Financial markets have been caught flatfooted by the massive rotation out of the dominant trade of 2019, a barbell with secular growth beneficiaries on one end and defensive bond proxies on the other. By the end of August, the valuation discrepancy between the barbell winners and the cyclical and value stock losers had reached an extreme only rarely seen before. This flood of money also included a flight into Treasury bonds that saw the 10-year Treasury yield collapse and almost reach the all-time-low yields set during the end of the first- and second-wave slowdowns in 2012 and 2016, respectively. From this perspective, it appears that the third-wave slowdown is now coming to an end, with a collapse in interest rates set to stimulate the next mini-cycle uptrend in 2020.
The Federal Reserve (the Fed) is finally on course to normalize the yield curve after a year of overly restrictive monetary policy that slowed global growth and created a pronounced downturn in inflation expectations. As short-term rates come down, monetary stimulus should boost growth going forward. The drop in mortgage rates has spurred a doubling in refinancing applications from a year ago, and new purchase mortgage applications are up by almost 10% as the housing market starts to grow again. Corporate treasurers caught the bottom in bond rates with record refinancing last month. The turn in U.S. policy has unleashed rate cuts all around the world, which should help the U.S. fourth wave be part of a global fourth wave higher.
Things are messier in Europe, but the European Central Bank (ECB) is trying to help. Fiscal stimulus may add to the trend change. Three years after the British people voted to leave the European Union (EU), the government continues to resist that mandate. Nevertheless, it looks increasingly like some sort of resolution is in the works by yearend. Whichever way it goes, clarity about the outcome is likely to help businesses to better make decisions about the future. Likewise, the dimensions of the trade war between the U.S. and other countries are beginning to crystalize. Deals with Canada, Mexico, Korea, Japan, the U.K. and Europe are likely to move the world in the direction of freer, fairer commerce. China has apparently decided that its system is threatened by the rules other countries abide by. As a result, a structural decoupling of the global economy into two spheres has begun, as hundreds of companies begin to reroute their supply chains to address this new reality. In the meantime, tariffs are likely to be fully imposed to incentivize this structural shift. After the last tariffs are imposed, the world is likely to adjust and move on. The primary risk has become the possibility of a pleasant surprise, where a deal is reached and tariffs are eliminated. Put another way, the worst case is priced in, with some small chance of a better outcome.
As these policy uncertainties are being resolved, the U.S. economy has weathered the drag better than most of the rest of the world. As happened in the cyclical slowdowns of 2012 and 2016, concern about recession has grown this year, and it was greatly amplified because of the inverted yield curve, which always reflects restraining monetary policy. Thankfully, the Fed is finally addressing this main risk of recession. Aside from the 100-basis-point drop in long-rates, real money supply growth has turned positive after collapsing last year when the Fed was shrinking its balance sheet with quantitative tightening and raising rates aggressively past the neutral rate.
The impact of U.S. monetary restraint hit the rest of the world more than the U.S., as well as the tradable-goods sector because of policy uncertainty around tariffs. By the end of the year, the extent of tariffs is likely to be known, rates are expected to be lower, and the Brexit outcome should be clearer. As these clouds of uncertainty lift, businesses can start planning for this new environment. High rates hit the rest of the world harder because U.S. consumers deleveraged in the early years of this economic expansion, while consumers elsewhere took advantage of low rates to lever up. Also, many emerging markets binged on U.S. dollar debt during the zero-rate era of Fed policy. Just as higher rates hurt them more, lower rates will help them more, especially if the dollar softens a bit, as we expect with an easier Fed and potential fourth-wave expansion.
In the meantime, while multinational U.S. businesses have seen confidence hit by the trade slowdown, the consumer and small businesses remain very strong. The August employment report showed very strong growth in household incomes, as moderate job gains were bolstered by still strengthening wage growth and hours-worked. The main constraint on job growth is the difficulty of finding qualified workers. For example, the National Federation of Independent Business (NFIB) recently reported the most difficulty finding labor in the history of its surveys.
Indeed, the latest NFIB survey seems to show a separate economic reality from all media buzz replete with recession fears feeding the flight-to-quality flows that created the valuation extremes now being reversed. Here's an excerpt from the September 10,
NFIB press release: "In spite of the success we continue to see on Main Street, the manic predictions of recession are having a psychological effect and creating uncertainty for small business owners throughout the country," said NFIB President and CEO Juanita D. Duggan. "Small business owners continue to invest, grow and hire at historically high levels, and we see no indication of a coming recession." Particularly impressive, given the concerns over the dampening effects of trade uncertainty on animal spirits, "Capital spending posted strong improvements with 59% of owners reporting capital outlays, up two points from the month before."
While the global manufacturing sector has been most impacted, the composite global Purchasing Managers Index (PMI) for manufacturing ticked up back above 50 in August after two months below that level. Also of note, PMIs for services remain at solid levels around the world. For example, while the U.S. manufacturing PMI slipped below 50 for the first time since 2016, the non-manufacturing PMI surprised to the upside, rising back above 55. This discrepancy between weak manufacturing and strong non-manufacturing PMIs was also characteristic of the wave one and two downturns in 2012 and 2016, which also raised recession fears but turned out to be false alarms. In recessions, services, which account for about 85% of the economy, deteriorate along with manufacturing. That's not the case today.
If economic momentum is bottoming, as we suspect based on the patterns of previous cycles, we believe returns on equities should surprise to the upside. Exhibit 1 illustrates the pattern of equity returns in different growth and inflation environments. As can be seen in Exhibit 1, when the Institute for Supply Management (ISM) manufacturing PMI is in its lowest region and the ISM prices-paid index is also in its lowest region, six-month forward returns have tended to average their best performance according to research by Jeff deGraaf at Renaissance Macro Research, based on a sample from 1951 through 2019.
Exhibit 1: Growth and Inflation Bullish For Equities.
This should not be too surprising since, when growth and inflation are in these lowest deciles, the odds are greater that they will rise in coming months. The bottom left corner of Exhibit 1 is also the region where cyclicals' outperformance has historically been most pronounced. This suggests there is room to run in the powerful rotation that began after Labor Day.
The only cohort on Planet Earth with a pulse appears to be the U.S. consumer. The Rest of the World, by various metrics, has flatlined: Germany, in all probability, has entered recession. In Japan, stagnation remains the norm, with the government (counterintuitively) set to boost the consumption tax from 8% to 10% in October. In China and India, personal consumption has decelerated on rising fears of a global trade war and its aftershocks. Auto sales in China have declined on a year-over-year basis fourteen times in the past fifteen months according to the China Passenger Car Association, while car sales in India plunged 41% in August from the same period a year ago, the fifth month of double digit declines, according to the Society of Indian Automobile Manufacturers. Add to the above the weekend attack on two major oil facilities in Saudi Arabia, which cut more than half the country's oil production and triggered a 20% spike in world oil prices, and the global economy is limping into year end.
Against this backdrop, save for the U.S. consumer, global growth and the global earnings backdrop would be even soggier than reported. Think of the U.S. consumer as Atlas, the Greek god, according to mythology, condemned to hold up the celestial heavens. Yes, the weight of the global economy rests squarely on the shoulders of U.S. households, and that is why we have outlined the following figures for some investment perspective.
The key takeaway: Fears of a U.S. recession are overdone, in our opinion. In decent financial health, the American consumer will hold up the U.S. and the world until help arrives (i.e., global monetary/fiscal stimuli kicks in). We continue to prefer equities over bonds, with a bias toward large-cap U.S. equities.
The salient numbers in and around U.S. consumption:
If the U.S. consumer were a standalone entity, it would rank as the largest economy in the world. Annual U.S. personal consumption outlays are greater than the entire output of the Chinese economy. In Q2 2019, U.S. consumer spending on goods totaled $4.5 trillion versus $10 trillion outlays on services. While U.S. manufacturing output has slowed, healthy consumer spending has been supportive of America's massive service economy. One footnote: A large share of consumer spending on services is sunk into health care, which totaled roughly $2.5 trillion in Q2 2019.
The American economy has long been built around the consumer and the accessories that promote consumption. The first credit card, for instance, was introduced in America in 1950, fueling consumption (and rising debt levels) for generations to come. Owning a home has been another driver of consumption, with the U.S. home ownership rate hitting 64.8% in the fourth quarter of 2018, the highest level since 2014. The bottom line: It's hard (but not impossible) to have a U.S. recession without a negative headwind from the U.S. consumer.
The U.S. consumer is not only important to U.S. growth but growth to the rest of the world. With less than 5% of the world population, the American consumer accounts for 29% of total world consumption. Putting that number into perspective, annual personal consumption in the U.S. is greater than the next five largest spenders in the world combined: China, Japan, Germany, the United Kingdom and India.
The net worth of U.S. households is truly staggering—and has been a long-time catalyst to consumer spending. Owing to robust U.S. equity returns over the past decade, the rebound in U.S. housing prices, and steadily rising disposable incomes, the net worth of U.S. households has surged by over 70% since 2009. Against this backdrop, it's little wonder that consumer discretionary has been the top performer sector of the S&P since the trough of 2009, posting total returns of 801% since March 9, 2009, versus 449% of the S&P.
One key caveat to the above: Gains in net wealth have not been evenly distributed. According to the Fed, only 52% of families in the U.S. own (directly or indirectly) stocks, meaning nearly half the country has been absent one of the longest bull markets in investments history.
One of the strongest employment markets in decades remains a key support of U.S. consumption. The August unemployment rate of 3.7% marked the 18th consecutive month where the unemployment rate has been at or below 4%. Just as encouraging, the labor force participation rate edged up by 0.2 percentage points to 63.2% in August. The labor force participation rate for prime-adults (ages 25 to 54) increased 0.6 percentage to 82.6%; the prime-age labor force participation rate for women jumped 1.0 percentage point to 76.3%, the highest level since 2002.
Not unexpectedly, the tightening U.S. labor market has translated into a sustained rise in wages, with nominal average hourly earnings rising 3.2% in August from the same period a year ago. That marked the 13th straight month that year-over-year wage gains were at or above 3%. Prior to 2018, according to the Council of Economic Advisers, nominal average hourly wage gains had not reached 3% in over 10 years. With low and steady inflation rates over the past year, U.S. households are enjoying real wage gains as well, not just nominal gains.
One reason the U.S. consumer is such a potent economic force is that the American consumer is conditioned to spend, not save. The United States has long had one of the lowest savings rates among the developed nations—U.S. consumers spend what they earn (a positive for near-term growth) and squirrel very little away in terms of retirement (a negative as the more workers retire/roll out of the labor force). Comparable rates elsewhere: France (14.9%), Germany (10.8%), China (36%), Japan (34%) and Korea (34.6%). The U.S. personal savings rate hit an all-time high of 17.3% in May 1975 and a record low of 2.2% in July 2005.
Transportation costs are among the largest items for many U.S. household items, so when prices decline at the pump, consumers have more income at their disposal and discretion. As of September 9, 2019, the national average for a gallon of gasoline was $2.56, down 4.1% from a month ago and 11.1% from a year ago. In that gasoline prices track the price of crude oil—with the latter the number one factor in the cost of gas— the 20.4% year-over-year decline in West Texas Intermediate Crude has been incomeboosting for U.S. households. More income, more spending by consumers. The weekend attacks in Saudi Arabia could lead to a near-term bump in gas prices but the extent of any price increase will be dependent on how soon Saudi production comes back on line and how fast other producers step in to fill the supply disruption.
U.S. mortgage rates now stand at the lowest level since October 2016, having tracked lower this year along with falling 10-year Treasury yields. The comparable rate a year ago was 4.54%. Falling mortgage rates not only portend rising home buying demand but also more cost savings for households per refinancing. According to the Mortgage Bankers Association's last survey, August's refinance volume was more than 150% higher than the same period a year ago. More home purchases, along with the savings generated by refinancing, are very supportive of U.S. consumer spending in the near term.
American consumers are best in class when it comes to spending, not saving, and racking up debt on autos, houses, credit cards, and of course, education, or student loans. According to the Federal Reserve Bank of New York, aggregate household debt balances totaled $13.7 trillion in Q1 2019. That's a large figure, for sure, but relative to U.S. GDP, household debt as a percentage of total U.S. output is at a multiyear low—76.3% in Q1 2019, down from a peak of 99% in Q2 2009. Similarly, another measurement of consumer indebtedness—U.S. household debt service payments as a percentage of disposable income—looks equally benign. The percentage stood at 9.9% in Q1 2019, near the lowest level on record. The bottom line: not all U.S. households are created equal, but, in general, a decade of consumer deleveraging has left households in decent financial shape versus existing levels of debt.
U.S.-China trade tensions have caused economic angst well beyond exports and imports. As America's top creditor (China owns nearly $1.2 trillion in U.S. Treasuries), a key export market for U.S. companies (China accounts for 6.3% of U.S. goods exports according to the Bureau of Economic Analysis), and as one of the most profitable markets for Corporate America in the world (U.S. foreign affiliates earned $13.4 billion in China in 2017)—given these metrics of interconnectedness, there is a great deal at stake for the world's two largest economies. Moreover, strategic U.S.-Sino linkages don't stop at traditional flows of goods and investment; and perhaps less obviously, consider the most recent data suggesting slowing flows of people.
Chilly U.S.-Sino economic conditions have some of the world's most eager globetrotters staying home. The number of Chinese arrivals to the U.S. in 2018 showed the first full year of declining Chinese visitors (-6% compared to 2017) ever on record (Exhibit 2). This retreat continued into 2019 with an average of 10,000 Chinese visitors missing out on a trip to the U.S. each month.12 The pain point: The annual economic weight of Chinese tourism to the U.S. has become significant over the last decade according to the U.S. Travel Association—the 3 million Chinese annual visitors to the U.S. account for just 4% of arrivals yet contribute 14% of total travel spending receipts. The U.S. received roughly 80 million visitors to the U.S. in 2018, contributing $256 billion in income to the U.S. economy. The crazy upside: Just 9%, or 120 million Chinese citizens, possess a passport, compared to higher averages around the world like 40% of Americans or 76% of U.K. citizens holding passports. There is more upside, in other words, to China's future globetrotting.
This highlights the collateral damage of the ongoing cold (economic) war between the world's two largest economic titans. The longer this battle brews, the greater the downside pressure on various sectors, corporate earnings, as well as guidance and earnings revisions. And more broadly, the greater the risk to future capital expenditures, consumer confidence and the effects on global growth. Not to be remiss, China is grappling with a new era of growth and development, one that will result in annual real growth of less than 5% over the medium and long terms. First, the bad news: The damage has been done—like in the case of the U.S. travel industry falling victim to the U.S.-China trade spat. Lastly, the good news: The U.S.'s decision to delay tariff hikes in October, a sign of "good will", has bolstered hopes of some type of U.S.-China truce.
Exhibit 2: Flight Status China to U.S.: Cancelled.