By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
We continue to think that investors should ignore the political headlines when it comes to considering the broad economy and markets. Other social issues notwithstanding, we think that policies in Washington, DC have little impact on the current economic picture, though they can affect individual industries.
Broad economic fundamentals are largely driven by innovation, labor force growth, and monetary/credit conditions. In the U.S., the federal government has little to do with innovation, which is driven by the private sector, or the growth of our labor force, which is primarily driven by demographic trends, though immigration does have an impact. However, monetary and credit conditions are a result of the interaction between households, private businesses, lending institutions, and the U.S. Federal Reserve (the Fed). We are thankful for the independence of the Fed and hopeful that it will remain so.
Broadly speaking, the group of economic indicators that we track suggest that the global economy is improving and will continue to do so in the months ahead. Gains in the U.S. economy are reflected in improving business sentiment and a solid labor market. For example, while manufacturing PMI and small business optimism are up (exhibit 1), layoffs, as represented by weekly jobless claims, are down.
Weekly jobless claims are among our best leading economic indicators. Large stock market declines are typically associated with economic recessions. Weekly jobless claims tend to increase at least 20% year-over-year ahead of recessions and the associated stock market declines. Currently, weekly jobless claims are down 12% from last year, suggesting little chance of a recession and the associated steep stock market declines in the near term.
Not only are weekly jobless claims down year over year, they are down to levels not seen since 1973 (exhibit 2). To put that into perspective, the 1973 labor force was approximately 90 million people. Today, the U.S. labor force is roughly 160 million strong. The size of the labor force is nearly double what it was 44 years ago, but layoffs are at the same low level. We think this situation reflects strength in the U.S. economy, which should lead to more jobs creation in the future. Additionally, we expect consumer spending to be exceptionally strong going forward as the economy adds more jobs and more income, which is already at an all-time high (exhibit 3).
This strength is not just reflected domestically. We think that the strong U.S. economy is helping to pull the economies of other countries higher as well. For example, euro zone business activity surged in February to its highest level in years, per the latest IHS Markit survey (exhibit 4). Euro zone job creation is at levels not seen in nearly a decade, while new orders and business optimism are moving higher, which bodes well for economic activity in the months to come.
We think the broad U.S. stock market’s strong rally since the November election has priced in high expectations for certain assets. As the political realities of how difficult it is to change government policies set in, we think that some asset classes that have done very well will lag. Therefore, given the equity market rally, we expect volatility and some down-side risk.
However, with our broader constructive context as a backdrop, this market offers opportunities for disciplined investors. For example, while fundamentals for U.S. consumer spending appear to be improving, as are broad foreign economic indicators, both the U.S. consumer discretionary sector and developed foreign equity markets are trading at a discount to the S&P 500 Index (exhibit 5). We think that these attractive valuations create a nice buffer to downside risk, while improving economic data supports higher prices.
With global economic fundamentals on the upswing, we expect inflationary pressures to build. Economic improvement should give the Fed room to raise short-term interest rates about 1% over the next year without disrupting economic growth. Meanwhile, global demand for high quality sovereign debt, like U.S. Treasuries, should keep long-term bond rates in a trading range below 3%.
Similar to our expectations that certain areas of the equity markets that have rallied strongly will begin to lag, areas of the bond market that exhibit more credit risk may also struggle. As exhibit 6 illustrates, the premium, or spread, that investors earn for owning both investment grade and below investment grade bonds has declined and may no longer represent an attractive value. Thus, we have reduced exposure to corporate bonds and mortgage-backed securities in recent weeks.
As a global investment firm who focuses on managing risk in real-time, we are finding abundant investment and risk management opportunities in this environment.
THE CASH INDICATOR
Though still elevated compared to its post-crisis average, the Cash Indicator has been receding lately. We think this tempering of risk measures reflects the positive readings that we have seen in global economic indicators. Thus, we think that market drops are buying opportunities.
IMPORTANT ECONOMIC FACTORS
We think that economic fundamentals, such as Gross Domestic Product (GDP) growth rates, and market fundamentals, such as valuations, matter over time. Clearly, history shows that earnings drive stock prices in the long-term. There are periods where prices deviate from earnings, and valuations compress or stretch, but the relationship over the long-term is telling.
Earnings growth drives stock prices, and earnings are heavily dependent on revenue. Revenue growth, in turn, is closely related to the nominal growth in economic activity, or NGDP, as the following graph demonstrates. When thinking about economic and stock market fundamentals, it is important to think about what drives NGDP growth.
Nominal GDP (NGDP) is real GDP, plus inflation. We care more about nominal GDP because revenues and earnings growth includes inflation. In generating its long-term forecast for real GDP (not including inflation), the Bureau of Labor Statistics (BLS) combines a forecast for labor market growth and productivity growth. Labor market growth is based on demographic trends, which move slowly and are relatively easy to measure. Productivity is more difficult to forecast because it is based largely on new technologies and innovation. The BLS forecasts annual growth of roughly 0.5% for the labor force, and approximately 1.8% for productivity growth, for a 2.2% real GDP forecast. To create a forecast for NGDP, we include an inflation factor using market-based inflation expectations as a proxy for what to expect going forward. We like to use the relationship between Treasury bonds and Treasury Inflation Protected Securities (TIPS) of the same maturity, known as the TIPS breakeven spread, to derive what the market thinks inflation will be over the next several years. The market expects inflation of roughly 1.5% over the next 10 years. As a result, we think that 3.7% (2.2% + 1.5%) is a good estimate for NGDP on average over the next several years.
By creating this nominal GDP forecast, we think that it is possible to create reliable expectations for U.S. economic activity, revenues, and earnings over the long-term. Obviously, short-term events can derail the economy’s near-term potential or accelerate revenue and earnings growth, but we think longer-term economic growth is rooted in these factors. Importantly, these factors suggest a positive environment for slow, but steady growth ahead.
None of these inputs to economic growth (labor force and productivity growth rates, along with inflation), corporate revenues, and earnings in aggregate are directly and significantly impacted by a presidential administration. Granted, an administration may have significant influence on specific industries through various policy measures (e.g. regulations or subsidies), but, in aggregate, what drives the U.S. economy is the stable growth rate of our labor force and productivity of the private sector. It is these factors that should be the areas of focus for broad equity market investors.
Unlike a centrally planned economy, such as China, these factors are not driven by the president. Through the wisdom of our forefathers, our system of checks and balances prevents any president from wielding too much power. The upward bias to our economy and our markets are a result of our democracy and capitalism. This has held true despite many different administrations, both republican and democratic, with very divergent economic and political policies.
Is it different this time? Yes, the candidates are different. Still, the dominant factors that drive our economy and markets are unchanged regardless of presidential administration. The demographic, productivity, and inflationary trends that drive our economy and financial markets are well entrenched. These trends indicate slow, but steady growth ahead and a positive environment for equity market investors with appropriate time horizons.