Have you ever driven a vehicle with an engine that has a governor on it, like a golf cart? No matter how much you step on the gas, it just won’t go any faster. We may be in a similar situation with the economy today.
We gauge economic activity by a measure called GDP (Gross Domestic Product). It is the total value of all goods and services produced in the country. Goods and services are produced and delivered by workers, or machines run by workers. One way to break down GDP is to look at the number of workers and the amount of output per worker. In order for the total amount of output to grow, you need to add more workers, or increase the amount that each worker produces (called productivity), or both. A formula for real GDP growth can be stated as the growth in the number of workers plus the growth in the real output per worker.
The Pew Research Center has estimated that about 10,000 people per day turn 65 years old and that is projected to continue for the next 13 years as the baby boom generation reaches retirement age. J.P. Morgan has looked at the growth in the working age population in 10 year increments over the last 60 years. From 1955 to 2004 growth was between 1% and 1.9%. From 2005 to 2014 it slowed to just 0.7% and they forecast from 2015 to 2024 it will grow at just 0.4%. Therefore, this component of GDP growth is expected to be 0.6% to 1.5% less than it had been previously.
What about the other component of GDP growth, productivity? The ability to increase the amount of production per worker is driven in large part by spending on machinery and technology. With new equipment, training and technology each person would be able to produce more goods and services per hour of work. Unfortunately, spending on capital goods by companies has been weak for several years. Companies have favored using their cash for dividends and stock buy-backs rather than investing in productivity enhancing capital goods.
The economic recovery since the financial crisis in 2008 has been the weakest on record. Calendar year GDP growth has not been above 2.7% since 2005. Since the labor force is likely to grow between 0.6% and 1.5% less than it did prior to 2005, productivity would have to increase significantly in for GDP growth to expand to 3% and above.
The unemployment rate is at just 4.6%, down from 10% seven years ago. The U.S. is very close to economic full employment. President-elect Trump is proposing an economically stimulative agenda of personal and corporate tax cuts, reduced regulation, and increased spending on infrastructure. While these policies may produce some increase in productivity, the capacity constraints of meager labor force growth could raise the threat of higher inflation. The Federal Reserve has recognized this and in December increased the Fed Funds rate by 0.25%. They also increased their expectation for additional interest rate increases in 2017 to three more hikes.
Economic optimism is up. The fourth quarter Duke University/CFO Magazine Business Outlook Survey jumped to its highest level since the first quarter of 2007. CFOs aren’t the only ones more optimistic. The Conference Board’s November Consumer Confidence survey rose to the highest level since July 2007. The stock and bond markets have reflected this increase in optimism with stock prices and interest rates rising dramatically in the weeks following the election.
The market may be getting a little bit ahead of itself. The economic benefits of any fiscal stimulus may not come as soon as many expect. It will take time to pass legislation and there is lag involved before the effect of it is seen in the economic data. Even if many of the policies are implemented, the economy might not have the capacity to expand faster, and that may result in higher inflation. The stock and bond markets may have gotten ahead of themselves in pricing in just the positive aspects of a change in policies.
Unfortunately, it looks like we are in a period where investors have no choice but to accept higher risk to get lower returns than historically.
The risk of an investment is measured by how volatile the returns are. Bonds are considered less risky than stocks because the returns on bonds are less volatile than the returns on stocks.
The return on an investment has two components; the yield (return from the income the investment produces) and the price (the return, positive or negative, from the change in the price of the investment). Over the last 90 years, bonds have averaged about a 5% return and have produced a negative return less than 10% of the time. Today, with the yield on the 10-year Treasury note just 1.6%, bonds are likely to struggle to produce half of that return and the chance of bonds having a negative return is significantly increased.
The bond market is the most expensive it has been in history. Recently, 10-year German bonds dipped into negative yield territory, joining the 10-year bonds of Japan and Switzerland. Globally, more than $8 trillion of bonds have negative yields. This is unprecedented in history. Weak global growth and extraordinary buying from central banks around the world have driven government bond yields down. Almost all of the negative-yield bonds are in Europe and Japan, causing investors globally to pour money into the U.S. Treasury bond market, pushing the yield on treasuries lower. Foreign demand at the U.S. government bond auctions has been at record highs.
At these yield levels, there is no margin of safety. A 10-year government bond that pays no interest will see a 9.5% price decline if interest rates rise by one percentage point to 1% and a 18.5% price decline if interest rates rise by two percentage points to 2%. It is difficult to believe that interest rates will not rise at some point. Never before have bond investors had to take on so much risk for so little gain.
The stock market is also providing less return with increased risk. The previous high level for the stock market was on May 21 of last year. The stock market has gone well over a year without hitting a new high and it has changed little from where it was a year and a half ago. In August of last year, and again in January and early February of this year, stocks experienced a correction (decline of more than 10%) but they have not entered into a bear market (a decline of more than 20%). Even though the stock market as a whole hasn’t entered a bear market, companies representing over two-thirds of the market cap of the S&P 500 have declined more than 20% from their highs. An extended sideways market can be a substitute for a bear market.
While stocks are not considered inexpensive relative to earnings, they are very attractively priced relative to bonds. Three years ago stocks were trading at 14 times earnings and had earnings growth of 10%. Today they are trading for 17 times earnings and have about 3% to 5% earnings growth. However, the dividend yield on the S&P 500 is 2.17%, which is more than half a percent higher than the yield on the 10-year Treasury note. It is just the third time this has happened in the last 50 years. On this measure, stocks are very attractively priced.
There are some positive things on the horizon for stocks. Corporate earnings growth is likely to improve in the rest of this year. Earnings declined 11% in 2015. Lower oil prices and the rising dollar accounted for a 21% decline in earnings, so without those two items, earnings would have been up about 10%. A smaller increase in the value of the dollar, and oil prices rising from the lows reached in February, means earnings growth should improve dramatically the rest of this year.
There are other positives. The economy is continuing to grow. Growth has been slow but fairly steady and is expected to be about 2% this year. The consumer, who is very important to economic growth, is in pretty good shape. A significant reason for that is the jobs picture has been very good. Initial jobless claims have been below 300,000 for 66 consecutive weeks, the longest stretch since 1973. Also, the number of job openings is at 5.8 million, the highest since the data has been tracked in 2000, and the unemployment rate has fallen to 4.7%. As a result, consumer spending is up and housing is improving.
Risks are elevated but I believe the economy will continue to be positive, earnings will rebound later this year, and the stock market will likely be higher at the end of this year than it is now. Investors will need to have a higher allocation to stocks to get better returns and unfortunately, that does come with higher volatility (more risk).
The future is never certain, but as we head into 2016, the level of uncertainty definitely seems even higher than usual.
What will the pace of interest rate increases be, and will that derail the economy or cause the markets to decline? What is the neutral, or equilibrium, interest rate in today’s economy? When will the global economic slowdown improve? How high will the dollar go relative to other currencies? When will energy and other commodity prices stabilize? Who will be the President of the United States a year from now? Will there be additional terrorist attacks this year and could it happen here? There is a lot to worry about.
It is difficult to gain confidence about investment positions and the economic outlook amid all of this uncertainty. As a result, companies continue to hoard cash and are reluctant to invest in capital spending. Also, consumer spending is curtailed when the news is full of concerns.
As a result, the U.S. economy can’t seem to get out of second gear. We are likely to grow this year by 2% to 2.5%. Inventory reduction is holding the growth rate back by about three tenths of a percent. Capital spending is being held back by the energy sector due to low oil prices. The strong dollar (up by 19% since mid-2014) is hurting the manufacturing sector by making our exports more expensive globally. Economic growth of about 2.5% in the face of all these headwinds is really not all that bad.
The problem with this low level of growth is the concern that it doesn’t provide much of a cushion. We are not too far from some of this economic data coming in a little worse than expected, raising fears about the sustainability of the recovery. This is not the level of economic strength that we usually have when the Federal Reserve starts to raise interest rates.
The Fed isn’t planning to raise rates to a tight monetary stance. In fact, they anticipate that the fed funds rate will remain accommodative for some time, just less so. It is a tough balancing act. Right now the “real” Fed Funds rate (Fed Funds minus inflation) is about negative 1.2%. In the long run, the Fed would like to “normalize” rates which they project will be about 3.5%, or 1.5% plus 2% for inflation, after years of quantitative easing and near zero interest rates. The Fed has said they will raise rates gradually, depending on the strength of the economic data, and it may take two or three years to get the fed funds rate to its equilibrium level.
Even in the midst of all this uncertainty, there are reasons for optimism. The U.S. economy is on course to experience its longest expansion in nearly a century. The lowest gasoline prices since 2009, and lowest natural gas prices in 13 years, puts additional money in the pockets of consumers. Crude oil prices have dropped by two-thirds over the past 18 months from $108 per barrel in June 2014 to about $35 per barrel recently. Natural gas has declined dramatically from nearly $14/MMBtu to under $2. Prices at the pump have fallen too, from nearly $4 per gallon to under $2. A rule of thumb is that for every penny decline in the price of gas, discretionary spending may increase by $1 billion. That means we could see an additional $200 billion in discretionary spending which could add roughly one full percentage point to GDP on an annualized basis.
The labor market has been solid and unemployment is at a seven year low of 5%. Initial jobless claims have also been running near a 4 decade low and wage gains have begun to pick up. Low energy prices, employment gains, and better wage growth help the lower income people the most, a group of people who have benefitted the least from the slow economic recovery of the past 6 years.
While the expected return on bonds will be held back by rising interest rates, investors gain from the diversification benefit bonds can provide. Investment grade bonds act as a baffle in a portfolio, moderating the volatility from riskier stock investments.
The stock market tends to produce some of its best returns when it is “climbing a wall of worry”. Right now that wall seems higher than usual. While stocks are not necessarily cheap relative to historical valuations, they are cheap relative to bonds. The earnings yield (earnings/price) on stocks is about 6.17% currently ($128/2075) compared to a yield of 2.28% on the 10-year Treasury bond. The spread of 3.89 percentage points is much wider than the 1.2 percentage point average of the last 20 years.
Right now the market already has a significant amount of worry and concern priced into it. It is nearly impossible to find anyone who is very bullish on the market. However, there is at least a fair chance that the actual data will be better than what the market has priced in. If some of today’s concerns abate, the market could resume climbing the wall.