Why modest economic growth is bullish for equities

The manufacturing and construction sectors continue to expand, despite the terrible weather. From this it follows that the economy probably continues to grow at a modest 2-3% pace. Although this doesn't sound very bullish, in one sense it is, since the alternative to being invested in assets tied to an expanding economy is to earn zero in cash. Investing in cash yielding zero only makes sense if you are anticipating or hedging against an economic downturn. Hiding out in cash imposes a stiff penalty in the form of foregone yields—which are still historically generous—in risk sectors. 

The February ISM manufacturing index was a bit stronger than expected (53.2 vs. 52.3), but as the chart above shows, this is consistent with overall economic growth of 2-3%. That's what we've been experiencing for the past several years, so it's not new news. But importantly, it is not the sort of economy that rewards investing in cash.

The chart above compares conditions in the manufacturing sector in the U.S. to that of the Eurozone. U.S. manufacturing continues to experience modest gains, while there has been a distinct improvement in Eurozone manufacturing, which is no longer in recession and is now expanding at least as rapidly as in the U.S.. The U.S. and the Eurozone are now in a coordinated manufacturing recovery, which enhances the outlook for all parties.

Construction spending in January was a good deal better than expected (0.1% vs. -0.5%, compared to December levels), especially considering the fact that December spending was revised upwards by almost 1.5% relative to November. In other words, January spending turned out to be about 2% better than expected. Construction spending has been rising at about a 9% annualized pace over the past six months, with very strong gains (over 20% annualized) in the residential sector. Residential construction is up some 14% relative to a year ago, while nonresidential spending is up over 6%. Construction activity therefore continues to add to overall economic growth, since nominal GDP is expanding at roughly a 4-5% pace. That's been the case for almost three years now, after the construction sector subtracted from growth for the previous 5 years. It's very likely that construction activity will continue to expand faster than the rest of the economy for the foreseeable future, if for no other reason than that it is still well below its historic share of GDP. 

The chart above shows the current yields available on a variety of different sectors. High-yield, REIT, emerging market, and the equity market offer yields that are significantly higher than cash or short-term Treasury yields. As long as the economy continues to post even modest growth, investors will be increasingly tempted to "reach for yield." 

To keep things in perspective I note that 1) bank savings deposits, which yield almost nothing, currently total about $7.3 trillion, 2) the average yield on the $8 trillion of marketable Treasury notes and bonds is 1.5%, and 3) the current market cap of the U.S. equity market is $22.6 trillion. Those are all big numbers, with a huge amount of, shall we say, "yield inequality." Continued economic growth will therefore bring considerable force to bear on the currently large gap between the yield on cash and the yield on risk assets. Cash yields will likely rise, while the yields on risk assets will likely fall (and their prices will likely rise). All that's required is more of the same: 2-3% economic growth.

As the chart above suggests, there is plenty of room for PE ratios to rise. So even if corporate earnings fail to grow, a continuation of zero yields on cash will, with time, likely result in higher equity prices and declining earnings yields.