4 Reasons Why the Consumer (and the Economy) Are Still in Limbo

Yellow balloon deflating in stages

Economic readings have been firm lately, with one major exception: retail activity. Retail sales continue to disappoint relative to expectations, as we saw again in August. While Hurricane Harvey certainly had a negative impact, the unfortunate truth is that retail sales have been decelerating since January.

Which raises the question: Why should spending slow when unemployment is at a cyclical low and confidence close to a cyclical high? Here are four potential reasons:

Wage growth has been conspicuously absent

US Wage Tracker

Despite historically low unemployment, wage growth is not accelerating as the textbooks suggest it should (see the accompanying chart). Although there are a number of secular factors impacting the numbers—not the least of which is the retirement of lots of relatively well paid baby boomers—the reality remains that wages are not providing the tailwind many had expected.

Auto sales have peaked

After years of stellar sales on the back of historically low interest rates, U.S. auto sales have been decelerating for the better part of the past two years. This is important as auto sales, including parts, comprise roughly 20% of overall retail sales. August’s sales numbers, a shade above 16 million annualized, were the lowest since early 2014.

The savings rate is already low

One of the defining characteristics of the multi-decade consumer boom was a consistent trend towards lower savings. While that trend temporarily reversed following the financial crisis, by late 2016 the savings rate was once again closing in on 3%, not far from last decade’s low. Savings can theoretically fall further, but at this point in the cycle consumers may need to take a breather.

Consumers are spending, just differently

There is an argument that sluggish retail sales simply represent changing consumption habits. Retail sales only capture physical merchandise. This creates a measurement problem in an economy in which services are accounting for an ever greater share of consumer activity.

In fact, the “glass-is-half-full” retort to weak retail sales is that overall consumption is doing okay. During the first two quarters of 2017 household consumption grew at an average rate of about 2.5% annualized, close to the post-crisis average. Countering the above headwinds are falling inflation, a still robust labor market and, for high-end consumers, record wealth. On the latter, it is worth noting that at $95 trillion, total U.S. household wealth is up about 50% from the end of 2011.

For now, this leaves spending activity roughly where it’s been. Consumption remains supported by a strong jobs market and a massive buildup in household wealth. At the same time, an already low savings rate coupled with a lack of wage growth makes a meaningful acceleration unlikely. And with consumption now back around 70% of overall gross domestic product (GDP), it will be hard for the overall economy to take off if the consumer remains in limbo.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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Leaning Against the Wind

Wind

There has been a great deal of excitement in the markets since the US elections late last fall, but in my experience, changes in presidential administrations have never extended or accelerated an aging business cycle. As the current expansion nears its eighth birthday, it’s important to note that the average business cycle lasts five years and the longest cycle in history lasted 10. Global growth has accelerated modestly in recent months, but we’re seeing few signs that this upturn is anything more than a momentary uptick in a cycle replete with fits and starts. Here in the United States, we see faltering real income growth, eroding profit margins and soft signals from some forward economic indicators. Against this backdrop, I feel it is important for investors to think about the importance of conserving principal should the cycle come to an abrupt end.

Do we think the nearly eight-year rise in equity prices and valuations is justified? Most decidedly, yes. Since March 2009, the S&P 500 Index has had a total return of approximately 250%, driven by two primary factors: First, super-easy global monetary policy in the wake of the banking crisis, which drove down returns on safe assets to the point where risky assets became a much more compelling proposition than is typical. Second, expanding profit margins — margins have been running 80%–90% higher during this cycle than their long-term average — and improving cash flows

However, both these pillars are starting to erode. Central banks are becoming less accommodative. The US Federal Reserve is in the midst of a tightening cycle, and pressure is building on the European Central Bank and others to taper their quantitative easing programs. Profit margins are eroding too as the pushback against globalization prompts multinational firms to cut back on their use of cheap overseas labor. Furthermore, higher costs of capital are being felt as interest rates rise. While weak capital expenditures have kept profit margins robust, they also reduce future productivity growth. Once rock-solid corporate balance sheets have weakened of late as debt as a percentage of assets and debt as a multiple of available cash flow have both risen to levels last seen before the peak of the US housing cycle in 2007. These factors call into question the ability of companies to increase profits enough to justify today’s lofty valuations.

While there could be more stock gains ahead, an investor’s entry point has a significant influence on subsequent returns. Entering the market at today’s S&P 500 price/earnings multiple of 21 times previous 12-month earnings gives investors little cushion should the present market ebullience fade, especially when one considers that the 40-year average P/E multiple is closer to 16 times. Small-cap and value stocks are even pricier, approaching all-time-high price/earnings multiples. History suggests that subsequent returns have been weak when shares are purchased at higher-than-average multiples. Further, since the end of World War II, the average price decline from the stock market’s peak during a recession is 24%, according to Ned Davis Research, and is sometimes much worse. For example, during the global financial crisis, the S&P 500 declined nearly 57% before bottoming in March 2009.

As noted at the outset, the market began to rally this fall as the global economic outlook brightened, and the rally intensified with the election of a new president who promised a reflationary policy mix of tax cuts, infrastructure spending and regulatory reforms. Among my greatest concerns is that the market is now priced for perfection and is ignoring myriad risks while embracing the reflation narrative. President Trump’s agenda faces the reality that Washington moves slowly in the best of times and not at all in the worst. Even once legislation is passed, it can take months or years to launch infrastructure projects — given extensive permitting and environmental processes — which dilutes their stimulatory economic effects. With congressional elections every two years, the new president, realistically, only has about an eighteen-month legislative window to get his top priorities enacted before representatives begin focusing on their reelection campaigns, bogging the system down further. Markets seem to be working under the assumption that significant economic stimulus will be felt this year. I think it will be later and smaller than the markets have priced in.

Lastly, predicting the demise of business cycles is tricky, but here are the warning signs I look for, and all are now evident to varying degrees:

  1. Decaying profit margins and profit share of GDP
  2. A marked increase in mergers and acquisitions
  3. A rise in interest rates
  4. A strong US dollar
  5. A “story” that justifies extending the market’s advance despite deteriorating fundamentals
  6. A lack of private sector investment
  7. A significant increase in corporate and consumer credit

While I can’t predict whether the market will rise or fall in 2017, investors may want to focus on capital preservation given current historically high valuations. Hard-won gains have been achieved during this extraordinary cycle, but further near-term gains may prove hard to come by.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

Too Much, Too Little, Too Late?

Business cycles don’t typically die of old age. More often than not, some outside force, such as higher interest rates, snuffs out the expansion. Surely the US Federal Reserve’s intent is not to bring the economic cycle to a close, but that is often the end result of trying to rid the system of risks like excessive financial leverage or runaway inflation. Sometimes the Fed has an accomplice or two, such as an oil shock or a currency dislocation. Whatever the cause, recessions are unwelcome, bringing with them rising job losses, falling financial markets and even bankruptcies.

The end of a business cycle can be tough on investors. Stock and high-yield bond portfolios typically tumble. The average decline in the S&P 500 Index during a recession is 26%, and during the global financial crisis, the index declined nearly 50%. Recessions can be particularly damaging to Main Street investors, as they typically exit the markets after most of the harm has been done and often do not reenter markets until well into the subsequent expansion, when confidence abounds. Poorly timed exit and entry points mean the average investor does not achieve anything like the returns of the major indices. For instance, only now, with markets up 230% from their March 2009 lows, are Main Street investors reentering the market. This begs the question, are they too late again?

Alive and kicking, for now

We’re in the midst of the third-longest business cycle in the post–World War II era. At the moment, even though the cycle is showing signs of fraying, there are no obvious threats to its continued well-being. However, it may pay to be wary of entering the market at this late stage, as risk/reward ratios tend to become unfavorably skewed late in a cycle.

With that in mind, let’s look at our late-cycle checklist.

late-cycle-checklist

Investors may want to take heed of the increasingly worrisome signs indicated above. However, these should be taken as cautionary signs, not a call to retreat. There are also some positive signs afoot. For example, inflation has been late to arrive this cycle, which should allow the Fed to tighten monetary policy much more gradually than would normally be the case. Also, the US labor market continues to slowly improve, suggesting this business cycle will be prolonged. However, there is the risk that the cycle could suffer a slow fade-out. While US personal incomes are rising, health care costs are rising faster, taking away purchasing power, which is impacting consumer-facing sectors such as restaurants and retailers. US business spending remains very weak, and credit conditions are already tightening for certain borrowers. Several market sectors are experiencing profit erosion, which contrasts with the first six years of this business cycle, when margins and profits rose in tandem. US worker productivity is falling, as well, as unit labor costs rise.

Aging expansion vulnerable

While we’re not yet in bubble territory, I’d caution investors that US and European markets are historically expensive on both a price-to-earnings and price-to-sales basis. For example, the Russell 2000® Index is now at a price/earnings multiple of 27. However, I don’t foresee a quick or violent end to this cycle, as we saw in 2008. But I am concerned that late-cycle entrants into risk assets like stocks and high-yield bonds are taking a leap of faith at a time when there is less room for markets to move up and growing risks of them falling back. I do foresee this cycle coming to an end, but not as suddenly or brutally as in prior episodes. This aging expansion, now in its eighth year, weakened by faltering profits, is becoming more vulnerable due to slowly rising interest rates, sluggish consumer spending, shrinking profit margins and rebounding energy costs. Gone are its youthful days of mid-cycle strength.

In the wake of the US election, the retail investor has come back to life. But history tells us that changes in political regimes have relatively modest impacts on the real economy, which obeys only the laws of supply and demand. The signals being sent by the real economy are much more sobering than the signals being sent by a euphoric market. In my view, the odds of a reacceleration in economic growth are minimal at this late stage of the cycle. Retreating slowly from risk is one way to manage today’s ecstatic environment, perhaps by lightening up on historically expensive assets and shifting over time into high-quality corporate bonds or shorter-term fixed income vehicles.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

 

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.

The Latest Projections for the Global Economy

IMF Global Growth

The world is struggling economically. In its latest World Economic Outlook, the International Monetary Fund (IMF) projected that the global economy would grow by about 3% this year. In early 2014, by contrast, it was projecting that global growth in 2015 would be almost 4%. Most of this decline was related to emerging markets.

In early 2014 the IMF was projecting that emerging economies would grow by 5.4% this year, but it now projects only 4% growth. The decline in its projection for developed economies (including the US) from 2.3% to 2% was much smaller. The dramatic deceleration in emerging economies is a large part of the reason why emerging market stocks have struggled so far this year.

Yet these disappointing statistics don’t necessarily mean you should avoid exposure to emerging market stocks in your portfolio. It’s important to remember that there’s only a very weak relationship between a country’s economic growth and its stock market performance. It’s well known that growth in many big emerging economies is slowing, so this information is likely already incorporated into stock prices. And some effects of sluggish economic growth—such as weaker currencies, lower inflation, and less wage pressure—could actually help some stocks.

The IMF’s projections show emerging market economies bouncing back to 4.5% growth next year and 5.3% growth by 2020, so they’re not completely dire. These projections of a quick rebound may prove too optimistic, particularly the IMF’s belief that China will be able to maintain a growth rate above 6%. But even if emerging economies continue to sag, it’s very possible that emerging market stocks could do well. Despite economic weakness, keeping a globally diversified portfolio is still a good idea.

The Big Trends in the Global Economy

Global Growth

A lot has seemingly happened in the global economy in recent months, from a plunge in the oil price to a surge in the value of the US dollar against foreign currencies to an election in Greece that led to renewed fears about the possibility that the euro zone would break apart. But what’s been the upshot of all these changes? The latest World Economic Outlook report from the International Monetary Fund provides some data to answer that question.

According to the IMF’s report, the global economy is expected to grow by 3.5% this year. That’s lower than the projection of 3.8% growth that the IMF made six months ago. The change is largely the result of slower expected growth from emerging markets (5.0% six months ago versus 4.3% now). The prospects for developed economies, on the other hand, have actually improved slightly. While the estimated 2015 growth for the US hasn’t changed (it’s still 3.1%), the IMF boosted its growth estimates for the euro area and Japan.

Even though expectations have declined for emerging economies as a whole, not every country has a similar story. Six months ago the IMF expected a positive growth rate this year in Russia and Brazil; now it expects both countries’ economies to get smaller. The anticipated growth rate for China has also declined, although it’s still very high at 6.8%. India has gone in the other direction. Six months ago the IMF was projecting that India’s growth this year would be 6.4%. The latest estimate is 7.5%.

It’s important to remember that there’s only a weak link between economic growth and stock market performance, so simply buying stocks of fast-growing countries (or stocks of countries where the economic outlook has improved) probably isn’t a good idea. In fact, China and Russia have been among the best-performing stock markets so far this year. Still, thinking about the global economy in terms of these numbers may make the big-picture trends more apparent.

What the Job Boom Means for Stocks

Jobs Stocks

On Friday the Bureau of Labor Statistics announced that the economy added 257,000 jobs in January and increased its estimate of last year’s job gains. The 3.1 million jobs that were added in 2014 according to the latest numbers were the most since the turn of the century, and 2015 seems to be off to a strong start as well. So what does this job market boom mean for your portfolio? The answer, perhaps surprisingly, is “probably not much.”

We’ve noted in the past that there’s only a weak relationship between the strength of the economy and how well the stock market performs. This can be seen in the graph above, which shows the relationship between how many jobs the US economy has gained or lost each year (on the x-axis, shown in millions) and the annual returns of US stocks (on the y-axis) over the past 10 years.

The black line shows that there has been a positive relationship between job growth and stock market performance, but it’s not a very strong one. (For the statistically-minded, the job growth explains less than 10% of the variation in stock market performance during this period).

There are clearly some years where the job market and the stock market moved in the same direction: 2008 had massive job losses and a tanking stock market, while 2013 had job gains and a stock market surge. But there are also years where there’s seemingly no relationship. In 2009 the economy shed almost 5 million jobs while US stocks rose by almost 30%. The stock market was flat in 2011, when there were almost as many job gains as in 2013.

This weak relationship doesn’t mean that the job market is completely meaningless when it comes to your portfolio. It could have less direct effects on a number of investments by affecting when the Federal Reserve starts to raise interest rates and whether the US dollar continues to gain in value against foreign currencies. But by itself the fact that the US economy looks likely to have another year of strong job growth doesn’t reveal much about how the stock market will perform.

Brazil’s Stock Market Struggles

Brazil Stock Returns

Emerging market stocks haven’t done particularly well in recent years, but Brazilian stocks have done especially poorly. From 2010 through 2013, Brazilian stocks substantially underperformed emerging markets as a whole in each calendar year. So far this year, however, Brazilian stocks have outpaced their emerging market peers. Does this reversal herald a comeback for Brazil’s stock market?

The struggles of Brazilian companies have a number of causes. The country has been battling persistently high inflation, currently above 6% per year. Worker productivity in Brazil has been weak due to factors such as poor infrastructure, a low-quality education system, and inefficient regulations. And declining commodity prices in recent years have hurt the country’s commodity producers.

Often times when a country’s stock market dramatically underperforms over a number of years, stock prices fall so far that they subsequently look cheap. By conventional valuation metrics such as price-to-earnings ratio and price-to-book ratio, however, the valuation of Brazil’s stocks isn’t much different from emerging markets overall. Other valuation measures, such as the ratio of the size of the country’s economy to the size of its stock market, suggest that Brazilian stocks may indeed be undervalued, but less so than other emerging markets such as China.

Since Brazilian valuations don’t seem especially attractive, the country’s stock market will likely need something else to provide a boost if it’s going to build on the gains achieved so far this year. Perhaps elections in October will provide the impetus for pro-growth economic reforms, or a stronger global economy will lead to higher commodity prices. If not, the stock market gains so far this year may be an aberration rather than the start of a trend.

Should You Prepare for a Long Period of Slow Growth?

Larry Summers 2

More than 5 years after the most acute phase of America’s financial crisis, the US unemployment rate is still far above its pre-crisis level. In a series of articles during the past few months, former Treasury Secretary Larry Summers suggested that the economy may be in a persistently depressed state (a “secular stagnation” in the technical jargon). The article sparked renewed debate among economists about whether such a prolonged slump was theoretically possible, and if so, whether the economy was in one right now.

An extended period of slow economic growth should be good for bonds (due to low inflation and interest rates) and bad for stocks and commodities (because of weak demand for goods, services, and raw materials). Yet there are reasons to think that even if the pessimistic side of the secular stagnation debate is correct, trying to adjust your portfolio in response could be a mistake.

One reason is that there’s only a very weak link between economic growth and stock market returns. A long period of low economic growth and high unemployment would hurt companies’ ability to grow their revenues, but it would also keep a lid on how much they have to pay their employees. The lack of pressure to raise employees’ wages is part of the reason corporate profits in the US have been so high since the financial crisis.

A second reason is that Summers and the other proponents of his hypothesis aren’t arguing that a prolonged slump is inevitable, but rather than the government would simply have to use some different policies to overcome it. They argue that policy changes such as increasing government spending on infrastructure, raising the central bank’s inflation target, and allowing more immigration would help boost investment in the economy and reduce the unemployment rate.

Shifting your portfolio to prepare for an extended period of weak economic growth therefore wouldn’t just be a bet that the pessimists are correct; it would also be a bet that the government wouldn’t properly adapt and that no unforeseen occurrences lead to a surge in investment. The secular stagnation idea was previously peddled by an economist named Alvin Hansen in the 1930’s, when he argued that trends such as a declining population growth rate would lead to persistent high unemployment. The unexpected baby boom following World War II invalidated his prediction.