Jul 26, 2017

Some Speed Bumps Slowing the Bull

I continue to believe that the two most important issues receiving inadequate investor attention are productivity and the role of central bank liquidity in the performance of financial markets. Productivity is critical to both earnings improvement and a rising standard of living. Central bank liquidity has driven price earnings ratios higher and kept interest rates low. Productivity has been declining everywhere during the past decade compared to the 1996–2006 period, with the exception of China and India. This has placed the burden of profit growth either on existing customers spending more or on new products and new markets. Improving profitability is increasingly difficult in a slowly expanding business environment. The intention behind central bank balance sheet expansion has been to stimulate economic growth but, by my estimate, three quarters of the monetary accommodation over the past decade has gone into financial assets with only one quarter invested in the real economy.

A major reason for the weak productivity numbers is that no major technological innovation improving productivity has occurred since the Internet and the smartphone in the 1990s. The next major positive change will probably result from the introduction of the driverless car and truck. Unfortunately, almost any innovation that improves productivity has the concomitant characteristic of eliminating jobs, leading to human hardship and increasing government costs for social support programs.

Skeptics believe the productivity numbers are flawed because some improvements in worker output as a result of software applications and greater use of medical technology are hard to measure, but there seems to be little question that the productivity gains of the 1995–2005 Internet/smartphone period have slowed in the past decade. The Bank Credit Analyst has conducted a study which concludes that low productivity gains ultimately lead to higher inflation and interest rates. The emerging markets exemplify this. We will have to see if this model applies in the current cycle. The BCA economists conclude that low productivity keeps interest rates from rising at the outset but eventually leads to higher inflation and interest rates as savings are depleted. Some believe the large amount of time millennials spend on Instagram and Facebook actually detracts from productivity. The decline in mathematics proficiency for graduates of American public high schools could also be a contributing factor. Low investment in capital equipment has also lowered worker output per hour worked. There is also evidence of declining entrepreneurship. The birth rate of new companies has declined by 50% since the 1970s and now roughly equals the general business death rate. Despite these negatives, there is some hope that productivity will improve in the second half of 2017 with a stronger economy.

One aspect of the productivity issue is reflected dramatically in the U.S. equity market. Through the middle of June the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix and Google, along with Microsoft) represented 13% of the capitalization of the Standard & Poor’s 500, but accounted for 33% of the appreciation. These companies were in the 90th percentile of all companies in the index, based on return on invested capital (close to a 100% return). The median was 20%. Investing in the companies with the highest return on invested capital and with the highest margins has paid off. It helps if they are in a dominant position in their respective industries and can maintain their market share. Looked at another way, Amazon and Walmart stocks were selling at about the same price in 2008. Since then, Amazon has soared and Walmart has stayed roughly flat. Today, Amazon has a market cap of $476 billion and Walmart’s is $230 billion. Amazon has 351,000 employees and Walmart has 2.3 million. Technology enables some businesses to build profits with a minimum of human capital and enjoy high margins as a result. That will be the shape of the future, with serious implications for the economy and the market.

As for central bank liquidity, it has increased 13% year-on-year for the four major industrial regions – the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan. The total of the balance sheets of those four is $12.8 trillion today compared with $3 trillion in 2008 before the financial crisis. We know, however, that the Federal Reserve is tightening its posture, having increased short-term rates twice this year with the promise of further increases to come later. The Fed is also planning to slowly shrink its $4.5 trillion balance sheet by letting maturing bonds be redeemed without buying replacements in the open market. This has the effect of reducing the supply of money in the economic system with bearish implications. The European Central Bank under Mario Draghi is also considering switching to a less accommodative stance. Draghi is going to the Jackson Hole economic conference at the end of the summer where he may announce a change in European Central Bank policy. If the Fed chooses to become more aggressive in its tightening process, Janet Yellen may use Jackson Hole as an opportunity to announce that change to the world as well.

Fortunately, earnings are coming in better than expected. After several years of modest increases, primarily because of poor performance in the energy industry, S&P 500 earnings are expected to break out and be up 10% this year to close to $130, or possibly even higher. Earnings improvements in the financial services industry will also help increase 2017 profits for the index. Continued double-digit earnings increases should not be expected, but I could see S&P 500 earnings exceeding $150 by the end of the decade if no recession takes place. While the current expansion is more than eight years old, few excesses are apparent and I am optimistic that the next serious downturn is several years away. If a recession should occur before then, determining what policy steps could be taken to get us out of it will be difficult. With interest rates already so low, the Fed has little room to create stimulus by dropping the Fed funds rate. Also, a Republican Congress is unlikely to pass bills providing significant fiscal stimulus. As a result, the best policy course is one that attempts to defer the next recession for as long as possible.

During the past few weeks, the yield on the 10-year Treasury has increased from 2.19% to 2.31%, and many observers are concerned that the yield is finally headed to 3% or higher. At the beginning of the year, the consensus was that higher interest rates would be encountered during 2017, but that view was largely based on Donald Trump getting his pro-growth agenda passed in Congress, and that has not happened. The big financial surprise of the year has been the decline in intermediate-term rates, but the recent rise suggests that trend may be reversing. At the level of 2.5% or below on the 10-year Treasury, my dividend discount model (which is designed to determine when stocks and bonds are equally attractive) indicates that the S&P 500 equilibrium point is above 3000, so stocks at present level of 2460 would appear to be very attractive. If the 10-year Treasury yield climbs above 3%, the index at present levels would be overpriced based on the model. While the model has the appearance of precision, it is actually a somewhat crude estimator. Until now, interest rates have not played much of a role in the performance of the equity market. One of the reasons the market may be consolidating recently could be that investors are apprehensive about the possibility of rising yields providing bond market competition for stocks.

The optimistic earnings projection of $130 for 2017 was originally based on the assumption that the Trump administration would get a good part of its pro-growth initiative passed in Congress. We are now six months into Trump’s first term and his team has been preoccupied with controversies over Russia, cabinet and other appointments, Twitter postings and other non-legislative matters. It has proven to be almost impossible to get a revision of the Affordable Care Act approved within the Republican Party. Some observers believe Trump made a mistake by trying to tackle healthcare first rather than other items on his agenda like tax reform, but I disagree. The Affordable Care Act is unworkable in its present form with so many insurance companies dropping out of the program. I believe we must know the cost of the revised program before a new budget can be agreed upon or tax reform can be accomplished.

While the United States economy appears to be strong, there are some signs of weakness that are worth watching. The employment report for June was better than expected, but average hourly earnings were flat, and this seems to have discouraged consumers. The University of Michigan Consumer Sentiment survey is at a nine-month low and this is likely to be reflected in Christmas retail revenues. Automobile sales have been strong for a long period of time, but they are finally showing signs of peaking. Capital spending has improved, but this is largely because of increased expenditures in the energy industry. With the recent soft price of oil, energy companies may pull back on capital projects until the outlook improves. Retail and food service sales are in a clear downtrend. Some of these weaknesses are viewed favorably by investors in the hope that they may persuade the Fed to go slow on raising rates. Softness in the economy will also help keep inflation low, dampening any tendency for interest rates to rise. One of the anticipated drivers of the economy for this year and next is housing, and the data for this sector have been mixed. Overall, the tone of the economies around the world is favorable, keeping an eye on potential areas of weakness is useful.

There is always the danger of a geopolitical event unsettling the world’s economies and markets. North Korea testing a long-range ballistic missile capable of carrying a nuclear warhead and reaching the Unites States is one possibility. Russia taking a hostile position in the Baltic States, as it did in Ukraine, would test NATO. The lingering question of Russian involvement in the 2016 presidential election may be hampering the Administration’s ability to pass legislation in 2018 as well as 2017, creating further problems for the market and the economy. Many attribute the current market’s rise to confidence in Trump’s pro-growth agenda. After all, the rally started with his election. If the Administration were unable to get even part of its program passed in 2018, there is the danger that the Republicans would lose a significant number of seats in the November 2018 congressional election and I think the markets would find that unsettling.

Since 2009, there has been a strong congruence between the expansion of the Federal Reserve balance sheet from $1 trillion to $4.5 trillion and the rise in the S&P 500. Since the beginning of 2017, the balance sheet has remained flat and the index has risen almost 10%. This divergence is disturbing, particularly since the Fed is contemplating a balance sheet shrinkage starting in September. The combination of small increases in productivity and tighter monetary policy represent an obstacle to the market for the second half of 2017. Earnings are coming though impressively, however, and I still believe that we will see higher highs for the index before Christmas.


Fed Balance Sheet Versus S&P 500


Byron Wien august 2017

Source: Gavekal Research, Evercore ISI (6/17).


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