“A wise man will make more opportunities than he finds.”
-Francis Bacon
Hedgeye is excited to draw your attention to a press release about the formation of a new private investment company called “Seven7.” Seven7 is a venture capital investment vehicle founded by former NHLer Marty St. Louis and certain founders of Hedgeye. Seven7will focus on investments in private companies that are sub $25mm in size that likely fall under the radar screen of traditional private equity and VC firms. Click here to read more about this initiative.
Hedgeye looks forward to building a relationship with Seven7 that will allow us to supplement our public company research as it will provide a new lens into what small, high growth companies are doing across the consumer and media landscapes. Innovation and opportunity occur on the edge, and we intend to be there helping you interpret what it means for large public companies. If you have interesting ideas for Seven7’s consideration to look at, please email .
Back to the Global Macro Grind…
The U.S. stock market today has only been this expensive just before the crash of 1929, the tech bubble, and the Great Financial Crisis (according to the cyclically-adjusted P/E ratio). Importantly however, in each of these instances, it wasn’t “expensive valuations” that caused the crash. What actually triggered significant stock market declines were material slowdowns in the U.S. economy.
In other words, financial market history suggests that the most consequential factors to consider before making any investment decisions are changes in U.S. economic growth and inflation.
Today, that means investors should be positioned for what has historically been the best environment for U.S. stocks. In particular, market history tells us “expensive” sectors like Technology (XLK) and Consumer Discretionary (XLY) will get more expensive as U.S. growth accelerates and inflation slows down.
The U.S. economy is heating up as the data shows.
- U.S. GDP peaked in 1Q 2015 at 3.3% year-over-year
- It bottomed out at 1.2% year-over-year by 2Q 2016
- …and has since rebounded to 2.1% in 2Q 2017.
This partly explains why major U.S. stock market indices are up between 9% and 19% in the past year.
The pick-up in economic indicators has been broad based, as evidenced by high-end consumption making a comeback. Some key metrics for measuring the economics of rich people:
- Stocks prices are up
- CoreLogic’s home price index up +7% year-over-year
- …and consumer confidence for the highest income earners is hovering at cyclical highs (Conference Board reading for incomes greater than $125,000).
All of this has flowed through to luxury goods, where spending has accelerated to +6.9% in 2017 versus a trough of +1.2% last year.
The top 10% of households own 85% of financial assets and the top 20% of income earners account for 40% of total consumer spending. For better or for worse, rich people are a really big deal in calculating the consumption component of U.S. GDP, which contributes about 70% of U.S. GDP.
Meanwhile, corporate America is booming. Within the data on durable goods and capital expenditure, new orders accelerated to +16.1% year-over-year (the highest reading since July 2014.) Capital expenditures decelerated -40 basis points from a five-year high of +6.0% year-over-year. So far, 477 of 500 S&P 500 companies have reported sales and earnings growth of 5.3% and 9.3% respectively.
These earnings numbers are just shy of a record set five years ago. According to FactSet, if earnings growth breaches 10% this would mark the first time since the fourth quarter of 2011 the S&P 500 has seen two consecutive quarters of year-over-year double-digit earnings growth, which looks promising as a barometer for further economic growth.
In addition, despite the Fed’s claim that falling inflation is “transitory,” low consumer prices have been stubbornly long lasting. The Fed’s preferred measure of inflation, core PCE (or Personal Consumption Expenditure), has been below the central bank’s 2% target for the last 62 months. Our call is for this environment of falling inflation to persist throughout 2017.
It’s worth noting that falling inflation is a net positive for real U.S. GDP growth and a key part of our call on U.S. growth accelerating. The government’s so-called “GDP deflator” subtracts from nominal GDP to correct for inflation. That number hit its highest level in nearly three years in the first quarter of 2017 at +1.9% and has since continued to fall (to 1.6%) alongside Consumer Price Index (CPI) and PCE data.
So inflation is falling and U.S. economic growth is heating up, now let’s consider financial market history and which sectors perform best in this environment. In our model, growth and inflation are the most consequential metrics for predicting future financial market returns. So in this two-factor framework you get four possible outcomes. Each outcome is assigned a “quadrant” in our Growth, Inflation, Policy (GIP) model:
- Growth Accelerating, Inflation Slowing (QUAD 1)
- Growth Accelerating, Inflation Accelerating (QUAD 2)
- Growth slowing, Inflation Accelerating (QUAD 3)
- Growth Slowing, Inflation Slowing (QUAD 4)
Our GIP model suggests that the U.S. economy is currently in Quad 1 for the second quarter of 2017 and should remain there through the first quarter of 2018. This has historically been the best environment for domestic equities. We can now select what we like and don’t like based on our historical back-testing of the different asset classes that perform best in each of the four quadrants.
Now, if you're looking to tilt your portfolio to Quad 1 asset classes, the top-performing S&P 500 sectors historically are Technology (XLK) and Consumer Discretionary (XLY). Over the past 20 years of quarterly observations, Consumer Discretionary and Tech have positive expected values of +4.4% and +4.0%, respectively, in Quad 1 (i.e. GROWTH ↑; INFLATION ↓).
It makes sense. Both of these sectors are levered to an uptick in consumer spending and an accelerating U.S. economy more broadly. It’s no surprise to us therefore that, in 2017, Tech is the top performing S&P 500 sector, at +19.5%, and Consumer Discretionary is fourth at +9%.
This is exactly what you’d expect to see as U.S. growth accelerates and inflation slows. We expect this to continue in 2017. So we have one question for you: Are you long the U.S. economy? You should be.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.16-2.27% (bearish)
SPX 2 (bullish)
RUT 1 (bearish)
NASDAQ 6198-6381 (bullish)
XOP 28.53-30.79 (bearish)
VIX 9.96-13.66 (bearish)
USD 92.78-93.99 (neutral)
EUR/USD 1.16-1.18 (neutral)
Oil (WTI) 46.37-49.08 (bearish)
Gold 1 (bullish)
Copper 2.86-3.01 (bullish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
