First Quarter 2017
"More Than a Feeling ..."
By Brent Schutte, Chief Investment Strategist, Northwestern Mutual Wealth Management Company
Indeed, the scars of the “Great Recession” were so deep, that the past eight years have been spent rebuilding the economic framework and fragile psyche of the United States consumer and business owner. As a result, consumers have fortified their balance sheets by paying down and eschewing debt, while business owners have forgone expansion and capital investment. At the same time, tougher government rules and regulations, coupled with annual balance sheet stress tests administered by the Federal Reserve, have forced large U.S. commercial banks to lend a little less, and instead, buy Treasuries and rebuild their balance sheets. Even the federal government has adopted the “austerity” mindset by spending and investing less. One could reasonably draw the conclusion that the sum total of these actions has been the root cause of the relatively weak economic growth in the recent past. However, our reading of the economic data over the recent months, especially during the first quarter of 2017, leads us to conclude that the U.S. economy has entered a new phase and finally shifted into expansion mode. In other words, the long-awaited arrival of animal spirits has finally arrived.
What are the Leading Indicators Telling Us?
During the first quarter of this year, the Conference Board’s U.S. Leading Economic Index (LEI) composite finally set a new high and filled in its hole left from the 2008 to 2009 economic recession. After hitting an all-time high of 125.9 in March 2006, this data set fell all the way to 90.6 in March 2009. These dates are important because the National Bureau of Economic Research has determined that the Great Recession began in December 2007 and ended in June 2009. In other words, the LEI does tend to lead recessions and recoveries.
This finding brings us to three important points: 1.While many continue to lament that this “recovery” is long in the tooth by historical standards, we want to point out that, on average, the next recession doesn’t begin until years after the LEI has worked its way back above its old highs. That event just occurred in February, suggesting that the economy still has time to expand. 2.The Conference Board states that a recession warning is generated after three straight negative months with an annualized rate of change over a six-month period of -4.5% and the diffusion index being below 50%. Currently, the LEI is expanding at an increasing pace reflecting improved prospects for U.S. economic growth. 3.Indeed, for those who suggest that the spike is being exclusively driven by confidence data, we would like to note that there are 10 indicators that comprise the Conference Board’s LEI. While some of them are soft data, many are hard data, such as job claims, the length of the average work week and building permits. Currently, the LEI advance is broad based. And a review of the LEI six-month diffusion index (or the number of indicators higher versus lower), shows that all 10 indicators are moving higher. In the past 695 months – that’s 57 years and 11 months – there have only been 40 such readings.
We believe the U.S. economy is accelerating and, absent some exogenous shock such as a natural disaster or an unexpected political event, hard U.S. data and overall U.S. gross domestic product will show continued, and likely accelerated, improvement. For those worried about my shock caveat, hopefully this puts your mind at ease. As we’ve said on numerous occasions, recessions have often occurred when American consumers and/or banks are harmed. The big recessions, such as the one that began at the end of 2007, occur when “something” has been done to both groups. And our assessment shows the U.S. consumer and banks are in as good shape financially as they’ve been in decades. In other words, if an unforeseen shock did occur, it would likely only cause a very mild and brief economic “hiccup.”
The Economy and the Equity Market
Many investors and pundits continue to fret about the relative valuations of U.S. equities. We don’t disagree that the valuations of equities look lofty on an absolute basis. However, when compared to incredibly, and perhaps artificially, low bond yields, equities still look like a decent deal. After all, for buy-and-hold investors, much of the bond market still offers yields and returns that are below the rate of inflation. We also note that while equity valuations are an important variable when it comes to the magnitude of long-term returns, they have little predictive power in the shorter- to intermediate-term.
One variable that we believe does matter to nearer-term equity market prospects is, not surprisingly, the U.S. economy. Reviewing U.S. Large Cap performance from 1948 to today, we note that there are roughly 16 clusters of negative year-over-year returns. Our analysis reveals that 11 of the downturns contained at least one negative quarter-over-quarter of economic growth, with two of the remaining five registering as barely positive; and the others were event driven – think the Cuban Missile Crisis, the Vietnam War, Black Monday in 1987 and Federal Reserve rate hikes.
Yes, history can be an imperfect guide, but it does provide the data to help build a probability-weighted mosaic for predicting the future. Given our expectations of a rising U.S. economy, and a U.S. investor who is anything but over exuberant, we continue to believe that, over the coming year, the stock market will be pulled northwards by the revived economy.
The Recovery Goes Global
Over the past few quarters, we’ve expressed our evolving belief that better relative valuations, and, therefore better long-term return opportunities, reside in overseas markets. While we may have arrived early to the party, the appetizers are now finally being served. Indeed, the first quarter of this year saw International Developed and Emerging Markets outperforming the major U.S. indexes.
We expect international’s relatively strong performance to continue alongside economic recovery. Eurozone economic data accelerated in the first quarter, and while election risks remain, we believe these worries are adequately reflected in current sentiment, not to mention the fact that for the most important election, in France, polls show the euro-friendly candidate ahead.
Even in Japan, the economic data is improving, with Japanese corporations showing signs that they will no longer hoard cash and choke the flow of money. With their jobless rate at the lowest level since 1994, wages are rising. Their corporations are also investing in new equipment, while paying out higher dividends.
The Fed is Pricing in Too Much Uncertainty
That said, there are some trends that we’re keeping a weather eye on. For example, bond yields around the globe remain exceedingly low. Trillions of dollars of debt globally have negative yields, and much of the debt in the U.S. still yields less than the current level of inflation. Against a backdrop of improving economic growth, the Fed – an entity that spent and expanded its balance sheet by buying Treasuries over the past few years – is now set to enter its period of frugalness. At some point, the Fed may be forced to sell some of the longer-term Treasuries it has accumulated. Indeed, the Fed still owns approximately 33% of the total Treasuries that have a maturity date greater than the next 10 years.
While consumers and business owners have expressed confidence and therefore less uncertainty about the future, Fed policymakers continue to make the term “uncertainty” the most overused economic descriptor in their press conferences and media appearances. At her most recent press conference, Chairwoman Janet Yellen noted her belief that caution, restraint and risk aversion among consumers and businesses over the past few years are some of the reasons why she believes the current real neutral federal funds rate has been low. Put more simply, this thinking shapes the Fed’s reasoning as to why short-term interest rates only reside at 1%. She further stated that as this aversion erodes, the real neutral rate will move higher. If our assessment is correct and this change is already underway, then we believe the odds are that the Fed will be forced to increase the pace of its rate hikes.
The Bottom Line
As the world returns to economic normalcy over the coming years, we believe the wildcard may be any adverse reaction in interest rates. While our base case is that any such rise will be gradual and contained, we worry that any unforeseen spike may filter through to the equity markets. As bond traders like to remind us, interest rates are the dog that wags the equity tail. Until then, however, we maintain a positive economic and market outlook.