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U.S. Economic Health Hinges on Domestic-Driven Growth

| July 17, 2017
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U.S. Economic Health Hinges on Domestic-Driven Growth

While the economic cycle has entered its eighth year, it still does not display late-cycle characteristics, such as significant wage pressures, high inflation or elevated interest rates. Domestic sectors, primarily driven by personal consumption, continue to spur economic growth.

The Trump administration's policies support continued dependence on domestic drivers, particularly in light of efforts to cut taxes and shrink the trade deficit. Government deficits have been shown to increase corporate profits. If the administration is intentionally muting corporate profits by decreasing the deficit then it will be essential for consumer spending to remain the primary engine of growth until potential fiscal tailwinds intensify in 2018 and beyond.

The first set of first quarter GDP revisions, up to 1.2% from the advance estimate of 0.7%, showed a firmer growth profile, with the consumer-spending stall now appearing less severe. This is favorable news in terms of signaling that the predominant growth driver over the last several quarters merely wobbled in the first quarter and is therefore likely to rise in the second quarter. However, the weakness in corporate profits demands attention as it is a critical driver of private sector decision-making with respect to hiring and investment.

U.S. economic vibrancy will be directly linked to the resilience of consumers – and therefore the labor market – for the foreseeable future. So long as the labor market's health is intact, recession risks should remain low.

 

U.S. Growth Centered on Consumers as Fiscal Prospects Fade

Global growth prospects appear to be improving, which should provide a moderate tailwind to U.S. economic activity; nevertheless, the U.S. economy will be primarily driven by domestic components for the foreseeable future, particularly consumer spending. As a result, domestic growth prospects will largely depend on household income creation and access to credit. Fiscal stimulus appears less likely, so the accompanying, secondary drivers will presumably be business investment and housing.

At midyear, we estimate the core pillars of Trumponomics – tax reform, infrastructure investment, and a shift to a protectionist tax system – are in limbo as the administration has refocused on other priorities amid a tight legislative calendar.

 

Labor-Market Slack Dwindles as U.S. Flirts With Full Employment

Healthy job growth has been a critical aspect of the current economic cycle. It has allowed the U.S. economy to sustain growth via increasing domestic consumption. Ample job gains, amid limited wage pressures and stable labor-force participation, support the view of the Federal Open Market Committee's (FOMC) doves that labor-market slack has not become excessively lean. This gives policy makers the luxury of proceeding slowly and deliberately.

Even as President Trump works to revive manufacturing, the sector is far less labor-intensive than in previous decades due to technological advancements in the form of greater automation. As such, the medium-term jobs outlook still depends on domestically-oriented private services.

 

Full Employment to Drive Firmer Wage Growth

Job gains have been sturdy over the past five years, but wage pressures are only starting to build. As long as job creation holds up at a pace that exceeds the natural growth rate of the labor force, the labor market should begin to display characteristics consistent with full employment. This will improve the "feel" of the economic cycle as wage pressures have remained an elusive element of faster growth in recent years.

Economists do not know the precise level of unemployment that corresponds to full employment, as it varies from cycle to cycle. The recent dip in the unemployment rate into low 4% territory signals the economy is very close to full employment.

 

Consumer Spending Becomes Dominant Growth Engine of U.S. Economy

Full employment could be a game-changer for U.S. workers because it may result in labor shortages extending beyond specific pockets of skilled workers. This potentially could help alleviate wage stagnation. The most direct impact from wage growth will be to fortify consumer spending. While wage inflation may moderately lag behind labor market performance, conditions are ripe for a sustained acceleration.

Firmer household income growth will support a faster pace of consumption and drive domestic activity. For this reason, the economy may be able to outperform the sluggish pace that has prevailed for most of the cycle.

 

Housing Modestly Boosting Growth, Prospects Still Encouraging

The housing sector is expected to add moderately to economic growth in 2017, even as rising prices, limited supply and tighter financing all produce headwinds. The housing outlook will greatly depend on whether overall economic growth accelerates enough to support potential home-buyer demand offsetting the impact of those headwinds.

The longer-term prospects for residential investment are still encouraging as consumer balance sheets have improved, the labor market strengthens further and the pace of housing construction continues to head toward its long-term average of 1.5 million housing units that prevailed before the crisis.

 

Corporate Earnings Are Key to Private-Sector Hiring, Investment

Corporate profits drive private-sector spending on labor and capital. Profits sank in 2015 as the strong U.S. dollar and global economic weakness weighed on domestic companies' returns from non-U.S. operations. Forecasters have been optimistic on the profits outlook since a multi-quarter contraction appeared to end in the second half of 2016. Earnings rose for three consecutive quarters in year-on-year terms through the beginning of 2017.

If the economy is maintaining a pace of growth near 2%, or even accelerating mildly as the year progresses, then the profit trend should continue to grow which will help boost business investment.

U.S. companies are expected to boost capital investment this year, following a downturn in 2016, as corporate profits rise and the prospect of the Trump administration's deregulation and tax-reform agenda bolsters optimism. Business investment is set to become a domestic growth engine amid faster overall expansion and rising capacity constraints. However, if growth remains mediocre and corporate profits rebound only gradually, the revival of business investment will likely prove somewhat sluggish as well.

 

Monetary Policy’s Effect on Stocks

With market valuations well above long-term averages yet real interest rates still low, equity investors continue to take comfort in the idea that the Federal Reserve will only slowly drain the punch bowl of accommodative monetary policy in the year ahead.  As long as Fed meeting minutes show that the central bank remains on track to maintain a slow and steady course of policy tightening, stocks will likely sail through the news unscathed.

In the past, Federal Reserve Chair Janet Yellen has suggested a desire to slowly shrink the central bank's balance sheet back to its natural rate of growth and provided some guidelines at the latest FOMC meeting on June 14. It's currently about $2.5 trillion in excess of the said run rate. Treasuries make up more than half of the Fed's balance sheet, with half of those maturing within five years. Any discussion of roll-off through maturing Treasury bonds could create complications for the yield curve and equities in the quarters ahead if investor psychology isn’t handled delicately.

As real interest rates are the key to stock valuations, any change in the outlook for the Federal Reserve's balance sheet is becoming the hot topic for equity investors keenly focused on monetary policy. Each time that the Fed has tried to stop expansion in recent years, stocks have corrected, as in 2010, 2011 and 2014-15. Stocks have been reinvigorated of late by improving economic indicators and hopes for fiscal stimulus. Low or negative real rates have allowed stocks to overcome concerns over policy change.

It remains to be seen how a shrinking balance sheet will affect the economy or investor sentiment. While policy is likely to generally stay accommodative as the Fed normalizes interest rates, any evidence that tightening appears set to speed up or that an unwinding of its balance sheet is imminent could rock the otherwise smooth sailing of the equity market relationship with Fed policy this year.

 

Market Volatility

Volatility as measured by the CBOE Volatility (or VIX) Index has remained very low, spending weeks below 10 (compared to a longer-term average in the high teens). This, despite many catalysts that could be sources of uncertainty that tend to push volatility higher: uncertainty around the new administration’s legislative agenda, controversy over alleged campaign collusion with Russia, contentious elections in Europe, repeated terrorist attacks, and tensions around North Korea’s nuclear program…the list goes on.

When volatility spikes, it’s helpful to both avoid indiscriminate selling and capitalize on turbulence by adding exposure at relatively attractive prices. In addition, non-traditional strategies away from pure index strategies can introduce reduced beta exposure while participating in up markets. These strategies, more commonly referred to as liquid alternative strategies, have the potential to help limit the full magnitude of a market downturn, while still having an upward bias if the market continues to climb and can be useful to investors who are cautious regarding volatility.

Current low volatility could be upset by a number of elements: signs of a debt crisis or weakness in China, overly aggressive central bank tightening, consumer weakness, or major moves in currencies or commodities. In short, developments that cause investors to lose confidence in GDP growth could undermine their confidence in risky assets. Volatility is part of the landscape and eventually higher levels are likely to reassert themselves. We believe that investors should be prepared while maintaining a long-term time horizon.

 

Constructive on Emerging Markets

While we are still cautiously positive on the U.S. equities, we prefer to maintain a globally diversified allocation and we have a constructive view on Emerging Markets (EM). U.S. based companies have been on a tear in recent years, but history has shown that is not always the case. With non-U.S. stocks accounting for roughly 50% of the world’s equity market capitalization, our investment universe is not limited exclusively to U.S. securities. Our viewpoint is informed by the following reasons:

•  Relative growth rates are improving for the first time in years – EM growth is now improving after 5+ years of deceleration while Developed Market (DM) growth has been resilient but is not accelerating.  

  • •  Productivity growth is now exceeding wage growth and the composition of growth is improving (more domestic demand and less export dependent).
  •  
  • •  Healthier fundamentals for emerging countries as many have undergone significant external adjustments and periods of deleveraging so credit cycles are improving.
  •  
  • •  Operating leverage is a key theme – EM is early in the growth cycle and many companies have taken steps to reduce CAPEX and improve cost structures, so they're now positioned well to realize margin expansion.
  •  
  • •  Governance and treatment of minority shareholders is improving (Korea, Russia, etc.) – focusing more on cost control, investing in automation, equity incentives, paying out more in dividends/buybacks.
  •  
  • •  Relative growth, profitability and valuations favor EM over DM:

25% PE discount (one standard deviation)*

30% PB discount (one standard deviation)*

Same ROE (and improving on a relative basis)*

Better earnings growth (18% vs 13%)*

Cyclically adjusted (Shiller) PE for EM around 10x while US is around 30x*

The former near historical lows and the latter near historical highs*

For long term investors who believe high current DM valuations will lead to lower future returns, we believe a sensible allocation to EM could benefit their savings portfolio.

Continue reading our detailed 2017 second quarter review in our blog.

 

 

Disclosures

*Source: MSCI EM vs. MSCI EAFE, Bloomberg.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. All economic data is historical and not indicative of future results.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

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Beta measures a portfolio’s volatility relative to its benchmark. A Beta greater than 1 suggests the portfolio has historically been more volatile than its benchmark. A Beta less than 1 suggest the portfolio has historically been less volatile than its benchmark.

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