As we discussed over the past several weeks, central-bank easing and fiscal stimulus in a growing number of countries together with the Fed's pivot from hawkish to dovish appear to have arrested downward global-growth momentum. Economic data have indeed become more mixed rather than outright negative, consistent with this view. However, U.S. and global sentiment data have remained very weak, the yield-curve inversion has persisted, the dollar has continued to strengthen, and stress in the overnight interbank lending (repo) market has amplified, all signs that the Fed has still not added enough liquidity to maintain financial system stability, stimulate growth, relieve fears of recession, and preclude inflation from falling further below its 2% target over the coming year.
Faced with the inevitable, Chairman Powell has recently announced that the Fed is getting ready to resume "organic" balance-sheet expansion to address bank-liquidity concerns, and the market is priced for another 25-basis-point rate cut at the October 29-30 Federal Open Market Committee (FOMC) meeting, both critically necessary steps for an improved growth and inflation outlook. Despite a slow Fed response, substantial drag on global growth from Eurozone's ongoing malaise, and understandable fears that the current U.S. and global growth slump may devolve into an outright recession, based on incoming indicators and constructive changes in Fed policy, we continue to believe that a new upturn is in its early stages.
Basically, as the global economy got squeezed by excessive Fed tightening, Eurozone weakness, and structural change in the Chinese economic growth model, uncertainty and risk aversion surged over the past year from already elevated levels, curtailing growth and suppressing the buildup of excesses. Based on the roughly 18-month lead from turns in uncertainty to turns in economic growth momentum, this suggests that the downside adjustment to the Fed tightening is likely to prove less severe than in past cycles and should be mostly over by now. Also important, sluggish inflation has allowed the Fed to start easing before a major blowup of the economy. With housing already benefiting from Fed rate cuts, real money supply increasing again, a high aggregate personal saving rate, oil prices contained, and growth overseas in the process of slowly picking up as a result of monetary and fiscal stimulus in numerous countries and led by emerging markets, the U.S. and global economy appear increasingly likely to avoid a recession.
For example, Exhibit 1 shows the Chicago Fed National Activity index (CFNAI), which is a weighted average of 85 monthly indicators of economic activity from four broad categories: (1) production and income; (2) employment-related variables; (3) personal consumption and housing; and (4) sales, orders and inventories. This comprehensive activity index bottomed about half a standard deviation below trend in 2012, 2016, and the spring of 2019, marking the end of each recession-scare period. In contrast, in all of the recessions of the past 50 years, the CFNAI fell at least a full standard deviation, or more than double the decline of the three mini-waves of the current cycle. Significantly, despite all the hype about a manufacturing recession, U.S. industrial production also bottomed in the spring, as did manufacturing output overall, and separately for consumer goods and business equipment. Hard data show the manufacturing recession is over despite weak sentiment measures.
Exhibit 1: U.S. Growth Moving Back to Trend as a Fourth Wave Appears To Begin.
Encouragingly, while the U.S. manufacturing Institute for Supply Management index (ISM), widely used as a gauge for the direction of the economy, surprised to the downside with a deeper plunge into contraction territory in September, the global ISM manufacturing index advanced for a second consecutive month—getting closer to the 50 demarcation line between contraction and expansion—confirming our expectations. The month-to-month improvement in the leading indicator for Organisation for Economic Co-operation and Development (OECD)-plus-6-major-nonmembers has also continued in line with our view, consistent with further gains in the global ISM index in coming months given past correlations.
These global signals are favorable for global industrial production and global trade growth, both of which seem to be in the process of bottoming and soon likely to start increasing again, in our view. For example, even assuming the dollar remains flat at current levels, our expectations for further improvement in the OECD leading index and global ISM index—combined with the lagged effects of favorable credit conditions during the past year—point to renewed growth in global trade by early 2020, which would be inconsistent with a U.S. and global recession.
In terms of the surprise U.S. ISM index plunge in September, we believe that the index is in part overcorrecting for its extreme strength in 2017 and 2018, when it averaged about 1.5 standard deviations above average compared to roughly 0.5 standard deviations above mean for actual industrial production. In general, the U.S. and Eurozone purchasing managers' indicators (PMIs) and other sentiment data were much stronger than actual production growth and other "hard" data in 2017-2018 and have now become weaker than "hard" data. Excessive worry about potential impacts of the trade war seems to explain the shift from overconfidence to excessive pessimism.
In any case, although we expect the recent ISM index plunge to prove brief and thus to not track an economy-wide recessionary pattern, we believe that the manufacturing gauge will return to only modest growth by early 2020, still restrained by past Fed tightening, a strong dollar, the German-led Eurozone manufacturing recession, and the surge in uncertainty. Favorable credit conditions offer support for an improved outlook (i.e., they are not consistent with a recession-type plunge in the composite ISM index), but a softer dollar and sustained manufacturing production growth in Germany after the positive August reading would go a long way in meaningfully strengthening the index ahead. Unfortunately, the Eurozone economy is on track for its weakest growth rate since the double-dip recession in 2011-2012, and leading indicators suggest that Eurozone growth may start to slightly improve only in mid 2020, creating mild headwinds to U.S. and global growth.
As noted above, recessions tend to be preceded by signs of high confidence and growing business-sector excesses, such as big drops in the gold/copper ratio, for example, and euphoric investment sentiment as reflected in rising debt on margin accounts (which is a component of the Conference Board's index of leading indicators). Notably, none of these conditions have been observed for more than a year. Uncertainty and risk aversion as measured by the gold/copper ratio and margin debt growth are at levels that with a lead of about 18 months tend to precede uptrends in growth, not contractions. In other words, despite fears to the contrary, the leads and lags involved in economic cycles suggest the past year's surge in uncertainty and caution after a period of strong animal spirits in 2017-2018 is opening the door for better growth ahead, including a stabilization and eventual rebound in ISM indicators, tame credit spreads, and further improvement in the CFNAI and the OECD global leading indicators.
While leading indicators point away from a recession, the risk remains that the deflationary shock from over-tightening monetary policy intensifies and global inflation expectations continue to collapse. Encouragingly, Fed Chairman Powell appears more focused than ever on stopping the disinflation trend, as noted in his October 4 speech: "…we are examining strategies that might better allow us to symmetrically and sustainably achieve 2 percent inflation. Doing so would help prevent inflation expectations among consumers, businesses and investors from slipping too low, as they appear to have done in several advanced economies." In our view, getting inflation "symmetrically and sustainably" around the 2% target implies a more accommodative monetary policy that will fuel the fourth wave higher over the next two years.
It's easy to get swept into the market hype associated with the first Friday of the month—"Jobs Day"—and lost in the fluctuations of high-frequency labor market data.
This month was no different. After a series of disappointing data releases (ISM surveys, ADP employment), traders and investors were glued to their screens as the U.S. Bureau of Labor Statistics (BLS) released its monthly assessment on the nation's labor market. The report showed a decent picture of the labor market, with jobs growth solid but slowing. Notably, the unemployment rate downshifted to 3.5%, the lowest level in 50 years. Meanwhile, wage growth was relatively constrained at a rate of just 2.9% year-over-year across all non-farm job sectors, but almost 3.5% for non-managerial positions.
Elsewhere in the BLS data trove, the labor force participation rate (LFPR) among working-age Americans continues to rebound, a bullish sign for the economy and corporate profits, given the tight jobs market. As we have written in the past, the positive supply-side effects of working age Americans re-entering the labor force can help to boost potential growth, despite large demographic headwinds from an aging population.
Exhibit 2 shows that while labor force participation has improved among prime-age workers in recent years, the overall rate remains far below levels achieved in the late 1990s. Since older workers are less likely to be in the labor force, the retiring of the baby boomers is forecast to drag down the overall participation rate in the coming decades. Indeed, the percentage of people aged 65+ in the United States is projected to grow from 16% in 2019 to 22% by 2040.
Exhibit 2: Prime-Age American Workers Expand the Labor Force.
Source: Bureau of Labor Statistics. Data as of October 2019.
That said, an important (and underestimated) offsetting factor to the aging population/ secular stagnation story is the fact that the baby boomer generation (born 1946–64) isn't retiring in droves as expected. Labor force participation rates are rising for older American workers. According to the BLS, one in five Americans over the age of 65 is currently working or looking for work, an increase from just 12% at the start of the century. That equates to an additional 4 million people added to the pool of workers (more than the combined workforce of Walmart, Amazon, Target and UPS). This trend toward delaying retirement remains in early innings, with the potential for significant upside to the long-term growth rate of the U.S. economy. While the increased participation rate will not entirely offset the drag on the economy from unfavorable demographics, it could prove a significant positive surprise versus what is currently baked into long-term consensus growth forecasts.
Each year from 2011 to 2029, an average of 3.8 million baby boomers are expected to reach retirement age (10,000 per day). However, as a recent report from the Pew Research Center notes, this shift has not been entirely reflected in the labor market. Instead, baby boomers have been exiting the workforce at a rate of just 2.2 million per year on average (5,900 per day). We expect this trend to continue—according to a survey conducted by the Insured Retirement Institute, one-third of baby boomers plan to retire at age 70 or older, up from 23% when the survey was conducted back in 2012.
Data from the OECD confirm this trend, with the U.S. average effective age of retirement increasing sharply in recent years (Exhibit 3). Various reasons for the rebound are described in Exhibit 4, including longer and healthier lifespans, higher educational attainment, and insufficient retirement savings, which force middle class workers to continue in the labor market.
Exhibit 3: Another Bullish Labor Surprise for the Decade.
Source: Organisation for Co-operation and Development. Data through 2017.
While the overall labor force growth is expected to slow as the U.S. population ages, upside surprises in the labor participation of older Americans would help to mitigate this effect. Increasing labor force participation of boomers can help add to the labor supply and improve the potential path for growth in the economy. It also helps alleviate some of the stress of a declining working-age-to-retirement-age ratio. This trend should also help to keep the unemployment rate near historically low levels, as boomers choosing to stay in the labor force are more likely to have a job. An increased pool of labor for employers comes at a time when businesses are faced with significant labor shortages. Total job openings in America remain in excess of 7 million, although this figure has been declining in recent months.
Higher-than-expected workforce participation by baby boomers can also contribute to higher tax collections, greater stability for the U.S. government budget, and greater levels of consumption among older Americans. Average annual spending for consumers 75+ is relatively low, with the cohort spending just $43,000 in 2018 versus overall average annual spending of U.S. consumers of $61,000. Consumers aged 65 to 74 also underspend compared to younger generations, yet working longer can help boost incomes and consumption for those in retirement. In addition, and widening the lens, while marketers are smitten with the spending power of the millennials, U.S. baby boomers control 70% of the disposable income of the United States. This is supportive of key sectors where older consumers are more likely to allocate additional spending— sectors such as healthcare, entertainment, autos, travel and leisure.
In the end, there are many strengths to the U.S. economy—with the rising labor participation rate among older American workers one of them. The U.S. economy is supported by both young and old workers.
Exhibit 4: Why Are People Working Longer?
Sources: Social Security Administration data as of October 2019; United Income data as of April 2019; Boston College Center for Retirement Studies data as of October 2018; Federal Reserve data as of Q2 2019; Bureau of Labor Statistics data as of September 2019. Kaiser Family Foundation data as of September 2019.
With the third quarter coming to a close and the beginning of reporting season upon us, consensus expectations are calling for -4.4% growth year-over-year (YoY), far below the +12% figure estimated in late 2018 (Exhibit 5).2 Earnings estimates have fallen over 4% since July, more than the typical 3% pre-season cut, according to BofA Merrill Lynch Global Research. While the prior two quarters have narrowly staved off an earnings-pershare (EPS) decline, risk remains that the third quarter could mark the S&P 500's first such decline since 2016. However, we believe the current bar may be set too low and expect earnings to come in better than expected.
Despite the numerous headline risks, revenue growth has held up relatively well in the U.S. and is on track to expand nearly 4% YoY, according to FactSet. Investor sentiment, however, remains incredibly defensive given the backdrop of weak manufacturing, rising geopolitical risks, lingering global trade uncertainty, and concerns regarding business and consumer confidence. Therefore, numerous companies have lowered investor expectations in recent weeks, ahead of upcoming earnings releases, likely placing further downward pressure on the already depressed analyst expectations. Considering the average quarterly EPS surprise over the past four years exceeds 4%,3 this lowered threshold may prove to benefit U.S. companies for yet another quarter, aided by historically healthy profit margins, strong consumer spending and robust stock buybacks.
We believe earnings may trough in Q3 and subsequently improve as economic growth potentially surprises on the upside, with the Fed staying and becoming more accommodative. In fact, consensus expects Q4 earnings to rise by 3% YoY and by 11% in 2020. Next year's estimates seem a bit optimistic, in our view, as nominal growth trends remain at moderate levels, but still supportive enough for the S&P 500 to generate roughly 6% EPS growth. If the trade outlook improves, leading to an expansion in the manufacturing sector, then earnings growth could surprise to the upside given that manufacturing accounts for 40% of the S&P 500's pre-tax earnings.
Exhibit 5: S&P 500 Q3 Earnings Expectations Have Fallen Dramatically.
Sources: Chief Investment Office; FactSet Research Systems. Data as of October 8, 2019.