Covington recently presented their observations on the market and economy at our annual shooting event held at Pike Run Country Club. Please find our presentation commentary below.
Looking at the business cycle framework, global expansion remains solid but many major economies have progressed toward more advanced stages of the business cycle where growth is moderating, credit tightens, and earnings start to come under pressure. Emerging markets face headwinds from China's industrial slowdown, looming trade uncertainties, and global monetary tightening. Europe has experienced the most significant slowdown among developed regions.
2017 was the first year since 2007 in which all major economies have growing/expansionary economies as measured by GDP growth. The trend is expected to be the same for 2018 with the exception of Argentina which is on pace to decline -2.83%. Note that Argentina has 40% interest rates, is highly dependent on commodities, plagued with corruption, and in 2018 reached out to the IMF for a $50 Billion emergency loan. The Organization for Economic Cooperation and Development (OECD) which tracks 45 of the largest economies expects most major advanced economies to have positive GDP growth in 2019 with the exception of Argentina and Turkey. GDP growth in the United States is still robust with a projected 2.7% annual growth rate for 2019. According to the OECD, world GDP including the emerging market countries is expected to grow at 3.5% next year.
We are in the midst of the longest but weakest recovery since WWII.So, the big question is: Can an economic recovery die of old age? The current expansion is the second longestrecovery since World War II lasting 113 months so far. However, it's important to note that with its longevity, it has also been the weakest recovery. The current expansion started in June of 2009 and if we make it to July of 2019, this will officially be the longest.
So, why is this recovery so weak?
- Typically when recessions occur as a result of a financial crisis, they take longer to recover from because of how embedded financial crises gets in the economy.
- The reliance of Monetary Policy to help recovery efforts versus Fiscal Policy. More specifically, the policies in place at the beginning of the recovery were not focused on economic growth. We have seen a shift from Monetary Policy to Fiscal Policy.
- The large amount of debt outstanding has put a drag on the current recovery. For households, it simply takes time for debt to be worked off and for corporate balance sheets, it takes time to deleverage. Also, during the early stages of the recovery, the Fed set the federal funds rate to zero to encourage borrowing and stimulate the economy however, households were more focused on deleveraging versus re-leveraging which was the intent with ZIRP (zero interest rate policy).
- Global growth was disappointing and weighed on US expansion.
We are often asked about when we think the next recession will come. While it's impossible to forecast future economic performance, there are some indicators that we follow closely to look for signs of a slowdown such as the most recent headline of tariffs, the labor market, and other recession indicators.
Impact of Tariffs on GDP
Aggressive US trade policy continues to be a potential risk to the markets. So far, the limited scope of tariffs has kept the impact isolated to a few individual sectors and it is currently reducing GDP by -0.06%. The pending tariffs of 10% on $200B of goods and an additional 15% on $200B of goods could wipe out an additional 0.25% of GDP when in place. Taking into account the next probable round of tariffs, in total, we can see a decrease of 1% to GDP growth. Some US companies have absorbed higher input costs while others have passed along higher prices to consumers. So while tariffs have the potential to impact GDP negatively, we don't think it's enough to send the US into a recession.
Tighter Labor Market
We have full employment - one of the mandates of the Fed (the other being price stability).
- Unemployment rate is 3.7%
- For the first time in a long time, we have more job openings than there are unemployed persons. In fact, there are currently 0.8 unemployed workers for every available job. Prior to the recession, there were 1.7 unemployed worker for every available job.
- The Quit Rate of 2.4% is at the highest level since January 2001. This is a measure of the number of people that voluntarily quit their jobs. This means that more workers are voluntarily quitting to find better jobs.
After years of stagnant wage growth, we now have full employment and we are finally seeing wage growth. Wage growth is an important indicator to watch because on one hand, it's good for the consumer which commands a large part of GDP. However on the other hand, it can hurt corporate profits as about 70-75% of costs are wages. While the strong labor market is a net positive for the economy, we are looking for 4% wage growth as a sign of a pending recession. Wage growth is currently at 3.1%.
Another recession indicator that we look at is the yield curve. The yield curve shows the difference between a longer dated bond and a shorter bond. The idea being you are compensated for the time value of money. When the yield curve inverts, meaning the longer dated bond yields the same as or less than a shorter dated bond, this has been a warning sign of a pending recession. Even when the yield curve inverts, we can still have positive equity market performance for some time afterwards. While not inverted yet, it's getting very close. In fact, the spread between the 10-year treasury and 2-year treasury yield (also known as 10s2s) is at 0.15% as of 12/5/18.
Other Recession Indicators
Some other recession indicators we look at are yield spreads at different points along the yield curve. Currently the intermediate range of the curve is inverted. The more telling signal is a long - short yield spread like the 10 year and 3 month yield spread which is at 75 basis points. There's also an index called the Leading Economic Index produced by The Conference Board which tends to "roll over" prior to a recession. We have not seen it roll over. The inversion of the front end of the yield curve signals that a recession could take place in the next two years.
There are two ways to influence an economy: Monetary Policy and Fiscal Policy. Monetary Policy has a lot to do with Central Bank mechanisms that influence the market. This can be setting the Federal Funds Rate, purchasing securities, selling securities to influence liquidity in the market and in extreme cases, extreme measures like Quantitative Easing. Fiscal Policy on the other hand is the government’s influence on the market. This is mostly in the form of increased spending, decreased spending, and taxes. The current government has been very focused on Fiscal Policy by cutting taxes and increasing spending. This is at a time when Monetary Policy is going the other way.
The latest tax package enacted in 2018 has lowered individual tax rates, increased the Estate Tax Exemption Amount, and lowered the corporate tax rate from 35% to 21%, the lowest corporate tax rate since 1939. The decrease in the corporate tax rate has boosted earnings growth.
So where has the money from the tax cuts gone? Companies are spending at record pace on stock buybacks and capital spending.
- A stock buyback reduces the number of shares outstanding.
- This boosts metrics like earnings per share.
Another positive for the markets that doesn't get as much attention is the decrease in regulations. Prior to 2017, an enormous number of new rules were created in reaction to the global financial crisis.
Bond & Equity Market Update
The bond markets are in an adjustment period as we go through a normalization period. We are coming out of a period where Quantitative Easing was in place to stabilize the markets. This led to zero interest rates, fiscal austerity and globalism. In the new period, we think, will consist of higher rates from tighter monetary policy, Fiscal expansion (like tax cuts and increased spending), and protectionism.
We've been in a 36 year Bull Bond market that has pushed rates down to zero. As rates go down bond prices go up. The Federal Open Market Committee (FOMC) continues on their path of normalizing rates with 3 rate hikes so far in 2018 (the 8thtime this cycle) with one more increase anticipated in December followed by potentially three more increases in 2019. The federal funds rate is currently at 2.25%. The implications are that with the Fed raising the short end of the yield curve, resulting in its flattening, and putting pressure on banks and other financial institutions. Another implication being, as stated earlier, the potential for an inverted yield curve.
Another factor that is impacting the bond market is the Fed unwinding their balance sheet at a modest pace of $50 billion per month. In October 2017, the Fed began reducing its $4 trillion balance sheet they acquired during QE* which ended in 2014. This means the Fed is no longer replacing the securities it owns and letting them just "run off the balance sheet" at maturity. This in turn creates more supply in the treasury market because the Fed is no longer a buyer. The implications of this should raise the yield in Treasuries.
*(QE=Quantitative Easing/QT=Quantitative Tightening)
Bonds tend to be a “safe haven” during periods of stock market volatility, however 2018 has been brutal for the fixed income markets also with many bond indices posting negative returns for 2018.
Looking at corporate earnings, among the 96% of companies that have reported their Q3 2018 earnings, 12 month operating earnings have growth 27% year over year to $150.53 and is expected to end 2018 at $157.69 per share. While impressive, earnings have been boosted by one-time factors like tax cuts and share repurchases. Historically, earnings for the S&P 500 index have grown at a more normalized rate of 6% and we expect going forward the earnings growth rate to decelerate back towards the historical mean. Volatility is to be expected going from 27% earnings growth back down to mid to upper single digits.
If you want to know what the equity market is going to do, follow corporate earnings. In fact, when comparing corporate earnings to stock market performance, they have a correlation coefficient of 0.93 meaning 93% of the time, they move in lockstep. It's more important to focus on the direction of corporate earnings especially the revisions of the estimates over time. Analysts are expecting corporate earnings to grow at 10.5% in 2019, so we are watching to see if that estimate comes down (which they usually do) but more importantly by which degree.
On average, during a mid-term election year the equity market has a drawdown of -17%. However, that is followed by a +32% gain one year later. With the mid-terms complete and the outcome that was largely anticipated, we hope the markets to return to "business as usual" however we also expect more volatility if there is gridlock in DC.
While the markets can be influenced by temporary factors like elections, ultimately what matters is the state of the economy, the state of corporate earnings, current valuation of stocks, and investor expectations.
In conclusion, we expect the economy and stock market to finish 2018 on a slightly positive note and we remain optimistic however more cautious as 2019 approaches. Favorable policy conditions have supported the US corporate sector during 2018 including tax cuts, fiscal stimulus, and a reduced regulatory environment. However, looking at 2019, there are several tailwinds that may set the stage for more volatility like a fading boost from corporate tax cuts, the continuing of rate hikes by the Fed, possible gridlock in DC, and cumulative drag to GDP from higher US-China tariffs, and potential medium term concerns about the trajectory of the US fiscal deficit.
Going forward, we continue to favor the equity markets over the fixed income markets. However, we expect a more normalized rate of growth of mid to upper single digit gains for equities while the market naturally corrects and adjusts to the new environment.