Tuesday, August 1, 2017

No boom, no bust

My reading of the economic and financial tea leaves is that the economy continues to grow at a sub-par pace (about 2%), just as it has for the past 8 years. I don't see evidence of a coming boom, nor of an imminent bust. I think the market expects roughly the same thing; it's not priced to either a boom or a bust, just more of the same. Dull.

Here are a baker's dozen charts, with the latest updates, to flesh out the story:

The chart above is one of my enduring favorites. It shows that the ISM manufacturing index does a pretty good job of tracking the growth rate of the economy. What's especially nice is that the index comes out with a relatively short lag of just a week or two, whereas we usually have to wait months to get a read on the economy. What it's saying now is that GDP growth in the current (third) quarter is likely to be in the range of 2-4% annualized. That won't necessarily mean that the underlying pace of growth is picking up though; it's more likely that some faster reported growth in the current quarter which will make up for the relatively weak growth of recent quarters. Such is the volatile nature of GDP stats.

The two charts above are encouraging, since they show that global economic activity is likely picking up. US manufacturers are seeing relatively strong overseas demand, and Eurozone manufacturers have experienced a significant improvement over the past year or so, after years of weak activity.

The chart above shows that US manufacturers are at least somewhat optimistic about the future of their businesses, since many reportedly plan to increase hiring activity in the months to come.

The chart above shows that the ISM manufacturing index does a pretty good job of predicting corporate revenues. For months now, the ISM index has been telling us that revenues per share for the S&P 500 were likely to increase, and they have indeed in increased by over 5% in the 12 months ended July. 

Not surprisingly, faster growth of revenues has gone hand in hand with increased profits. Trailing 12-month earnings per share (earnings on continuing operations) were up over 9% in the year ending July. No wonder the stock market continues to edge higher. Profits and prices are both at all-time highs and rising.

The current trailing PE ratio of the S&P 500 is just over 21, according to Bloomberg's calculation of earnings from continuing operations. That's a good deal above its long-term average of just under 17, but it's not impossibly high. The inverse of the PE ratio—the earnings yield on stocks—is still a healthy 4.7%.

The chart above subtracts the yield on 10-yr Treasuries from the earnings yield on stocks. Equity investing still gives you a yield that is substantially higher than the risk-free yield on Treasuries. It's not always thus. In fact, during periods of robust growth and strong stock markets—such as the 1980s and 1990s—the earnings yield on stocks was usually less than the yield on Treasuries. When investors are confident and the economy is strong, investors are willing to accept a lower yield on stocks because they expect to more than make up for that with capital gains (i.e., rising share prices). The situation today is quite the opposite: a positive equity risk premium suggests that investors are skeptical of the ability of earnings to grow, and are thus willing to accept a lower yield on Treasuries in exchange for their increased safety.

Not all is rosy, however. As the chart above shows, the dollar has taken quite a hit since the "Trump bump" of last November. It's down about 10% in the past 8 months, in what is surely a sign that the world has become a lot less excited about the growth prospects of the US economy.

The chart above provides more evidence that the market doesn't expect the US economy to be very strong going forward. The current real Fed funds rate—the best indicator of whether monetary policy is tight or not—is about -0.25%. The current 5-yr real yield on TIPS (a good indicator of what the market expects the real funds rate to average over the next 5 years) is only 0.11%. This means the market doesn't expect the Fed to do much more in the way of tightening for the foreseeable future. And that, in turn, means the market holds out very little hope for any meaningful improvement in the US economy.

The chart above suggests there is very little reason to expect a recession for the foreseeable future. Every recession for the past half century has been preceded by a monetary tightening sufficient to raise real short-term rates to at least 3-4%, and to flatten or invert the Treasury yield curve. We're a long way away from either of those conditions today. The Fed is relatively easy, and is not expected to tighten much, if at all, because the economy is not expected to improve much, if at all. 

The chart above compares the 2-yr annualized growth of real GDP to the 5-yr real yield on TIPS. I use a 2-yr measure for GDP to "edit out" the quarterly fluctuations which are more due to statistical vagaries than to any real change in the economy's strength. The chart suggests that the current level of real yields is a sign that the market thinks the economy is still likely on a 2% growth trend. (The latest revision to GDP boosted growth during the 2014 -2015 period, but reduced it in the past two years. That is consistent with my repeated observations that the trend growth rate of jobs has slipped in the past year or so from 2.0% to 1.6-1.7%.)

Another not-so-rosy-sign is construction spending, which has softened and dipped year to date. This could just be a pause that refreshes, but in a worst case scenario—if this weakness continues—it could be an early warning sign of another recession. I doubt that is the case, since mortgage originations and home sales are still relatively healthy, but if you want something to worry about, here it is.

I highlighted this chart a few weeks ago, noting that the stability of China's foreign reserves this year is a healthy sign that the yuan has moved to a level that is balancing capital flows (forex reserves under a floating-pegged currency regime such as China's are a direct measure of net capital flows). The yuan has appreciated a bit more of late, a sign that the situation in China is improving on the margin (more money wants to get in than out). Good news from overseas is always good news for the US, especially for a major player like China.

To sum up: I see no sign of excessive optimism or pessimism in market prices. The market's expectations are for a dull economy to remain dull and for inflation to remain relatively low. 5-year expected inflation, according to TIPS and Treasury prices are 1.7%. There is no compelling reason to worry about a recession, or to get excited about a boom. The market is thus "vulnerable" to signs of emerging weakness or increased strength. If we get a decent tax reform package, look for optimism to emerge. If we don't get tax reform, the downside risk is likely not significant, since reform expectations have not been priced in. Fortunately, we have had some meaningful reform in the area of regulatory burdens so far this year, and this should give the economy enough of a lift to keep things on an even, 2% growth trajectory or maybe slightly better. 


The Cliff Claven of Finance said...

The S&P 500 Price to Sales Ratio is higher than at any other time in history
except for one week in 2000 when the 1990s bull market peaked.

The median Price to Sales Ratio is 50% higher than the previous record.

Market Capitalization to GDP, Warren Buffett's favorite indicator,
is the highest in history except for the 2000 peak,
and can be viewed on charts at the link below:

I don't know how any honest person could look at stock valuation data
and not recognize overvaluation.

If the stock market is not overvalued now,
and its a good time to buy stocks,
then centuries of stock market history are wrong,
and this time is different ... for the first time ever.

Al said...

Nice scott. I like the bakes down posts. Special request: could we get some credit and swap spreads graphical updates in the coming weeks even if there is no major change...those are always my favorite as they say so much in the health and liquidity of the system.

steve said...

Good luck trying to time the market Cliff. You're going to need it (LUCK, that is).
Re this piece, looks like an exact replication of O's economy. What happened to the "Trump Bump"? Even considering the gridlock/incompetence in DC, hasn't the DT admin been slashing regs and shouldn't that help the economy or is it too soon?

Scott Grannis said...

Alain, re credit and swap spreads. Not much going on here, US credit spreads are all at low levels. Eurozone 2-yr swaps remain somewhat elevated, however, trading today at 54 bps. US 2-yr swaps at 24 bps. 5-yr CDS spreads at 56 bps. No liquidity problems and very low systemic risk.

Unknown said...

There is a free app that uses employment to give early warning of recession. https://play.google.com/store/apps/details?id=com.forecaster&hl=en

There is a $5 app that uses Treasury 10year - 3month data, and employment and industrial production to give earliest warning of recession https://play.google.com/store/apps/details?id=com.forecast3&hl=en

Michael Meyers said...

Scott....great charts and commentary....you are the best! Thanks, Michael

Benjamin Cole said...

Terrific overview of the economy and markets by Scott Grannis.

My only complaint is that there seems grounds for the Fed to stimulate, not restrict. Inflation dead, sluggish growth.

Outside of housing, core inflation is rising under 1%.

Housing is a strange case. The supply is restricted through property zoning, but demand is boosted through large trade deficits (capital flows into US real estate result).

I think Obamacare is a nothing burger, macro-economically speaking.

Al said...

Txs scott.

marcusbalbus said...
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