Even with growing uncertainty about the new administration’s policy priorities, geopolitical risks (North Korea and China, Syria and Russia) are beginning to steal the headlines. These risks, along with relatively weak domestic economic data releases last week, helped create a bid for defensive assets and selling pressure on risk assets. Domestic equities declined for the second consecutive week with the S&P 500 falling a little more than 1%. In Japan, the Nikkei Index fell 1.8%, marking a 6.6% decline in the last four weeks. International developed and emerging markets managed marginal gains between 0.1% – 0.2% for the week and remain the best performing geographies year-to-date. The yields on both the 10-year (2.24%) and 30-year bonds reached five-month lows with the latter breaking down through the 3% threshold to close at 2.89%. Gold rose 2.5% and the VIX Index jumped to 15.96. Given all that is going on in the world, including domestic politics, it has been a bit of a head-scratcher that the VIX Index (which is a market-based measure of stock volatility over the next 30 days) has remained so low for the last few months. Keep in mind that a VIX of approximately 16 is not particularly high. While the 24% rise in the VIX Index from 12.87 one week prior is noteworthy, market expectations for stock volatility remain well below the 20-year average of 21.5.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Having just completed our quarterly Investment Committee meeting, below are a few observations about the state of the economy. We will elaborate on these points and more in our quarterly Economic Review and Outlook later this month.
Overall: Houston, we may have a problem. The disconnect between sentiment indexes and hard economic data has not closed – consumer confidence and small businesses optimism indexes remain elevated, but where’s the beef (i.e. economic activity)? Risks of recession are rising, and while these are notoriously difficult to predict with precision, we believe there is a better than 50% chance of one occurring in the next two years (other economists we respect are assigning either a higher probability or shorter timeframe to the next recession). As the chief brain behind a hedge fund said “It’s better to be approximately right, than precisely wrong” and there are clouds gathering on the economic horizon.
Personal Income and Consumption: With consumption comprising approximately 70% of GDP, our resident economist Sean Foley likes to say, “If you get the consumer right, your GDP estimate will be in the correct zip code.” For several quarters, consumption growth has outpaced the rise in Disposable Personal Income. Hence consumption has been fueled by an unsustainable combination of withdrawing from savings accounts and increased borrowing. On that last point, it’s worth noting that Consumer Debt as a percentage of Disposable Personal Income is now higher than in 2007 (see chart). Much of this is student debt that, by law, cannot be discharged (aka “forgiven”) in a bankruptcy and this debt must be repaid over time. Dollars paid to reduce debt are not dollars spent on goods and services, which impacts consumption levels and GDP growth.
Sources: Federal Reserve and Foleynomics
It looks like reality is beginning to assert itself in the first quarter as the savings rate started to mean revert and revolving credit levels moved lower. Given the lack of income growth and reduction in other sources for spending, it is not surprising that consumption levels disappointed in the first quarter and that overall real annualized GDP growth will end up being only around 1% in Q1. Going forward, it appears that the wind will be in the face of the consumer:
- Average Hourly Wages are in the midst of a weakening 6-month trend
- Recent sequential data suggests slowing growth in Disposable Personal Income
Construction: Overall the construction sector is healthy, but the strongest growth is likely behind us. New single family home sales as well as single family housing building permit levels are consistent with growth over the last several years. Multifamily permits are weakening after a long period of strong growth. New housing inventory continues to be tight as developers learned their lesson about speculation following the Financial Crisis. Tight inventories support higher prices. Speaking of which, housing affordability remains an issue as only 32% of existing home sales are to first-time buyers (the long-term average is closer to 40%).
Inflation: Nothing to see here, move along. As forecast, measures of inflation are beginning to ease following a data-induced move higher in the first couple of months this year. Indeed, the headline Consumer Price Index (CPI) declined 0.3% in March to 2.4%. If you recall, oil prices bottomed in early 2016, so year-over-year comparisons of the CPI produced an illusion that inflationary pressures were building in the economy earlier this year. For example, in February the CPI reached 2.7% after remaining below 2% from July 2014 until December 2016. Core CPI (which strips out energy and food prices) is less susceptible to volatile swings and has hovered around 2% since the beginning of 2016. Importantly, Core Personal Consumption Expenditures (the Fed’s favored measure of inflation) remains at 1.8% year-over-year, below the Fed’s long-term 2% target. Absent a major fiscal stimulus policy from the government, inflationary pressures will remain at bay.