Takeaway: The consensus bull case for U.S. capital markets hinges on omitting commodity-linked industries (namely energy) from important economic and financial market indicators. While we continue to think such omission is off base because it misses the point of proactively positioning one’s portfolio for interconnected risks, we’re happy to entertain such discussions. Even if we were to concede the conclusion(s) of such studies, we’re not so sure they are being conducted in the most appropriate manner – i.e. in rate-of-change terms.
One common line of pushback Keith and I have been getting on the road visiting clients and prospective clients lately has centered on energy’s impact on the broader economy. The U.S. remains a net importer of crude oil, so, naturally, one would think energy price deflation has a net positive impact on U.S. economic growth.
Moreover, since energy is an essential input to the vast majority of production and consumption activity, there is an assumed net positive impact from a corporate and consumer PnL perspective as well. We don’t disagree with the assumption; it makes sense intuitively.
But does it make sense empirically?
Consider the following analysis which shows the cumulative change in the mining sector’s contribution to nominal GDP (which is as targeted as the data allows) from its 2Q14 peak juxtaposed with the cumulative change in personal outlays on gasoline, fuel oil and other energy goods. The assumption here is that to the extent a positive spread exists, the tailwind to PCE from falling energy prices is greater than the headwind to GDP from declining mining sector activity. Thus far, the spread has been negative, implying a cumulative net headwind to economic activity.
Another way to show this relationship is on a QoQ basis. In any given quarter, if the spread between these two nominal rates of change is positive, then it could be said the economy experienced a net tailwind from the perspective of energy price inflation or deflation; the opposite holds true as well. After a period of a mostly-sustained net tailwind from 4Q12 to 3Q14, the U.S. economy has experienced a persistent net headwind from the change in energy prices.
There are two key assumptions in the aforementioned analysis: 1) that mining sector GDP is predominately driven by energy prices; and 2) that U.S. consumers have a marginal propensity to consume any savings from declining energy prices, rather than pocketing the change.
Empirical evidence proves our first assumption correct, in that there exists an extremely tight positive correlation between crude oil prices and mining sector GDP.
Regarding the latter assumption, there exists an observable inverse correlation between national gasoline prices and real PCE growth for much of the past ~10yrs. The key outliers are during the 2H08-2011 crash and recovery in energy prices and during the 2H15-present fuel price deflation.
When gas prices collapse nationwide (alongside the NAV of 401(k) and IRA portfolios broadly), does the U.S. consumer get spooked and cut back spending? Probably not, but maybe. At least the following chart seems to think so:
Jumping ship, we find it important to consider multiplier effects as well. While it’s impossible to accurately quantify the multiplier effect of the domestic energy economy, we can at least assume one exists given the capital-intensive nature of the industry. The following two charts highlight this relationship by showing that growth in both employment and income in key energy-producing states contributed an outsized share of cumulative employment and income growth from their respective cycle-lows.
Specifically, at its peak share of 12.9% in OCT ’14, employment growth in key energy-producing states accounted for 18% of the cumulative growth in total nonfarm payrolls from its FEB ’10 trough and remains at a still-disproportionate 15.1% per the latest data. Moreover, at its peak share of 12.7% in 1Q15, personal income growth in key energy-producing states accounted for 16.5% of the cumulative growth in total personal income from its 3Q09 trough and remains at a still-disproportionate 15.3% per the latest data.
While there are some key assumptions here as well – namely the somewhat arbitrary level of production at which we have decided to label a given state as a key energy producer – the aforementioned relationships hold true in terms of explicit exposure to commodity production in both GDP and CapEx terms. Specifically, at its peak share of 3.2% in 3Q13, the mining sector accounted for an outsized 8.2% of the cumulative growth in nominal GDP from its 2Q09 trough. Moreover, at its peak share of 5.7% in 2Q12, the mining sector accounted for an outsized 14% of the cumulative growth in nominal private nonresidential fixed investment from its 1Q10 trough.
As the charts highlight, the mining sector’s contribution to the cumulative growth of GDP and CapEx has since dwindled to 0.5% and -1%, respectively. Not surprisingly, it is at these levels where peak mitigation or outright exclusion of energy from just about every relevant economic and financial market indicator occurs. Perhaps there’s a bee in our bonnet, but we can’t help but point out the lack of mitigation and/or exclusion on the way up.
To add some ethos to our rant, the current peak-to-trough decline in the mining sector’s contribution to cumulative GDP and CapEx growth is not unlike the decline witnessed by the housing sector in the mid-to-late 2000s. Specifically, at its peak share of 6.7% in 4Q05, nominal private residential construction accounted for an outsized 13.7% of the cumulative growth in nominal GDP from its 4Q01 trough; that share had declined to a mere 2.4% by the end of 2007. We know of no investor that would dare “ex” housing from the last economic cycle.
As with leverage, multiplier effects work both ways. This more than likely why you continue to see carnage in rate-of-change (i.e. deceleration) and/or absolute (i.e. outright contraction) terms across the broader domestic manufacturing and export sectors:
In terms of staving off an outright #USRecession, the key question investors should be asking themselves is whether or not the U.S. consumer can continue its Sisyphean struggle to hold up the U.S. economy until the aforementioned indicators begin to lap easy comps at various intervals throughout 2016.
Based on the preponderance of data, our answer is increasingly “NO”. For those of you looking for more details on why that is the case, we encourage you to review the following research reports:
Q: If industrial activity is going from “horrific” to “just bad” while consumption growth that went from “great” (in 1H15) to “good” (in 2H15) is on its way to “bad” (by mid-2016) at the same time, what are you left with?
A: The most obvious slow-moving #LateCycle slowdown we’ve seen since the early-2000s.
And even if the U.S. economy avoids recording a technical recession, we could just have an 2000-02-style corporate deleveraging cycle that drags down equity market cap alongside it. After all, it's EPS that matters most to stocks, not GDP. Recall that the 2001 downturn was the shallowest recession in U.S. history; that didn't preclude the stock market (SPX) from getting cut in half.
Oh and by the way, it’s not just energy. With 263 of 500 SPX companies having announced results throughout the 4Q15 reporting season to-date, the Energy (-65%), Materials (-18.8%), Industrials (-4.1%), Financials (-3.4%) and Tech (-2.7%) sectors are all reporting YoY declines in EPS.
If you’re bullish, best of luck in your attempt to: A) “ex” all of that out; and B) avoid making eye contact with your credit team in the elevator or restroom.
If you’re bearish, best of luck out there preserving capital amid the continued pricing in of the aforementioned business cycle risks.