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Are We There Yet?

Third Quarter 2018

Download PDFCapital Investment Services Third Quarter 2018 Perspective - The Picture Within the Picture

In just a few months the present economic expansion will likely go down in the record books as the longest in U.S. history so far.

Like the proverbial annoying question during family travel—Are we there yet?—this business cycle expansion has been hounded nearly every inch of the way by repeated prognostications that its end is just ahead. (A chart presented in Appendix 1 provides a timeline summary of dire forecasts and associated worries of the day).

A cartoon showing a dog and its owner telling a passerby that the dog is sensitive like the 10-year US Treasury bond

Economic growth, while slow by historical standards, has proved resilient in the face of real or perceived challenges encountered along the way. And the earnings of many companies—particularly those at the forefront of innovation—have likewise marched ahead powering their stock prices higher as well.

But since past expansions (and stock bull markets) have typically ended after a period of rising interest rates, and rates are currently on the rise, it’s a good time to again discuss the prospects for the expansion and the associated bull market in stocks.

Taking away the punchbowl as the party gets rolling?

Why do “business cycles”—repeated expansions interrupted by recessions—exist in the first place? Although business cycle theory is hardly “settled science” among economists (go figure!), we believe the business cycle pattern can be traced to the accumulation of excesses and their subsequent purging.

Let’s return to the analogy we’ve often used in the past to describe business cycle dynamics. Consider an athlete that wears the form fitting material, spandex. In their prime, a spandex-clad athlete is fit and trim. As the athlete ages, and if they abandon their training regime, they may well accumulate some “excesses”. The spandex clothes may still stretch enough to fit, but “the look” is, well, much less flattering.

Like the athlete in our analogy, as an economic expansion ages, excesses (usually in the form of too much debt and inflation) tend to accumulate. As the excesses build, an expansion becomes vulnerable.

In response, policymakers—typically the Federal Reserve (“Fed”)—move to address, or prevent, the accumulation of excesses. They may do so, as one former Fed official long ago noted, by taking away the (financial liquidity) punchbowl before the economic party gets out of hand and the excesses really build.

A cartoon depicting Dr. Frankenstein proclaiming the creation, named inflation, on the gurney is alive followed by a statement of or maybe not

If financial system liquidity is constrained, credit flows are constricted. Such “tightening” ultimately impacts the pace of commerce within the economy. Firms find themselves with unwanted inventories and respond by slowing new production. Slower-than-anticipated business results in less demand for labor and unemployment rises. Loans made in “good times” go bad as cash flow expectations prove too optimistic.

Recessions that follow tend to alleviate the excesses. In the downturn, policymakers change course, step up the provision of financial system liquidity, and foster conditions conducive to a resumption of economic growth.

How stretched is the financial spandex in the U.S.?

As always, while some businesses and consumers will struggle with their finances, it does not appear that systemic growth-threatening excesses are lurking about.

Chart 1: Consumers remain in good shape

US household debt service payments as a percent of disposable personal income from 1980 through 2017
The banking system—ground zero in the last recession—is better capitalized than it’s been in decades.

Meanwhile, loan demand is hardly robust as the intangible nature of the emerging digital economy brings with it relatively modest needs for capital.

Overall consumer debt burdens appear manageable with ample cushion against potential cash flow deterioration. (Refer to Chart 1 above).

The same conclusion appears reasonable when assessing corporate debt.

What about student loans, are they a threat as some fear? These balances are indeed substantial.

But employment is rising across the demographic cohorts with the largest loan exposures, helping repayment wherewithal. Furthermore, student loan balances have likely acted as a restraint on spending rather than supercharging consumption in an unsustainable “boom” that will “bust”. Finally, unlike the subprime mortgage situation last decade, the credit exposure is directly tied to the government, not individuals or businesses.

Which leads us to government finances. Pro-growth tax cuts and deregulation have helped fire the economy’s “animal spirits” and the pace of growth has recently picked up. A faster growing economy will generate more tax revenues—perhaps to a degree that surprises many.

Chart 2: Debt service cost on the national debt will increase, but it’s a long way from levels of recent decades

US federal debt service payments as a percent of GDP from 1980 through 2017

And while there seems little reason to believe Washington will curb spending anytime soon, the government debt service burden appears relatively modest, even as the government’s cost of funding rises as Treasury yields rise. (Refer to Chart 2 above).

What about inflation?

We do not believe the economy is all that inflation-prone. Modest population growth and (deflationary) technological advancements that will favorably impact productivity growth should help keep inflation subdued.

Yes, oil prices have moved abruptly higher of late on supply issues due to sanctions (Iran) and economic disaster (Venezuela). Oil prices will continue to impact measured inflation. But U.S. oil production continues to expand, tempering the rise in prices. Higher prices will induce still more U.S. supply. Meanwhile, most other commodity prices remain well behaved.

What about the potential for inflation as a result of the Fed’s “QE” (quantitative easing) actions of prior years?

The Fed’s ability to pay interest on the reserves banks keep with them, coupled with the relatively modest loan demand mentioned earlier, suggests to us that the transition mechanism between the Fed’s balance sheet and the economy is no longer as powerful as it may have been in the past. Serious monetary inflation does not appear likely anytime soon.

Forward-looking indicators also suggest inflationary pressures will remain relatively modest. On previous occasions, we discussed the Chicago Fed’s National Activity Index (“CFNAI”—good index, bad nickname!). We noted that it’s worth monitoring as it has garnered a decent track record as a leading gauge of both economic activity and inflationary pressures.

Also appealing about the Chicago Fed Indicators are the “key threshold levels” provided with each monthly update. These levels act somewhat like warning lights on a car’s dashboard.

Chart 3 below provides the latest readings on inflationary pressures. As the Fed’s description under the chart reflects (in the notes section below the chart, we’ve added bold and italics print to the key sentences). Readings above the two dashed lines are warnings lights for increasing inflation. Sustained inflationary pressures do not appear present.

Chart 3: Inflation warnings lights are not flashing

Chicago Federal Reserve National Activity Index and inflation from 1966 to 2017

Notes: Shading represents periods of sustained increasing inflation. An increasing likelihood of a period of sustained increasing inflation has historically been associated with values of the CFNAI-MA3 above +0.70 more than two years into an economic expansion. Similarly, a substantial likelihood of a period of sustained increasing inflation has historically been associated with values of the CFNAI-MA3 above +1.00 more than two years into an economic expansion.

If inflation and debt are not excessive, why is the Fed tightening?

When the Fed embarked on their rate hike campaign, then Vice-Chair Stanley Fischer characterized policy as “moving from ultra-easy to extremely easy”. The starting point for Fed rate hikes was an extraordinary 0% rate policy that they maintained for the better part of a decade.

As the Fed became convinced that crisis era ultra-easy policy was no longer warranted, they moved to “normalize” the interest rates under their control. Failure to change policy could well have fostered excesses.

Although extremely easy policy may have brought Fed interest rate hikes, rates remain low in historical context, and financial system liquidity remains flush.

Chart 4: Despite rate hikes (red “line” in chart), it sure doesn’t look like the Fed’s taking away the liquidity punchbowl as financial conditions remain “easy” (purple “line” in chart).

Chicago Federal Reserve National Financial Conditions Index vs Effect Fed Funds Rate from 2014 to October 2018

Are stock prices excessively “high”?

After a long bull market advance, is it possible an “excess” exists in stock prices?

We believe the evidence is clear that over time stock prices are driven by the earnings results of the underlying businesses. Therefore, stock prices must be examined in the context of a company’s earnings to render any sort of judgement about whether stock prices are “excessive”.

Yale professor Robert Shiller is in the camp that believes stock prices are “too high”. He doesn’t expect the economic advance and the associated uptrend in general corporate earnings to continue. (We’ll address such concerns in a later section).

But interestingly, in a recent article Shiller noted the following about the relationship between earnings growth and stock price growth in recent years :

“The U.S. stock market, as measured by the monthly real (inflation-adjusted) S&P 500, has increased 3.3-fold since its bottom in March 2009.”

“Real quarterly S&P 500 reported earnings per share rose 3.8-fold over essentially the same period, from the first quarter of 2009 to the second quarter of 2018. In fact, the price increase (in stocks) was a little less than equal to earnings.”

“What if we measure earnings growth, from the beginning of the Trump administration, in January 2017?”

“Over that interval, real monthly U.S. stock prices rose 24%. From the first quarter of 2017 to the second quarter of 2018, real earnings increased almost as much, by 20%.”

With prices and earnings moving together on a nearly one-for-one basis, one might conclude that the U.S. stock market is behaving sensibly, simply reflecting the U.S. economy’s growing strength.”1

Another concern often recently expressed relates to valuations within the stock market? Are the stocks of companies at the forefront of innovation—“growth stocks”—that have advanced smartly of late in another valuation bubble similar to the dotcom mania at the turn of the New Millennium?

Morningstar researcher John Rekenthaler and his staff offer some worthwhile insight on this topic. Here’s what they had to say:

“Relative P/E ratios (within the market) have gone nowhere for 16 years. The P/E ratio of the Vanguard Growth Stock Index reached 2.5 times that of the Vanguard Value Stock Index (index of lowest P/E stocks) at the start of 2000 (peak of the dotcom stock bubble), then sank to 1.5 times by 2002. It’s stayed at 1.5 times, with a few small wiggles along the way.”

“The P/E evidence indicates that growth stocks have earned their way to success, rather than being buoyed by higher investor sentiment.”2

Our view? The stock market is, of course, comprised of many different stocks. Each company has its own business prospects. Valuation is both a “macro” (overall market) and “micro” (individual company) issue. If a company’s shares becomes “over-valued” relative to its prospects—even within the context of an overall bull market—we believe it’s prudent to trim the pricey holding.

Regarding macro valuations, on a price to earnings (“P/E”) basis, the market may not be “cheap”, but valuation does not look excessive.

We also agree with economist Ed Yardeni’s recent comment: “The bull market (in stocks) will last as long as the economy continues to expand.”

As we’ll discuss next, the current uptrend in aggregate corporate earnings growth should be extended as the economic expansion itself continues.

Are bond prices excessively “high” or, said another way, are bond yields too “low”?

We have often noted on past occasions that since the Financial Panic of 2008 pervasive fear, uncertainty and doubt about the economy has kept the expectations “bar” for economic growth pretty low. Expectations generally were centered around 2% for inflation adjusted Gross Domestic Product (GDP).

The “are we there yet?” mindset also reflects low confidence in the resiliency of that growth.

While the bar remains low, it appears to be rising. Yields on 10- and 30-year Treasury securities have recently risen above levels not experienced since 2011.

Just as the Fed shifted policy when they believed economic conditions warranted a policy change, we believe the bond market is recalibrating bond yields in light of both rising economic growth expectations and increased confidence in the durability of the growth.

Many economic indicators are suggesting the yield recalibration for sturdier economic growth may be appropriate.

The research firm Bespoke, for example, recently took a “deep dive” into the Leading Indicator data series published by the Conference Board. The following chart and commentary reflect Bespoke’s analysis:
Year over year percentage change in leading indicators from 1959-2018

(Recent reports indicate the year-over-year rate of change is trending at a rate above 6%.) “Since 1980, the earliest a recession came following a period where the year-over-year change in leading indicators was above 5% was 24 months. The average amount of time that elapsed from the last 5% or more reading to the earliest stages of a recession was 35 months. No matter which way you cut it, the Leading Indicators do not show signs of a slowing economy.”

If the historical relationship Bespoke identifies holds up in the current expansion, the next recession is still some ways off yet. Expansions don’t die of old age. They die of excesses.

Analysts at Goldman Sachs came to a similar conclusion after studying other countries where growth cycles lasted more than 10 years (Australia from 1992 to present; the U.K., 1992-2008; Canada, also from 1992-2008; and Japan, 1975-1992).

They found that common characteristics of these long expansions were that inflation didn’t become a big issue; financial regulation was strengthened so banks didn’t implode and the expansions lacked financial imbalances. All traits that the current U.S. expansion shares. They conclude the next U.S. recession may not occur until 2021.

What about stocks and rising rates?

But, if bond yields need to recalibrate somewhat higher, won’t that be bad for stocks?

Not on a lasting basis if history is a guide.

Vanguard recently did a study that identified 11 periods of rising rates over the past 50 years. Vanguard’s conclusions?

“The data may surprise you.”

“The historical research we’ve done, doesn’t show a pattern of falling stock prices during rate-hiking cycles. In fact, hiking regimes often take place when the economy is performing strongly and earnings growth is robust and, therefore, stocks tend to perform respectably during those periods.”

“As the graphic below illustrates, in the 11 periods of rising rates we looked at over the past 50 years, stock market returns were positive in all but one of them. And even including the -15% return for the period in 1974, the return of stocks across those periods was in line with the 10% average for stocks from 1925 through 2017.”3

S&P 500 historical total returns during periods of rising rates from 1967 through 2018

What to do about bonds?

Returning to the earlier question that we left conveniently unanswered; are bonds excessively priced because yields are too low?

The answer again requires both a “micro” and “macro” assessment.

In Appendix 2 we present the specifics of our micro analysis. Our bottom-line conclusion?

The risk/reward profiles of shorter-term bonds have already been significantly altered by the Fed’s rate hikes. Their risk profile is much lower and their reward profile is much improved.

The same is not true for longer-maturity bonds. There remains very little cushion in longer term Treasury securities (for example) to absorb higher yields.

Bond portfolio investment should remain focused on shorter-term securities.

Are we there yet?

Don’t be surprised if some of the persistent doom-and-gloom voices shift from calling for the next recession because the economy is feeble, to calling for the next recession because the economy is “over-heating” and the Fed will be jumping on the monetary breaks.

As always, perspective and context matter in trying to understand the world. Bond yields have been incredibly low. Economic expectations have been very low.

Both yields and overly-glum expectations may have to rise some as the resiliency of the economic advance continues to be demonstrated. But until, and unless excesses build, bond yields will likely remain relatively low from a historical perspective.

Meanwhile, the economic ground beneath our feet continues to shift as the creative-destruction process of economic betterment unfolds and the digital/physical economy continues to evolve. Stock market “indigestion” and price “corrections” will occur along the way. Expect them.

But rewarding opportunities still await investors.

Appendix 1

S&P 500 historical all time highs line graph corresponding to pundits' negative commentary

Appendix 2

Not all bonds have the same risk/reward profiles. Bond yields and bond prices move inversely. But the sensitivity of a specific bond’s price to a change in its yield depends upon the bond’s maturity. Longer-term bonds are much more sensitive to changing yields than are shorter-term bonds.

The following table reflects the risk/reward prospects for Treasury securities of different maturities at two different points in time—today, and in mid-2016 before the Fed began its rate hikes.

table demonstrating the change in risk and reward of holding bonds during periods of rising interest rates

The impact of Fed hikes on bond yields has been uneven. Shorter-term bond yields have moved higher almost in lockstep with Fed rate hikes. Longer-term yields have barely budged.

A significant change in the risk/reward prospects of shorter-maturity bonds has occurred as their yields have risen. Whereas only a relatively small (70 basis points) rise in 2-year yields would wipe out a year’s worth of bond income back in 2016 (right-hand side of table), today 2-year yields would have to rise towards 6% to inflict the same damage (left-hand side of table.)

Longer term bonds, however, have very little insulation to absorb higher yields.

We remain focused on understanding the current trends in fundamentals because it gives us the best probability for investment success.

Sources & Notes

1 “Do spectacular earnings justify spectacular stock prices?”, Robert Shiller, September 24, 2018, Project Syndicate.com
2 “Growth Stocks Outpace Value,” Investor’s Business Daily, October 2018
3 “Rising interest rates do not equal poor equity performance,” researchcommentary/vanguard.com