Strong, Though Distorted
For years the U.S. economy hovered around a moderate, near 2% average pace of growth. But in the last 12 months, we have risen visibly above that.
You’ve heard us report that demand perked up last fall as “replacement” activity spiked post hurricanes Harvey (August, 2017) and Irma (September), most obviously in auto sales. Then, as the rhetoric and actions on trade became increasingly threatening, evidence revealed accelerating demand in anticipation of higher tariffs and heavier business costs. Commodity prices have been on an up-leg, too, helping energy and materials sector activity.
Finally, the Trump administration and Congress passed a large, front-loaded tax cut and government spending boost, which has contributed to faster growth.
All of these have a nagging, temporary feel to them. In fact, the last factor – tax cuts and government largesse – hasn’t been quite as powerful as we expected, which may also suggest that it could fade sooner than its vast size would suggest.
Nevertheless, strong growth it is, for the time being, which has contributed to a pace of inflation that has reached our central bank’s target of near 2%, while wages accelerate and government deficits rise predictably. These factors typically translate into higher interest rates. And both “Main Street” and most financial assets tend to dislike higher rates.
Is it any wonder that, as we write this, the fourth quarter is starting with a bout of nerves in bonds and stocks alike?
Day to day, we see that restaurants are full and people are spending money. What’s the broader economy telling you?
Pretty much the same. Most is well, growth-wise.
In fact, the pace of spending and investing, overall, has improved. Sure, there always are pockets that show otherwise but, overall, we are firing on most cylinders…or, given the direction we’re headed, humming on less-polluting batteries!
You know, when we hear your thinking it often feels like there’s another shoe to drop. Go ahead, what else is on your mind!?
Proudly guilty as charged!
The fact is, no matter how much we want to make this straightforward, we can’t help looking at the whole picture, including the part of the canvas that will only be painted in 6 or 12 months. And the reality is, this economic painting is always impressionistic in style.
The one thing we feel compelled to point out is that recent growth is probably boosted by temporary factors.
You’ve heard us talk about the echoes from the Harvey and Irma hurricanes last summer and fall, and how the economy saw a burst of demand for rebuilding and replacement from the havoc and destruction wrought particularly in Texas and Florida. We may still be feeling the lingering effects of that.
More recently, business gradually heard more alarming rhetoric and saw more actions on trade – tariffs in particular. These are viewed by many as simply a tax on purchases and thus a higher cost of doing business, with higher reporting and other regulatory costs in tow. Many businesses may be accelerating future spending to avoid these anticipated higher prices.
Finally, we’ve also previously reported on the tax cuts and higher government spending that represent the key economic legislative step taken by this administration and Congress. This has accelerated capital investment and improved consumer spending.
Is it all panning out as you might have expected?
Well, that’s a very interesting question, particularly with regard to the fiscal boost.
Washington designed the tax cut and faster spending to be front-loaded, to create higher activity near-term and worry less about outcomes in the out years. They are politicians seeking re-election, after all.
We expected this might mean that jobs, for instance, could show a very noticeable bulge for the first 6-12 months before reverting to their underlying glide path.
It appears that higher savings and stock buybacks could be seeing new emphasis, as we have seen a modest boost in payrolls, although more subdued than might have been. This likely arose from an unemployment rate so low that businesses can’t find the people for their record number of job openings – over 7 million – be they skilled or unskilled. We’ve used up a good chunk of the available labor force, and those arguing that there’s a hidden pool of unemployed people are, in our humble but extensively researched view, not giving enough weight to structural forces that have shrunk the pool of potential employees. Most prominent is the huge wave of retiring baby boomers, but it’s also impacted by the lower participation of women. Smaller but still relevant is the number of disabled, only some of whom can be persuaded to re-enter the labor force, and then only over a period of years and after extensive treatment.
Instead, as one would expect in a setting of low unemployment, this strong recruitment of job candidates is leading to higher wages, which have accelerated to over 3%. This is a component of inflationary pressure, and an important one for the U.S., where labor is a large part of our cost structure.
Speaking of inflation…?
So, we already described that wages are speeding up, from near 1.75% as recently as 2015 to 3.2% or so in the last 9 months. Overall, inflation has reached the Fed’s target of 2% and is hovering there for now. Not exactly excessive, but it certainly suggests that the Fed’s previous view that the economy needed stimulus no longer seems warranted.
So, how would you put it all together?
Well, we have strong growth. Even if some of it is exaggerated by fleeting factors, it’s strong for now. Even the sectors showing moderation or weakness, like housing, would not translate into anything terminal for some time.
We also have inflation that has reached the central bank’s target and is seeing acceleration in a key component – the cost of employees.
Finally, as was predictable, a large unfunded tax cut and increase in government spending are driving up our budget deficit in a setting where the federal government is already burdened with a heavy debt load. This will continue to pressure the central bank to move from stimulus toward neutrality and eventual tightening. And higher interest rates are typically a negative for both Main Street and financial assets, which explains the air pockets that bonds and stocks encountered in early October.Download PDF
Expensive Thrills Built On Cheap Money
Economic growth, earnings, stocks and many other asset classes and strategies, like bonds and under-performing hedge funds, have been built on cheap money and debt-fueled government favors, which, as intended, also increased inflation and used up excess capacity in the economy. That, of course, now forces the closing of the monetary spigot, eventually reducing the life blood of markets. And round it goes in the economic circle of life.
The resulting higher interest rates hurt risk assets like stocks, both through reduced demand as well as making the present value of their earnings stream less valuable. That helps explain the volatility we’ve seen early in the fourth quarter.
But make no mistake, Fed policy on interest rates is all about Main Street. Wall Street is merely an intermediary – a supporting and often eccentric character actor on the stage of economic growth, jobs and inflation management. In fact, to help Main Street, the Fed often and unintentionally creates dislocations (and mispricing) in financial markets. And no one has ever figured out a way to avoid that.
The stock market, through September, has shown that it likes strong GDP and the after-tax, per-share earnings that are exaggerated by tax cuts and stock buybacks, leading to earnings growth in the 20+% range. But revenue growth, and pre-tax earnings growth economy-wide, are far more moderate, leading one to wonder whether we’re riding the crest of “peak earnings.”
What’s the worry? In a context of stretched valuations – a necessary though insufficient condition – the concerns arise from higher rates, higher oil/commodity prices and trade worries. Though some pooh-pooh it, we are steadfast in our conviction that markets prefer what, for decades, we’ve labeled an “open trade” architecture. And there is a cost to raising the drawbridge, in terms of opportunities for jobs, investment, innovation, and profit and productivity growth. It isn’t the best way to make Americans wealthier.
We’ve read that the economy, earnings, bond yields, and really many asset classes, including, of course, stock prices, are all healthy (or were – let’s keep this through September-end). Talk a little about what’s brought us here.
Through the third quarter, many financial markets and economic indicators have flashed green. And there is good reason for that. In the midst of the 2007-2009 recession, our central bank as well as the U.S. Treasury, both concluded that unusual action was required to prevent a serious problem from becoming an uncontrolled event – an economic China Syndrome. So the former cut interest rates aggressively and the latter increased government spending sharply.
There was strong consensus that this was the right thing to do for the economy. And we agreed. Then things diverged a bit, as they should have.
As to the former, interest rates were kept low for years. This was appropriate, as the economy had gobs of excess capacity and extreme business uncertainty, and households’ and banks’ balance sheets were severely damaged and needed repair. Only low interest rates could have achieved that, and only a prolonged application of the medication would do.
On the other hand, not long after applying an historic level of stimulus, the government soon set about reversing it so as to limit the pressures that unfunded spending can cause (think deficits and higher debt). It, too, was the right policy, and it took years to reverse, but government net spending was reduced and brought back roughly to where it had started before the crisis…until now.
As to all that money printing, who was it designed to help? So many people feel that it was all about the banks.
We strongly disagree that helping banks was the end game. But you’re right, the widespread impression has been that it’s just government helping big business.
In fact, the central bank has succeeded in remaining apolitical. It has been given a job by Congress and, by and large it really does go about its business, trying hard to ignore the political context that surrounds it.
The Fed, along with the Treasury, helped the banks and other financial institutions (like FNMA and AIG and auto companies) because it was the necessary means to help all the individual employees and borrowers on Main Street (individual and business alike) that needed help fixing their excesses and starting new ventures. Though it’s not well understood, that investment was worthwhile and profitable for the U.S. taxpayer.
Interesting. So, now that we’re watching what’s happening to markets in October, it begs the question – will it last?
In the last few years we’ve watched two more reversals of policy, one warranted (tighter money), one less so (looser government purse strings). Let’s focus on the former.
For years, low interest rates created large incentives to invest, increase demand, bring the economy back to health, increase jobs and avoid the very-hard-to-manage risk of deflation (i.e., prices that are outright falling). But we no longer need the crutch. As a result, the central bank has embarked on a gradual path toward a neutral stance.
This slowing flow of cheap and plentiful liquidity is necessary to prevent bigger problems down the road. Anticipation is a good thing, and given how long it takes for the monetary lever to translate into results, we believe the Fed is acting appropriately now, as inflation has risen to its target and wages are accelerating (not surprising since we have used up much of our labor pool, as evidenced by the record level of job openings, many going unfilled).
So the answer to your question is no, it probably won’t last. This reduction in monetary stimulus has resulted in economy-wide, pre-tax earnings and revenue growth that are moderate, leading many to wonder how much longer we’ll see additional earnings growth. Combine that with expensive valuations and things can look less attractive for investors. But the pull-back we have seen so far in October is relatively small potatoes – even an 800-point drop ranks about 80th since the 1950s.
So that’s the problem, higher interest rates?
Yes. Along with higher oil/commodity prices and trade worries, to name some key factors.
So far the administration has reached two revised trade agreements, a new KORUS with South Korea and a new NAFTA, renamed USMCA. Neither changed things very much and markets are primarily glad that the risk is behind us (though ratification is still ahead in 2019 and not assured).
But other trade noises are potentially more worrisome. And markets don’t like uncertainty. They largely prefer the fairly open trade architecture we’ve lived under for 40+ years. We know it’s controversial, yes, but this is our economic and markets assessment. And if markets see a meaningful risk of reversing this, then they will demand a risk premium, which can mean higher volatility or lower asset prices. Or both.Download PDF
Fixed Income Portfolios
The Interest Rate Path Of Least Resistance Gradually Up
Investors who have harbored doubts about our cautious duration position should be few and far between by now. Going back 1~2 years, who would have believed the U.S. 10-year bond yield would stand firmly above 3%, doubling the level of mid-2016? U.S. inflation might be up and down month to month, but accelerating economic growth, rising wage costs and higher tariffs are all adding up. Inflation could easily overshoot the Fed’s 2% target. In light of this, we believe the Fed was right to raise interest rates, and we should expect more rate hikes to come unless the U.S. suddenly decelerates.
Higher inflation is a staple of a good economy, so why is the Fed worried about it?
You’re right, we do normally see higher inflation in a strong economy. When inflation is driven by higher aggregate demand, reverses previous deflation risk, and is not pushed too high by speculative activities, it can be healthy. However, some inflation is cost-pushed. We believe what concerns the Fed right now are faster prices resulting from higher wage costs and additional tariffs, for instance. U.S. labor costs have already accelerated, rising 2.8% for Q2 2018, their highest growth since 2009. Amazon’s $15 minimum wage and J.B. Hunt’s 10% raises for truckers are a few signs of even higher wage costs to come. Higher tariffs have not yet caught up to the consumer, but as the trade war with China escalates, sooner or later the impacts of these tariffs will be coming to a store near you.
Does this mean that the Fed’s interest rate policy is justified?
We have long argued that the Federal Open Market Committee (FOMC) consists of a group of professional economists and financial technocrats. Their decisions have not and should never be influenced by politics. From the Fed’s point of view, recent GDP numbers showed the “output gap” (the difference between actual and potential growth) is closing, which historically has tended to usher in higher inflation. At 3.7%, the unemployment rate is hovering near a 50-year low and below the Fed’s 4.5% estimate of the sustainable level. It’s therefore reasonable for it to drop the long-standing use of “accommodative” monetary policy to reflect the reality of the current economy.
Are you saying interest rates will head higher?
Based on the Fed’s so-called “dot plots,” the FOMC will likely raise rates yet again in 2018, and possibly three more times in 2019. At the same time, the Quantitative Tightening process (shrinking the Fed’s balance sheet, as opposed to Quantitative Easing) will continue as the U.S. enters a more mature phase. Unless the U.S. suddenly decelerates in the very near future, and the Fed reverses its policy, we envision higher interest rates a year from now.
Another factor that could push U.S. interest rates higher is the rising federal deficit. As the Treasury issues more bonds to fund itself, this can reduce the price of bonds, which raises interest rates. Because of the tax cut and increased spending, the U.S. deficit rose 17% for fiscal year 2018 and, as a percentage of GDP, it has been steadily increasing since 2016. Without a drastic change in approach, this trend is expected to continue.
What is the implication to fixed-income investing?
Higher interest rates mean lower bond prices, so as long as interest rates are rising, we expect to see bond prices drop. Most of the time, longer-term bonds drop more in price than shorter-term bonds because of their higher sensitivity to interest-rate changes – so called duration risk. Fortunately for Hamilton Capital clients, our fixed-income portfolio is well positioned to weather the duration risk. Our bond duration is, on average, only half of the benchmark duration. This is part of our effort to manage both relative as well as absolute returns for the assets entrusted to us.Download PDF