Telling the Time
Second Quarter 2013
What “time” is it in the global economy and the financial markets? Is the economic expansion nearing “old age”? Are the markets living on borrowed time? There are no clocks to guide investors of course. However, we believe a few insights into prevailing conditions, along with some historical perspective, provide the next best thing towards telling the time on these and related investment issues. Our conclusions can be summarized as follows:
- The economic expansion is still young at heart.
- An industrial renaissance and an energy revolution are also underway.
- Perhaps slow but long business expansions are the new norm.
- The economic clock has not been rewound to 1937.
- The stock market may be resuming a leading indicator role.
- We are not so sanguine about bonds, however.
- Emerging markets are undergoing structural change.
What “time” is it in the economy? At four years and counting, is the current economic expansion long in the tooth? After all, this economic advance is about as long in duration as the average expansion in the post-war period.
Alternatively, is the economic clock being rewound even further back, all the way to 1937? Back then, the Federal Reserve thought the Great Depression was behind them, and so they shifted their monetary policy stance and unleashed the granddaddy of double-dip recessions. Is the current Fed taking us down the 1937 path?
What time is it in the stock market? After achieving all-time new “highs” in many U.S. market stock indexes in recent weeks, is the clock about to run out on the advance?
What time is it with respect to interest rates and bond yields? Is the 30-year bull market in bonds out of time?
Is the clock striking midnight for China, turning their economy into a proverbial pumpkin and potentially dragging the world economy down along with it? What time is it in emerging markets in general and the global economy?
There are no actual clocks to guide investors, of course. However, we believe a few insights into prevailing conditions, along with some historical perspective, provide the next best thing towards telling the time on these and related investment issues.
Those who have subscribed to our email updates recently received a commentary regarding the state of the housing and vehicle segments of the economy. (You can subscribe, by the way, at the bottom of this page in the first column of the site footer). As explained within that commentary, the early stages of economic expansion are usually powered by vigorous recoveries in auto and home sales.
For most of the current business expansion, however, housing and autos have been a drag on the economy. Only in recent months have these two sectors begun to contribute to growth. While auto and home sales have rebounded well off their recession “bottoms”, they still remain below levels consistent with general population growth and replacement requirements. (The average age of the existing auto fleet is 11 years old, for example.)
Besides giving the economy a cyclical (and temporary) bounce in its step, autos and housing sales also stand to benefit from emerging demographic tailwinds. As noted last quarter, the 30-44 year old demographic group is once again growing in numbers within the U.S. This is the first such growth in this age “cohort” since the year 2000.
This demographic group is of particular focus for they have typically been responsible for “moving the needle” with respect to household formation and all that comes with it—auto purchases, home sales and furnishing expenditures. Just as importantly, this age group also has been responsible for the bulk of new business formations and associated job growth over time. We expect they will again prove to be significant contributors to economic growth over the next several years.
While some pundits worry that recent (and potential future) increases in mortgage rates threaten housing prospects, most assessments of housing affordability suggest mortgage rates would have to go a good bit higher before the housing recovery would be impacted (see Chart 1 above – click it for a larger view).
Housing and auto fundamentals are not the only reasons the expansion is young at heart. The relentless push for productivity growth by businesses continues to be intense. To compete successfully, firms are on the hunt for tools, methods, and technologies that enable them to produce products and deliver services more cheaply, more quickly, and with higher quality.
Simulation software, computational manufacturing, 3-D printing, voice recognition software, and advanced robotics are just some of the technologies that are powering a renaissance in U.S.-based industrial activity. This renaissance is also gathering momentum from the dramatic shift in the domestic energy situation that is unfolding—despite political odds—as a result of hydraulic fracking and horizontal drilling technologies. (See Charts 2 and 3 – click them for larger views.)
The supply and cost implications of the energy revolution benefits U.S. consumers to be sure, but also provides significant competitive advantages to U.S. domiciled manufactures (Chart 3).
The productivity gains and energy situations also are beginning to reverse some long established trends. Whereas “offshoring” and “outsourcing” activities to foreign destinations were all the rage in past years, “reshoring” and “insourcing” are emerging and bringing industrial activity and jobs to the U.S. from overseas.
The Wall Street Journal recently documented these trends within the auto industry. The story noted:
Research firm Cornerstone Macro added some details on this development:
We suspect investors will hear a great deal more about these emerging trends over the next few years as they continue to power and reshape the domestic economy.
That the pace of the current expansion has been slow is well documented. But, there is a silver lining in the grind forward nature of the advance. Slow also likely means long in terms of the duration of the expansion. This is not without precedence.
The last two business cycles (those of the 1990s and the 2000s) were also both punctuated by “sub-par” growth for the first three years. These two expansions also ended up running much longer (at roughly 9 years and 7 years, respectively) than the 4-year post-war norm.
Why might a tradeoff exist between the speed of an economic expansion and its duration? With “slowness” in growth also comes slowness in the build-up of businesses cycle excesses—particularly in the form of debt accumulation and inflationary pressures. Traditionally, as these excesses build, the vulnerability of the economic expansion significantly increases.
In the past, we used the analogy of the form-fitting material spandex to describe business cycle dynamics. If a once sculpted athlete gains weight, the spandex shorts that had highlighted his or her physique can stretch to accommodate for a time. Additional stretch may be possible with still more weight gain, but the risk increases that a rip in the fabric will occur.
In 2008 we had a major rip in the stretched financial fabric. In the midst of the current economic expansion, the memories of 2008 have remained vivid. Fear, uncertainty, and doubt have been pervasive. Caution, not boldness nor recklessness, has been the constant companion of businesses and consumers.
Massive cash hoards exist at many companies, bank and consumer balance sheets are also generally in good shape (see Chart 4 – click it for a larger view). Troubling excesses in debt are absent.
Excesses on the inflation front also appear lacking. Those forecasting troublesome inflation as a result of Fed policies believe it is only a matter of time. We are not in that camp.
To see why, it may be helpful to consider a profound distinction made some years back by economist Ed Hyman. He noted the importance of differentiating between Fed actions that build a mountain of money, and Fed actions that “fill a hole” within a ripped financial fabric.
The 1960s and 1970s serve as a prime example of the inflation that accompanies a Fed-created money mountain. In contrast, we believe Fed actions of the past few years are of the “filling-the-hole” mode. During the 2008 Financial Panic, much of the so-called “shadow banking system” (non-banks that extended credit) retreated or disappeared outright. Within the banking system, stressed balance sheets no longer could support prior lending commitments—let alone extend new credit. The Fed stepped in as “lender of last resort” to fill the hole created within the financial system.
Chart 5 (click it for a larger view) portrays some of the “hole-filling” activities of the Fed. Their actions eased the impact of the ripped financial fabric and prevented a Great Depression repeat.
Relatively recent memories of the 1970s provide cause for concern about inflation. However, the inflation clock has not been rewound to that earlier period. Very different economic circumstances prevail, currently making the inflation outlook more benign than many pundits fear.
(Chart 5 represents the Change in Consumer Debt Outstanding + Change in Federal Reserve Balance Sheet, the vertical axis = % change, horizontal axis = year)
In recent days, the Fed has begun laying the groundwork for “tapering” its hole-filling actions. Some worry if the economy can withstand such a change in Fed policy. These worries largely stem from the experiences from another instance (1937) when the Fed ended major hole-filing actions.
As we noted a few years back, the Great Depression economy was punctuated by two bookend recessions: the massive economic contraction that accompanied the collapse of the financial system in 1930-33 period and the savage double-dip downturn of 1937-38.
The Fed in 2008 boldly avoided repeating the disastrous monetary mistakes of 1930-33. The modern day Fed rushed in as “lender of last resort” while their counterparts failed to do in the early 1930s.
Similarly, it is important to distinguish between the indicated policy of the current Fed and that of the 1937 Fed. The 1930s Fed crushed the recovery that had unfolded between 1934 and 1936 by literally jumping on the monetary brakes. The current Fed in contrast, is suggesting a gradual “tapering” of their hole-filling actions.
Chart 6 (click it for a larger view) reflects Fed actions through the lens of changes in the supply of money. Sharp contractions in the money supply that contributed to the 1930s bookend economic contractions are easily visible. One does not need to strain their eyes to see that current policy looks much different from that of the 1930s.
Will Fed policy become “tight” again at some point in the current economic expansion? Absolutely. As excesses build—including some rise in inflationary pressures as the expansion reaches “old age”—tight policy to combat the excesses will sow the seeds of the next recession. But until excesses build, those days are likely some time off into the future.
Just like Fed policy, we believe the stock market is in the midst of an important transition as well. Typically the stock market is a leading indicator of the economy and the prospects for corporate earnings. In recent years it strikes us that the stock market has behaved more like a lagging indicator. New all-time “highs” in stock prices merely reflect the fact that corporate earnings have been making record new highs for the past three years.
This year’s stock price advance seems reflective of an increased confidence in the resiliency of the economic expansion. The increased confidence appears a long way away, however, from the type of optimism and euphoria that characterizes market “tops”. The “market clock” diagram (click it for a larger view) provides a generalized anatomy of bull markets and changes in investor psychology.
With signs of market-top type froth in stock valuations largely absent, with major investors (pension funds) having their lowest exposure to stocks traded on U.S. exchanges in decades, and few believing investor sentiment could ever again even reach the optimism/euphoria zones, it would appear the current bull market is still in the early “rise on skepticism” stage.
This is not to say that the advance will be a straight line up, of course. The skepticism phase is, by definition, marked by fragility in confidence. And the world is (as always) anything but trouble free. Recurrent bouts of jitters are ahead, but we expect the bull market, like the economic expansion itself, will prove resilient.
Despite market noise to the contrary, we believe the Fed’s talk about moving away from its hole-filling actions is a favorable signal for investors. Rising interest rates and bond yields are reflective of increased confidence that the Fed’s hole-filling actions are no longer necessary.
The Fed marking a path towards allowing rates and yields to normalize at higher levels will not be an easy ride for bond investments. Especially if the yield rise is compressed in a short period of time, as the last several weeks have suggested might be the case.
How high might bond yields lift in the “normalization” process? Using the 10-year Treasury as a gauge, 4-5% yields (it currently is approximately 2.6%) likely represents “normal” yield structure given prospective economic growth rates.
As the normalization process unfolds, we expect the risk/reward profile of bonds will materially improve, and as it does, we anticipate becoming bond buyers once again.
We believe the emerging markets investment story entered a new and much less favorable “time zone” over the past few years. Because many developing countries roughly peg their currencies to the U.S. dollar, they have, in essence, imported the monetary policy of the U.S. And while the Fed’s hole-filling monetary policy was appropriate for the U.S. as we discussed earlier, in emerging markets cases inflationary “money-mountain” situations have evolved.
In addition, three other problems have emerged in the developing world. Their labor cost advantages are rapidly eroding as wages have risen substantially faster than productivity growth (crushing the profit margins of home-grown companies), they are experiencing mounting credit problems from their money mountain situations, and they have limited policy options to deal with these troubles.
The communist leadership in China, for example, is trying to slow growth to deal with these issues. However, the difficulty of combating accumulated excesses is compounded by the pressures from a populous that is eager to climb the economic ladder out of poverty. Additionally, China must grow fast and soon, for the average age of its population is rapidly increasing as a result of its “one child policy” of previous decades.
While China’s slowdown may periodically be a source of “jitters” in world markets in the months to come, the good news for developed countries is the downward pressure on their inflation rates as commodity prices decline. The story behind escalating prices of many commodity prices over the past decade has been the rapid build-out of China and other emerging market economies. Slower growth is making the commodity “super-cycle” that supposedly was here to stay look much less “super”. And that is good for consumers and many businesses around the globe.
In closing, the “time clocks” on many trends appear to us to be giving off favorable readings on many fronts. Although the global economy looks to be downshifting to a lower growth gear, the U.S. looks to be shifting to a higher growth gear as the technology revolution and the renaissances in manufacturing and energy evolve, the U.S. stock market advance still has ample room to run, higher bond yields reflect greater confidence, and inflation and debt excesses in the U.S. are not likely to reach the troublesome stage for some time.
As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.
1 Rogers, Christina and Neal E. Boudette. (2013. July 2). “A Revitalized Car Industry Cranks Up U.S. Exports.” Wall Street Journal.
2 Zweig, Jason. “Saving Investors From Themselves,” The Intelligent Investor (blog), Wall Street Journal, June 28, 2013, http://blogs.wsj.com/moneybeat/2013/06/28/the-intelligent-investor-saving-investors-from-themselves/.