable aggregate wage growth translates into relatively stable consumption growth. Of course, consumption levels can be temporarily enhanced via increased borrowing or through the depletion of savings accounts. Yet, neither of these are sustainable sources of consumption growth as there are natural limits to how much money can be borrowed and savings accounts cannot be drawn down below zero. Thus, it is unlikely that consumption growth will accelerate from its current levels on a sustained basis until aggregate wage growth accelerates. This condition creates a headwind for GDP growth as consumption comprises roughly 70% of the domestic economy. One other potential source for accelerating consumption is a meaningful tax cut for the low and middle class. Yet, studies on the long-term effect of tax cuts on economic growth by the Bureau of Economics are inconclusive.
Running On Fumes – While equity markets had a banner first half of the year, there is an increasing chorus from prominent financiers that asset prices have moved to far relative to fundamentals.
- The flood of capital into ETFs has been the primary driver of the equity market rally. That trend will change in the second half of the year. Our target price for the S&P 500 at year-end is 5% lower than where we are today. David Kostin, Chief U.S. Equity Strategist @ Goldman Sachs
- Asset valuations are “somewhat rich if you use some traditional metrics like price earnings ratios” Janet Yellen, Chair of the U.S. Federal Reserve
- “We’re at a high [valuation] level, and it’s concerning”. Robert Shiller, Sterling Professor of Economics Yale University
- The sum of the S&P 500 earnings yield and the 10pyear Treasury yield is 6.84%; the combined valuation of stocks and Treasuries is now richer than 99% of readings over the past 55 years. Michael O’Rouke, JonesTradings Chief Market Strategist.
- “The stock market seems to be running pretty much on fumes”. John Williams, San Francisco Fed President (and Vice Chair of the Fed) On a side note, this comment reminded me of Kramer and his test drive
Might these comments be the tenuous vines hanging over the famed “wall of worry” upon which the market climbs higher? Perhaps. After all, the market has been defying the odds for quite some time in a protracted economic cycle that includes the weakest recovery since the Great Depression. Ultimately, however, fundamentals and asset prices will reconcile, whether that be through improving fundamentals or a re-rating of asset prices. The varying views on the process by which the situation is resolved outline the sandbox in which the market Bears and Bulls play. While there are many opinions about how this plays out trying to time it is a fool’s errand. Said differently, and more eloquently:
There are no facts about the future, just opinions. Anyone who asserts with conviction what he thinks will happen in the macro future is overstating his foresight, whether out of ignorance, hubris or dishonesty. – Howard Marks, Founder Oaktree Capital
As such, it would seem prudent to diversify your portfolio prior to an unforecastable reconciliation process begins.