The Katy Perry song, a once constant in my house of now grown and gone millennial children, seems appropriate as we celebrate our nation’s birth and, as of this month, the longest economic expansion in U.S. history, surpassing the previous record holder (March 1991-March 2001). But this expansion has been a laggard. Industrial production is up 25.8% since June 2009 through May of this year, about a third of the record post-WWII increase of 75% from February 1961 to December 1969 and well short of the 32% average increase during the previous 11 expansions. Similarly, the 25% increase in real GDP from Q2-2009 through Q1-2019 is the second-weakest 10-year performance compared to the previous six 10-year periods that started with expansions, Yardeni Research notes. In other words, because there has been no boom, the economy has not set itself up for a bust, a point I have made many times in my speeches. On the other hand, this expansion has seen a 65% increase in real capital spending, beating two of the previous 10-year periods and demolishing the myth promoted by the naysayers that capital spending in this cycle has been the worst ever.
With Q2 earnings reporting season just around the corner, red flags continue to accumulate as the economy loses steam (more below). Negative preannouncements have been the highest in 13 quarters, and consensus expects earnings per share to decline 1%, setting up the market for positive surprises off the newly lowered guidance. Short of recession, weaker economic data tend to be bullish as they favor an accommodative Fed. This may help explain why equity volatility has been far less influenced by changes in macro data than normal this year. Indeed, “narratives” such as the U.S.-China trade war, and not fundamental economic variables, have emerged as the largest driver of volatility, with investor sentiment hitting historically low levels and equity fund flows remaining negative despite new market highs. This dynamic was evident this week as a post-G-20 truce, even if fleeting, gave a lift to the market. JP Morgan cautions the enthusiasm maybe overdone as the tariff moratorium was widely expected and the Huawei development remains vague. A key differentiator for positive forward returns has been low inflation. Strategas Research believes the tariffs and trade restrictions have acted as deflationary shock, some of which could prove permanent even if tariffs reverse if confidence remains depressed. The Fed typically tightens until something breaks, and what broke this cycle was inflation expectations to the downside—they’re now at a record low. This is a global story, as central banks are easing everywhere to try and stoke up inflation. This dovish tilt was reinforced this week with Christine Legarde’s nomination to replace outgoing Mario Draghi at the European Central Bank, helping push negative-yielding German Bund yields to a record low. In the U.S., mortgage rates have fallen 100 basis points from 2018’s peak, a move that historically has spurred housing activity and growth. Mortgage purchase applications have been surging and are now up 10% year-over-year (y/y). This lower-rates-for-longer environment has fueled a liquidity boom, which along with strong market breadth makes Renaissance Macro comfortable this market has more time to run.
The S&P 500 posted its best first half since 1997 (up 17% on a price-return basis) and its best June since 1955 (up almost 7%). Global equities lagged but still posted healthy gains, as did long-term Treasuries as the 10-year yield fell 68 basis points. Gold’s gains topped 10%. Large-Cap equity names have been driving alpha, but the recent historical tendency is for small caps to close this gap. Also, there looks to be plenty of room for companies to pull forward merger activity ahead of the 2020 election, should they wish to do so. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance,’’ Strategas posits. This strength in equities is, in my opinion, the best reason for a summer pullback. Put another way, you wouldn’t want to annualize 17%! But, as do my equity colleagues here at Federated, I would view any sell-off as a buying opportunity, as long as the economy continues to grow as we expect it will. So as we look ahead, I’m rooting for this expansion. With apologies to Katy Perry: " 'Cause economic expansion you're a firework, Come on show 'em what you're worth ... " Happy Fourth of July, everyone!
- U.S. manufacturing may be bottoming … Despite slipping for the fourth time in five months, June’s ISM gauge came in above consensus at a level consistent with 2.6% annualized GDP growth, and Markit’s separate PMI unexpectedly rose on modest upturns in output, new orders and export orders. The reports suggest that, after grinding lower since reaching a cycle high last August, manufacturing may be at a turning point.
- The labor market remains tight June ADP payrolls rose at a modest 102,000, a bit below consensus, but May was revised up. Jobless claims and layoff announcements also fell, with both remaining at historically low levels.
- One reason the Fed may cut Inflation pressures remain almost nonexistent. The ISM measure of prices fell to its lowest level since February 2016, with 11 commodities (mostly metals) down in price. Only four raw materials rose, the fewest in 3.5 years. Markit’s survey found similarly muted inflation.
- … but manufacturing elsewhere keeps weakening The global manufacturing PMI slipped in June for the 17th time in 18 months to 49.4, its lowest level since October 2012 and its second straight month in contraction territory. Of 29 countries reporting, only five posted improvement. The latest sub-50 reading is consistent with a modest slowdown such as occurred in 2011-2012, Ned Davis says, not severe recessions such as in 2008-2009 when the gauge fell to the low 30s.
- Services soften somewhat The Institute of Supply Management June survey of non-manufacturers showed activity matching a 2-year low as new orders and employment moderated, but the gauge still remained at healthy expansion levels. Markit’s separate measure improved off a much lower level, although confidence in the lookout fell to a 7-year low.
- One reason the Fed may cut U.S. economic growth is moderating. The Philly Fed’s leading indexes for states and the U.S. are signaling a slowdown in coming months. Redbook and International Council of Shopping Centers surveys show retail sales growth easing in June. And May construction spending fell for the first time in six months and, on a y/y basis, dropped the most since June 2011, as structures investment declined sharply. The Atlanta Fed is projecting GDP growth to slip to 1.5% in Q2.
We’re going to be hearing a lot more about MMT When there’s another downturn, both monetary and fiscal policy could be starting from a weaker position (i.e., we did the rate cuts and tax cuts early to extend this cycle). This could make alternate approaches such as Modern Monetary Theory (under which deficits arguably don’t matter as the government can just print all the money it needs) more popular, with some $13 trillion of negative-yielding debt globally making a pivot to such polices possible, Strategas says.
Growth stocks like a dovish Fed Growth has outperformed 80% of the time in the six and 12 months following an initial Fed rate cut, Credit Suisse shares. It notes the P/E ratio of growth vs. value stocks is 0.8 standard deviations above its norm, with the absolute P/E of U.S. growth stocks at 27 vs. 45-60 seen at the end of most bull markets. Meanwhile, the value side of the equity market has rarely been so disrupted. Price momentum is extreme, but historically, growth as a style has continued to outperform from current levels 85% of the time.
The impact of buybacks has been greatly exaggerated On balance, buybacks reduced the share count of the S&P by only 8% from Q1 2011 through Q1 2019, or an average of 1% per year, Yardeni says. That’s because it found that roughly two-thirds of buybacks may be mostly offsetting stocks issued as labor compensation.