Weekly Update Special: Three's a charm
(Editor’s note: As I wrap up my vacation in Alaska, I’m sharing insights from my sources on three topics that should bode well for this market and the economy. My regular column returns next week).
Is inflation really a worry?
It doesn't seem that long ago that investors were concerned the U.S. was facing a Japan-like deflationary era. Fast forward to today, and the number of inflation news stories make it seem like it's the 1970s all over again. Indeed, one of the great ironies this year is that even as growth has disappointed to the downside, inflation has surprised to the upside. Bank of America notes core CPI inflation has been rising at its fastest rate since before the global financial crisis. Moreover, the pickup has been fairly broad-based. Both goods and services inflation is higher.
Despite the strong numbers, however, the fundamentals don't support a market-disrupting sustained increase in inflation. Some investors fear wages may be moving up after years of stagnation, feeding inflation and derailing profit margins and equity returns. But the past suggests the unemployment rate would need to decline to 5.5% before we see sustained wage inflation. Also, with nominal GDP growth on track to be less than 4% year-over-year in 2014, it would be very difficult to have a sustained period of higher inflation. Finally, the history of market returns and wage growth is positive, Cornerstone Macro reminds us. Even during the period of the highest wage inflation (1970s), equities still rose in some cases. The real concern isn’t wage inflation (wage inflation would likely equal stronger top-line growth), it’s commodity price inflation.
Let’s take a look at that. Recent geopolitical events, notably Ukraine/Russia and Israel/Gaza, have caused oil prices—and volatility—to move up. But oil right now is up only 8% year-over-year, hardly a threat compared to past experiences, and over a three-year period, oil has moved sideways. In fact, oil volatility (swings in price) is sitting at a 22-year low! Agricultural prices already have had a meaningful decline, and market volatility is still near 7-year lows. Historically, the most consistent predictor of a spike in volatility is oil and recent moves in oil do not warrant a large increase in volatility. Each past spike in volatility was preceded by a large surge in oil prices.
The real question, then, is why would inflation move higher? ISI notes that despite the recent tick up, wage growth remains weak, with enough slack in the labor market to keep non-commodity inflation under control. Besides, given the low level of wage growth, some upward pressure on inflation as employment improves should be more positive for the markets and economy than negative. And if you don't expect food and medical to sustain CPI’s recent move higher, and if you don’t expect oil prices to make a meaningful and sustained move up, then it is tough to argue that inflation should surge.
A longer-lasting consumer
Every once in a while a severe recession can alter an economy’s character. That might be what has happened in the U.S. consumer sector, Cornerstone Macro says, with the severity of the 2007-09 recession causing U.S. households to become much more sensitive to the cost of credit. For the previous 30 years, consumer debt was an important driver of consumer spending and housing, increasing from 62% of disposable personal income in 1983 to 130% in 2007. Without that debt surge, consumer spending and housing would not have been as strong.
But in 2012, far more dollars were spent using debit cards than credit cards (roughly $45 billion to $25 billion), reversing habits from just 10 years ago, when credit-card payments outstripped debit-card payments ($20 billion vs. $15 billion, respectively). In addition, Americans have become much more responsible in how they use plastic. A new report from the American Bankers Association found the share of cardholders paying off their credit- card balances in full each month has continued to climb, reaching 29% in Q4 2013, the highest share on record.
Consumers are being similarly cautious about mortgage debt. When the average 30-year mortgage rate surged from roughly 3.4% to 4.6% in just a few months in 2013, existing home sales fell almost immediately, slowing housing’s recovery. The drop-off indicates that home buyers are being more prudent than they were in the go-go 2000s, when the motto seemed to be “buy as much house as you can.’’ This caution may make for a slower but ultimately longer-lasting recovery in housing.
Overall, this increased sensitivity to the cost of credit may help explain why the consumer is willing to buy a car but not splurge. Based on consumer spending data for May, nominal consumer spending on autos (the 12-month average) has increased 9.2% year-over-year, while nominal consumer spending on clothing has increased just 2.2% the same period. By potentially keeping consumer-debt delinquency rates lower for longer, this sluggish non-auto debt growth is a longer-term plus for the economy.
The trifecta—energy, manufacturing and capex
Thanks to shale and new drilling technologies, U.S. crude oil production now exceeds U.S. imports from OPEC by over 4 million barrels. Who forecast that to happen 10 years ago? On top of this, natural gas and solar energy are gaining market share, helping support industry and reduce energy costs for consumers and businesses. This energy renaissance represents a global competitive advantage that also is boosting manufacturing, with employment rising 5.6% since early 2010—the largest increase in over 30 years! From many discussions in my travels a lot of my fellow Americans don’t know this.
While cheaper domestic energy is an important reason to be bullish, the real driver of economic performance is competitiveness, most importantly labor costs. And on this front, the U.S. is gaining ground on the world’s second-largest economy, China. Measured in dollars, Chinese wages have increased 17% every year for the past five years, putting Chinese hourly compensation costs at 20% of U.S. hourly compensation costs, up from 4% 10 years ago, Deutsche Bank says. The picture is similar across all emerging markets (EM) and as their labor costs continue to rise rapidly growth prospects for the U.S. will look better and better.
If the U.S. is experiencing manufacturing and energy renaissances, then capital spending likely will benefit, giving the U.S. something that data from the Department of Commerce suggests it hasn’t had for 30 years—a strong capex cycle. Deutsche Bank says indicators already are suggesting capex is expanding at its fastest pace since 2012, with core capital goods shipments up 4% year-over-year on a rolling three-month basis, double the pace of the past two years. And the increase could be just a start. Total corporate capital spending is currently at 9.6% of GDP, well off the peak of 11.5% in Q2 2000 at the height of the dot-com era. It also is significantly lagging the growth in corporate profits, which are up 45.1% over the past 6½ years.
There’s plenty of money available to help support more spending. In addition to near record levels of cash and low interest rates into the foreseeable future, U.S. companies should find banks to be willing lenders. With bank loans at $7.7 trillion and bank deposits at $10.2 trillion, there's an unprecedented and widening $2.5 trillion gap between the two! Before the Great Recession, the two were roughly equal. And with bank deposits increasing at a 7.2% annual rate so far this year, ISI says bank loans would have to grow at an even faster 9.6% rate to close the gap. Globally, there’s a glut of savings, with the IMF estimating the savings rate will be a record by a wide margin this year, before moving even higher in 2015 and 2016. This should help keep rates relatively low and capex financing costs relatively cheap over the next several years. We are bullish.