Download Making Sense of Conflicting Signals

INVESTMENT OUTLOOK
October 2016
Making Sense of Conflicting Signals: Where is the
Economy Taking Us?
by Jim McElroy, [email protected]
We are living in unusual times. The U.S. economy is now in its eighth year following the "great
recession". Under normal circumstances, we would expect that a recovery lasting eight years
might be a little long in the tooth: the average since 1950 has been just over five years. But this
has been no ordinary recovery: it's been the weakest since the end of WWII. Not once in the
twenty-nine quarters of this post-recession expansion has GDP grown at an annualized rate in
excess of 5% and only twice has it grown in excess of 4%. The average number of greater than
5% quarters for the preceding ten post-war expansions has been seven. During those ten
earlier expansions, the average annual GDP growth rate was 4.85% per quarter; the current
average through June has been 2.08%. Is slower better and does incremental growth last
longer? Or, does the tepid nature of the current expansion serve as a warning that the
economy is vulnerable to an unexpected shock? The question we're asking -- the question
we're always asking -- is where are we in the economic cycle: are we closer to the beginning,
middle or end of an expansion? The answer to that question is obviously critical to the
timeliness of investment decisions.
Investment markets are supposed to be semi-reliable predictors of the economy. The stock
market, reputed to be the best market harbinger of economic growth or decline, has been in a
bull market for over eight years and is near all time highs. On the other hand, fixed income
markets, sporting absurdly low yields -- below 2% for ten-year U.S. Treasuries and negative for
many international debts -- suggest anemic prospects for the economy. So, which market are
we to believe? And, to further cloud the picture, this is a presidential election year. That and
the fact that the two major candidates have distinguished themselves by their unpopularity
create a situation fraught with uncertainty.
The continuing strength of equity performance is noteworthy in that earnings for major U.S.
corporations (i.e. the S&P 500) have been declining for the last five quarters and are expected
by analysts to have declined even further for third quarter, which ended September 30th.
Though much of the index's earnings decline over the past five quarters came from the energy
sector and, according to FactSet, earnings would have been mostly positive without its negative
impact, this does not, on its own, justify record high prices or an almost 20 multiple on trailing
earnings. Either the stock market is extremely forgiving of lackluster earnings -- not its
reputation -- or factors other than earnings are driving stock prices. We need look no further
than the fixed income markets and the level of interest rates for at least one explanation of
equity strength.
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There are at least two ways through which interest rates influence stock prices: through their
impact on overall economic activity and through competition. High interest rates obviously
discourage borrowing and encourage savings, results that reduce economic activity and limit
equity earnings. In addition, high interest rates raise the bar for stock returns, causing investors
to require either higher earnings and/or dividends (difficult in a period of reduced economic
activity) or lower stock prices. Low interest rates, or in the current case, ludicrously low interest
rates, normally produce the mirror image of the above: aggressive borrowing and depletion of
savings by investors and consumers and a lowered bar for equity returns. As it happens, the
current environment of near zero interest rates has had only a limited impact on economic
activity: the consumer is spending more and low mortgage rates are encouraging him to invest
in more home ownership, but corporations to date have been unwilling to borrow funds or
employ cash savings to invest in new plant and equipment. Consequently, the effect of low
interest rates on economic activity has been limited and has had very little impact on stock
prices. However, the impact of low interest rates on the competition for returns on risky
investments, such as stocks, has been enormous. When cash management funds are yielding
less than .25% and ten year Treasuries are yielding below 1.6%, a dividend yield of 2.06% (S&P
500) or higher, with the potential for growth, looks very attractive indeed. It looks so attractive,
on a risk return basis, that corporations have been employing excess cash reserves to buy their
own stock rather than investing in plant and equipment. Little wonder that all time highs in the
stock market are coinciding with all time lows for interest rates. All this begs the question of
what happens to the stock market when central banks like the Federal Reserve begin to raise
interest rates.
The Federal Reserve raised short term interest rates .25% last December and said that it
expected to raise rates four times in 2016. Because of a variety of weak economic news during
the first three quarters of 2016, the Fed balked and did nothing. It now is signaling that it will
likely raise rates by .25% this December. We believe the Fed will raise rates in December, but
will continue their message of caution and patience in bringing interest rates to levels consistent
with sustainable growth. As long as the Fed succeeds in conveying this message of patience,
there should be no December collapse in asset prices.
It is becoming clear, even to many central bankers, that a low to negative interest rate will not in
and of itself create economic growth or inflation. Those effects, like almost everything else in
economic and market activity, are driven by the collective psychology of humans behaving as
humans or, as John Maynard Keynes called it, "animal spirits". Among investors it's called fear
and greed. Without the presence of optimism among economic participants, reducing interest
rates to extremely low levels in order to produce growth is only so much pushing on a string.
And, as many have seen over the last few years, it can also be counterproductive: desperately
low rates can produce a degree of pessimism that may discourage investment and the
assumption of risk. On the other hand, lifting interest rates from very low levels may not
discourage investing and risk taking when in the context of growing consumer and investor
optimism. And, at least domestically, consumers and investors appear to be demonstrating an
incipient degree of optimism: U.S. consumer confidence has been climbing since May -- the
latest reading places it at its highest level in nine years (since just before the last recession);
and the stock market is hovering within 2% of its all time high, which was set during the
current/third quarter.
We've already mentioned that the absence of competition from bonds has provided a support to
the equity markets. With rates set to increase, this support could slowly disappear, a future well
appreciated by stock investors. Since the stock market has the reputation of discounting
practically everything, we may assume that the market at current levels is not overly concerned
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with a .25% increase in overnight rates. However, in order for the stock market to grow from
current levels, investors will have to believe that earnings growth will make a long awaited
appearance sometime in 2017. In order for that to happen, there needs to be a lift in GDP well
above the "muddling through" pace to which we've grown accustomed.
It seems to us unlikely that a 2% GDP growth rate will last indefinitely: it will either accelerate or
the economy will slip back into a recession. In addition to the increases in consumer confidence
mentioned above, there are signs that the U.S. economy is improving: the unemployment rate
has declined to 4.8% and payroll employment is holding steady; perhaps more importantly, the
labor participation rate, after having declined for most of the last nine years, appears to have
bottomed (at 62.8%) and begun to rise; the housing market is steadily improving and new home
prices are closing in on levels not seen since before the last recession; and the Federal
Reserve, after having modestly lifted short rates from zero last December, now finally sees
enough strength in the economy to consider another increase. As long as the Fed raises rates
gradually -- and they say that they will -- then we see no reason why the domestic economy
won't benefit from higher rates. Perversely, there may be nothing like higher capital costs to
quicken the animal spirits of corporations and investors. If this is correct, then this long recovery
may last even longer and we might actually see significant growth and returns on invested
capital.
Not
Investment
Advice
or
an
Offer
This information is intended to assist investors. The information does not constitute investment advice or
an offer to invest or to provide management services. It is not our intention to state, indicate or imply in
any manner that current or past results are indicative of future results or expectations. As with all
investments, there are associated risks and you could lose money investing.
For more information about the commentary found in this newsletter, please contact a member of the investment committee.
John McCollum
Brandon Glenn
Frank Hosse
Vaughn Antley
Matthew Bankston
David Fuselier
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
David Thompson
Jeff Asher
Sam Boldrick
Jed Miller
Erik Aagaard
[email protected]
[email protected]
[email protected]
[email protected]
[email protected]
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest
or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past
results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose
money investing.
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