In This Issue
Positive incoming economic data so far this year have confirmed our belief that the path of least resistance for the U.S. economy would be up after the Fed cut interest rates and the effect of other central banks' rate cuts started to be felt around the world. The global economic surprise diffusion index has turned sharply positive, reflecting increasingly more upside surprises than downside surprises on the economic front worldwide in recent weeks.
The U.S. improvement has been broad-based, ranging from better-than-expected employment growth, consumer and small-business confidence, home sales and manufacturing/ nonmanufacturing surveys to productivity growth and fourth-quarter 2019 corporate earnings. The big jump in the Institute for Supply Management (ISM) manufacturing new-orders index from 47.6 in December to 52 in January has been particularly encouraging given its early-signal properties and disconcerting plunge into contraction territory through late 2019. This improvement, along with continued positive signals from the Organisation for Economic Co-operation and Development (OECD) leading-indicator index and a "phase one" U.S.-China trade deal have kept U.S. equity prices around record highs and corporate credit spreads generally narrow, consistent with a sustained economic expansion.
That said, leading growth indicators for manufacturing, consumer income and spending, hiring, and housing remain consistent with only moderate real GDP growth around 2.25% in 2020 (similar to 2.33% in 2019). It would take another leg up in consumer and business confidence for growth to accelerate much in coming quarters, which is unlikely absent a quick resolution of the Coronavirus problem. Until that becomes apparent, risks to growth and inflation will more likely remain to the downside in light of bigger potential disruptions to global economic activity and a conceivable eventual hit to consumer and business confidence.
In addition to renewed downside risks to real GDP growth, the recent surge in the gold/copper ratio, 20% drop in oil prices, 10% copper-price decline, softening 10-year Treasury rates and renewed inversion of the yield curve reflect deflationary effects of Chinese travel restrictions and production disruptions that add another layer of risk to an already wobbly U.S. inflation and nominal GDP growth environment. Indeed, rapid Fed rate hikes in 2017 and 2018 caused a big setback on the inflation front, with nominal GDP growth weakening sharply from almost 6% year-over-year in early 2018 to less than 4% in the second half of 2019, suppressing corporate revenues, profits, capital spending, and wage growth. As we discussed in past reports, weak nominal GDP growth (in our view, below 5%) impedes a smooth run of the economy by impairing the ability to service the debt in a highly leveraged economy such as the U.S.
With heightened risks to the downside from an already moderate real-growth and soft inflation outlook, the likelihood that the Fed will significantly miss its 2% target for the eleventh straight year has increased. As a result, and as reflected in the renewed inversion of the yield curve, the probability that the Fed will need to cut rates to address the situation has also increased. In other words, even if real GDP growth remains moderately positive, as we expect, downside risks to nominal GDP growth from the deflationary effects of the Wuhan Coronavirus crisis have raised the specter of subpar growth or recession ahead. The fact that the Fed boosted money-supply growth as 2019 progressed has helped stabilize the economy, but the Fed may have to do more to preclude money-supply growth from slowing again, either by cutting rates or expanding its balance sheet at a faster pace if downside risks to the economy materialize.
In our view, the fifty-year-low unemployment rate, stronger-than-expected payrolls increase in January and still-favorable leading indicators for employment over the next few months do not preclude a case for more rate cuts. First, with manufacturing hours worked already reduced in response to last year's manufacturing recession, the Fed may have to step in to prevent a prolonged period of below-potential growth that would result in layoffs and a rising risk of recession. Importantly, while the ISM manufacturing index surprised to the upside with a spike back into growth territory (to the highest level in 6 months), its employment subcomponent has remained consistent with contracting manufacturing payrolls. In addition, renewed dollar strength is hampering this year's anticipated manufacturing-sector rebound. At the same time, even as the ISM nonmanufacturing index inched higher into expansion territory in January, the survey's employment subcomponent cooled, and its price component declined again and has been weakening since inflation peaked in mid-2018.
These surveys' readings fall short of signaling an acceleration in employment or inflation in coming months and face downside risks ahead from negative effects on global growth from the Coronavirus. The plunge in the Job Openings and Labor Turnover Survey (JOLTS) also suggests that businesses are becoming more cautious about hiring.
Second, the surge in the labor force participation rate (LFPR) and improvement in the productivity growth trend have raised U.S. growth potential. As we had anticipated, pro-growth supply-side policies have continued to attract workers off the sidelines. Led by a spectacular surge in the female participation rate to the highest levels since the late-1990s boom, the participation rate for the prime age 25-54 cohort has continued to surpass expectations. However, with 1) male participation rates lagging and still below pre-financial crisis levels; 2) the highest job-finding rate in twenty years (i.e., the share of unemployed workers in one month that got a job the next month); and 3) manufacturing activity and employment still soft, the prime-age LFPR has more room to advance.
Further potential labor force expansion combined with the ongoing productivity uptrend suggests that real GDP growth has room to accelerate before its gap to potential growth increases enough to create stronger inflation pressures (Exhibit 1). Indeed, restrained by the lagged effects of the Fed's excessive 2018 tightening, the Boeing 737 Max production debacle, the trade war and high uncertainty, real GDP growth has lagged this potential growth proxy. As shown in Exhibit 1, because of typical lags between growth and inflation, this shortfall is likely to keep downside pressure on inflation in coming quarters.
Exhibit 1: Real GDP Growth Has Increasingly Lagged Potential Growth, Pointing to a Peak in "Core" Inflation in Coming Quarters.
The fact that hours worked have been cut in response to weakening manufacturing conditions in 2019 and that the seemingly tight jobs market has not stoked wage inflation is consistent with growth falling short of potential, and explains why inflation pressures have continued to soften despite very low unemployment. In fact, average hourly earnings growth (AHE) for production and nonsupervisory workers lost momentum by the end of 2019 in a lagged response to the housing and manufacturing-led economic growth moderation, which, along with cuts to manufacturing hours worked, has suppressed labor income growth and business pricing power, ultimately restraining inflation.
While we expect AHE growth to reaccelerate this year in a lagged response to growing labor force dynamism, upbeat small-business sentiment and a less stingy Fed, it also appears likely to remain in a 3.5%-to-4% range over the next year or so. At the same time, and as we had anticipated, productivity growth remains on a gradual uptrend. It has accelerated from an average of 0.8% per year between 2012 and 2016 to 1.8% in late 2019, and, based on leading indicators we watch, it appears likely to continue to surprise to the upside. Given our maximum 4% AHE growth forecast over the next year or so, this suggests a cap on inflation of at most 2% for the foreseeable future, inconsistent with an overheating economy even before accounting for any negative effects from the Coronavirus. With the Fed set to try for an inflation overshoot, a rate cut will likely be needed to move inflation up.
The bottom line is the Fed has leeway to cut rates if needed to buoy inflation and nominal GDP growth, and the yield curve has started to point in that direction. In our view, unless Chinese economic activity returns to normal soon and the yield curve re-steepens, the Fed will likely have to cut rates again this year to stop inflation from falling even further below target. In his semi-annual policy testimony on February 10, Fed Chairman Powell emphasized the Fed's desire to "resoundingly achieve 2% inflation" after a decade of falling short. Coronavirus-related risks to the inflation outlook raise the odds that a "material reassessment" of the need for further easing may occur by mid-year.
Our baseline forecast for the U.S. economy to grow around trend this year and next is premised on several key assumptions, including continued monetary accommodation from the Fed, low inflation, improving U.S. profits, a healthy jobs market, reduced global trade tensions and the Coronavirus disruption being temporary. It also is based on the important observation that financial stability risks are currently moderate, preventing the Fed from restraining growth.
To that end, we are continually monitoring the U.S. economy for financial excesses or imbalances. One area of concern for investors in recent years has been the buildup of leverage as the U.S. business cycle ages. Last year, the U.S. lagged only China in terms of debt accumulation, driven by an expanding government budget, rising corporate leverage and moderate growth in consumer debt.
We expect this debt buildup to continue, given the current era of easy monetary policy, but with minimal impact to our base-case growth assumptions in the near term. Still, these debt dynamics warrant close watching, as problems can arise where least expected and when growth becomes increasingly driven by leverage.
U.S. personal consumption continues to be the bright spot of not only the U.S. economy, but also the global economy. Looking ahead, U.S. consumption growth should continue to be supported by a strong jobs market, rising wages, high levels of consumer confidence, and, importantly, healthy household balance sheets.
Data released last week by the Fed shows U.S. household debt at a record high in nominal dollar terms, but remember: Relative to overall levels of income, consumer debt trends have been continuously improving since the 2008/09 financial crisis. Household debt as a percent of GDP is currently at cycle lows (Exhibit 4). Also, thanks to last year's Fed rate cuts and deleveraging in the mortgage space, household debt payments as a percent of disposable income are at all-time lows in the history of the data.
The headline figures, which are primarily driven by healthier credit conditions in housing debt, mask some pockets of pressure in other areas, which have risen rapidly over the past decade. Student loan balances have more than doubled to $1.6 trillion, auto loans have risen 84% to $1.3 trillion, and credit card debt is now 17% higher than levels in 2009. Auto and credit card delinquencies have been steadily rising, driven by subprime borrowers. Student loan delinquencies remain elevated (Exhibit 2).
Exhibit 2: On Watch: Rising Delinquencies for Auto and Credit Card Debt.
Risks building in consumer credit are likely to not be as severe as during the subprime mortgage crisis. Importantly:
New estimates from the Congressional Budget Office (CBO) show federal deficits averaging $1.3 trillion per year over the decade, with the national debt held by the public rising from 79% of GDP in 2019 to 98% by 2030. These budget forecasts, however, have a wide range of variability. The latest White House budget unveiled last week assumes a 3% average real GDP growth rate over the decade and forecasts debt to fall to just 66% of GDP by 2030 (Exhibit 3).
Exhibit 3: U.S. Federal Government Debt Forecasts.
Currently, we believe the U.S. government has some fiscal room. Interest rates have continued to surprise to the downside, helping keep a lid on interest payments. The Fed's monetary policy framework review suggests this trend of lower-for-longer interest rates will continue. Strong demand for U.S. Treasuries, low rates, the dollar's status as the world's reserve currency, and the ability of the U.S. to control its currency allows the U.S. government to sustain larger debt loads than other countries.
But deficits do matter. Interest rates and inflation are not guaranteed to stay low forever. Rising interest payments on the debt can escalate quickly and crowd out productive public investments. Last year, federal debt payments to foreigners totaled $164 billion (vs. $97 billion spent on transportation, $38 billion on natural resources and the environment, and $32 billion on science and technology). Surging government debt can also crowd out private investment, since higher debt levels, in theory, lead to higher interest rates, which makes financing investments more expensive for businesses and households. Another risk associated with large deficits is that the government has less flexibility to respond to unexpected economic crises.
Financial vulnerabilities in the corporate debt sector also continue to build. Driven by low borrowing costs, U.S. nonfinancial business leverage as a percent of GDP has reached all-time highs. Chief among investors' concerns: Growth in investment grade (IG) debt since the crisis has been driven by BBB issuers, which now make up half of outstanding U.S. IG corporate debt. The risk is that in a recession, a larger amount of debt could be downgraded to the high yield universe, upending credit markets.
These fears have somewhat abated due to recent central bank easing. Lower interest rates help keep corporate debt payments manageable. Last year, the number of global companies with credit ratings downgraded from investment grade to speculative grade hit the lowest level in 23 years. Also, the buildup in corporate debt has been gradual and in line with the business cycle, unlike the spike in housing debt leading up to the 2008/09 financial crisis (Exhibit 4).
Favorable liquidity conditions and continued economic growth supported by the Fed should continue to prop up markets in the year ahead, but the risks have not been eliminated. In BofA Global Research's Fund Manager Survey, investors cited concerns about the bond market as the second biggest "tail risk" in February 2020, ahead of the Wuhan Coronavirus. As the credit cycle ages, this is something we are watching carefully.
Exhibit 4: Corporate Debt Surpasses Household Debt in 2019.
The current state of household, government and business debt appears manageable for now. The latest read on nonfinancial leverage, measured by the National Financial Conditions Index, currently does not show signs of financial stress.
The main risk to this outlook is an unexpected spike in inflation that forces the Fed to raise interest rates. When it comes to assessing financial stability, it is not the level of debt in the system that matters—but instead the future rate of growth of leverage and the ease of debt servicing. These rely heavily on the path of monetary policy.
Finally, taking a more long-term view, debt is not a bad thing if used for productive investments and spending that boosts the long-term growth rate of the U.S. economy. In this sense, it's important to identify what debt is used for. For the federal government, 70 cents on every dollar is directed toward net interest payments and mandatory programs such as Medicare, Medicaid and Social Security— leaving just a small amount of funds for productive programs like infrastructure, education and research and development. Growth in corporate debt has primarily been used to increase shareholder payouts (dividends and buybacks) and to fund mergers and acquisitions, while business investment has lagged. Student debt does provide some benefit in terms of a more skilled/productive workforce, but the returns on investment in a college degree have somewhat diminished.
Coming out of a decade in which Growth-oriented areas of the market dominated equity returns in the U.S., many investors were looking for signs that a style rotation favoring Value could be taking shape. But with rates and commodities falling on concerns over the Coronavirus' impact on the global economy, Value is again making new lows against Growth to start the year.
Over the past two decades, the relative performance of Financials, Energy and Technology has been a major driver of Growth versus Value, which underscores the importance of interest rates and oil prices as the year progresses (Exhibit 5). With concerns over the Coronavirus' impact on the global economy remaining front-and-center, Growth could continue to outperform over the near term as commodities remain under pressure, especially from slower growth in China. According to the Energy Information Administration (EIA), China represents 14% of global oil consumption, more than India, Japan and Russia combined, and reports indicate Chinese demand could fall 25% due to the virus. At the same time, rates could move lower from risk-off sentiment, deflationary pressure from the Coronavirus and the potential for central banks to cut rates in response, which is a headwind for Financials. And while heavy exposure to China has weighed on semiconductors, the broader Technology sector has continued to outperform thanks to strong performance from the software industry. Since Financials and Energy are 37% of the Russell 1000 Value index, and Technology is 41% of Russell 1000 Growth, this favors Growth on a relative basis.
How can Value make a comeback? Evidence that the virus is being contained could help global economic momentum start to rebound, supporting profits, which is a tailwind for Value: According to BofA Global Research, Value has historically outperformed Growth by 3% (16% vs. 13%) when profits are accelerating and underperformed by 2% (12% vs 14%) when they're slowing. Financials and Energy would also benefit as rates and oil move higher from improved investor sentiment.
However, even then Value wouldn't be completely out of the woods, as election concerns could lead to periods of risk-off sentiment that weigh on rates and commodities. Given the broad range of potential outcomes and uncertain timing on the Coronavirus, we favor a balanced approach to both styles as 2020 progresses, enjoying exposure to tactical opportunities within each.
Exhibit 5: Growth Versus Value Performance.