- A slew of recent economic developments have been supportive of the view that the current economic expansion has plenty of room to run.
- Specifically, our analysis of the domestic labor, household consumption and private nonfinancial sector credit cycles suggests the post-cycle peak progression to sub-0% growth is likely to take longer in duration than it has in previous cycles.
- This has positive implications for equity beta and credit markets and may further serve to perpetuate the ongoing backup in rates and the U.S. dollar – neither of which we view as material headwinds to the U.S. economy or domestic capital markets.
In the ensuing weeks post Donald Trump’s surprise election victory, Keith and I have been on the road visiting with clients and prospective clients in Kansas City, Chicago, London and New York. Needless to say, the fiscal policy outlook and potential changes to the regulatory landscape dominated our discussions. The general sentiment ranged from giddy bullishness brought on by another round of supply side economics to skeptically optimistic. Few, if any, investors were explicitly bearish on The Don – which is probably a signal in and of itself.
One of the more consistent debates throughout this round of marketing centered on trying to identify where the U.S. economy is in the business cycle. Obviously anyone in the giddy bullish camp believes (or at least hopes) the economy is early-cycle. Conversely, 100% of the skeptical optimism centered on the belief that the U.S. economy is late-cycle. Valuations, the rising U.S. dollar and rising interest rates also contributed to said skepticism.
From our vantage point, the U.S. “economy” is neither early-cycle nor late-cycle because we think it makes sense to separate the components of the economy into distinct elements. The cyclical side of the economy, which endured a shallow, but protracted recession is clearly early-cycle and has room to run based on at least 18-24 months of easy comps.
By contrast, the consumption economy is clearly late-cycle; Friday's jobs report confirms that view as the progression in nonfarm payrolls growth from its FEB ’15 cycle-peak to where it always goes late in the business cycle (i.e. sub-0%) continues.
With “C” being the dominant factor in the C + I + G + NX equation at roughly 70%, it’s likely a better bet to side with the aforementioned labor market signals in one’s expectation for economic performance over the intermediate term. But just how late-cycle is late-cycle? There’s an enormous difference between the top of the 9th inning and the 7th inning stretch in asset price terms.
Over the past few weeks one of the primary focuses of our internal discussions has been trying to identify the correct answer to that question. Specifically, we’ve been searching ardently for supporting evidence of the view that business cycle is not as long in the tooth as we had previously thought.
This we know: the relatively tepid pace of leverage growth in the private nonfinancial sector throughout this expansion would seem to imply the credit cycle has legs. Moreover, the lack of financial tightening means debt service ratios have not risen enough to facilitate the kind of deleveraging that has historically perpetuated recessions.
The sharp and ongoing retrenchment of high-yield credit spreads off of their FEB ’16 cycle peak is supportive of the aforementioned conclusions. Moreover, the fact that credit spreads have continued to tighten to new YTD lows throughout this historic backup in rates would seem to suggest that rising rates won’t be as much of a headwind to economic growth as many investors fear. We’re decidedly in that camp; as Keith wrote last week, the strongest periods of domestic economic performance have always coincided with concomitant trends higher in the U.S. dollar and Treasury bond yields.
Going back to the labor market specifically, the following two developments are supportive of the developing view that the progression to sub-0% nonfarm payrolls growth might be considerably slower than we initially anticipated:
- Corporate profit growth – which has historically lead peaks and troughs in nonfarm payrolls growth – has recovered as of 3Q16. While it remains to be seen whether or not the nascent positive inflection develops into a trend in the face of a rising U.S. dollar, the latest data suggests this causal factor to firings is receding, at the margin.
- Even if the aforementioned sequential uptick is a head-fake and the corporate profit recession remains ongoing, a strong case can be made that corporate profit margins are so elevated by historic standards that we need to see a considerable degree of incremental erosion to necessitate a broad-based reduction in labor expenses. Said differently, U.S. corporations have a wide margin of safety in operating margin terms before negative profit growth begins to threaten their ability to service debt.
All told, the sine curve that is the domestic labor cycle has historically exhibited a period of “x” and an amplitude of “y”. The protracted and mild nature of the post-2009 recovery therein would seem to suggest the downturn might be equally as protracted and mild – i.e. containing a period of “2x” and an amplitude of “0.5y”.
Shifting gears to the U.S. consumer, one of the arguments we consistently heard was that “Trumponomics” – specifically the prospect for meaningful tax cuts for high-income households – has the potential perpetuate “animal spirits” and propel consumption growth forward amid the toughest base effects of the cycle. We don’t necessarily disagree with this view; the breakout to a new cycle-high in consumer confidence in NOV certainly corroborates that narrative.
Moreover, to the extent consumers respond positively to the mere prospect of tax relief, there exists a considerable degree of pessimism about the future that stands to be eroded at the margins. A potential recovery in forward expectations off of their current recessionary levels certainly has the degree to unlock incremental consumption growth via lower savings rates.
Lastly, revolving credit as a percentage of disposable personal income is VERY low relative to prior peaks. This would imply the household sector has about ~$350B in additional credit card borrowing capacity. We know from the NY Fed survey data that the overwhelming preponderance of revolving credit growth over the past two years has come from the sub-prime borrowers as high-end consumers retrenched. What if “Trumponomics” inspires enough confidence and stock market inflation for the high-end cohort to lever up again? There’s your additional $350B.
Given the aforementioned potential for an extended household consumption cycle, it’s worth recalling that both the 1980’s and 1990’s expansions experienced protracted cyclical downturns that did not end with full-blown recessions; the latter didn’t even see a stock market crash.
The U.S. demographics curve doesn’t side with the “weathering the storm” thesis, but stranger things have happened – like the shape of this recovery itself. It’s been such a painstaking slog higher – especially relative to all the v-bottoms recorded in modern U.S. history. As such, why would this cycle end so uncharacteristically abruptly? If base effects do indeed matter to growth rates, shouldn’t the slowdown mimic the shape of the ascent? This cycle may go down in history as having never reached “escape velocity” on the upside or downside.
If the U.S. economy does reaccelerate without experiencing a recession, I genuinely wonder where we are on the following chart relative to the 80’s and 90’s. This market may “feel” long in the tooth to bears, but one could’ve said that at any point in time during the epic bull run from 1980 through 2000 as well.
Not so fast, however. One of the factors that helped perpetuate the epic bull run of the 80’s and 90’s was the fact that U.S. households were very under-invested in equities at the onset. Baby Boomers' collective need to establish retirement savings as they reached mid-life helped to perpetuate significant inflows into U.S. equities throughout. The current setup simply doesn’t lend itself to a protracted bull market from the perspective of this valuation-based lens. If anything, the ongoing aging of the U.S. population is a material headwind to sustainable inflows into the equity market (think: target date funds).
At any rate, it doesn’t make sense for us to try and be heroes by pinpointing precisely where we are in the economic and market cycles. Hopefully the analysis above helps you contextualize where we might be and how to be positioned accordingly. Our GIP modeling process might offer additional color in this regard.
Specifically, our model is calling for a continued #Quad2 setup here in the fourth quarter. The advent of recent economic data (highlighted by the aforementioned consumer confidence release, personal income and spending data, factory orders and ISM PMI reports) continues the trend of positive revisions to our GDP estimate for Q4. Our predictive tracking algorithm is now up at +1.8% YoY/+1.8 QoQ SAAR.
Note the emergent sea of green in the “trending data” column across the 30 factors in the model – especially in the cyclical data. This is something that has the potential to help perpetuate a trending [bullish] #Quad1 setup once we lap a difficult GDP compare and cycle-peak reported inflation in Q1.
We’re content, however, to cross that bullish bridge when we get there. For now, enjoy the performance chase through year-end and potentially through President Trump’s inauguration. We’re expecting a correction following that as the harsh reality of #Quad3 in 1Q17 refocuses investor attention to the equivalently harsh reality that fiscal stimulus is, at best, a late-2017 event.
Unlike in previous corrections, however, we’ll be looking to aggressively take up our exposure to equity beta in anticipation of a likely rotation into #Quad1 during Q2-Q4 of 2017. Recall that #Quad1 is the quadrant in which equities have performed best and also better than all other asset classes.
In conclusion, recent market price action and noteworthy developments across the compendium of domestic economic data clearly warrant a reset of any formerly bearish positioning and sentiment to a decidedly more bullish disposition. We hope this note was additive to your thought process regarding where best to be positioned post the current euphoria associated with “Trumponomics”.
Risk works in both directions. As always, please feel free to reach out with any follow-up questions.