The economy is expanding, yet business confidence is eroding, according to the Federal Reserve’s most recent “Beige Book,” a report that compiles anecdotal information from regional business contacts in each of the Fed’s 12 districts. While the outlook is generally positive, the report reflects a retrenchment in business optimism that is due to a noxious blend of rising short-term rates, heightened market volatility, falling energy prices and political and trade uncertainties. While energy prices have stabilized and the stock market has regained its footing, the other ambiguities still cloud C-suite crystal balls.
Business investment is a critical input to our economy’s long-term health. Investments in plant, property and equipment drive growth while research and development drives productivity, that magic ingredient that enables us to expand our living standard without debt or inflation. Business investment expanded 9.6 per cent year-over-year through Q3/18, its strongest showing since 2014 (Exhibit 1). Policymakers fear a business spending belt-tightening might be on the horizon.
Business Investment vs Productivity
Recent data confirms their concern. The National Federation of Independent Businesses survey in December showed a dramatic decline in capital expenditure plans among its members, who are small and mid-sized businesses (Exhibit 2). Republicans predicted a big corporate tax cut would set off a virtuous cycle of higher business investment and expanding growth that would last for years. Recent studies suggest, however, that oil prices have more influence on business spending than tax incentives. Thanks to innovations in horizontal drilling and fracking, America has become the world’s largest producer of oil and natural gas, with output of nearly 12 million barrels per day. The energy sector comprises about 6 per cent of the US economy, but nearly 15 per cent of the corporate bond market because of its capital intensity. Energy prices have had an outsized influence on business investment in recent years (Exhibit 3). MarketWatch recently reported that a surge in oil prices was responsible for much of the fixed investment boom in 2017 because of investments in drilling equipment, storage tanks, pipes and other machinery. This suggests the recent downdraft in energy prices could have a deleterious impact on business spending as the year progresses. Investors should keep an eye on oil prices.
Small Business Capital Expenditure Plans (Diffusion Index)
Business Investment vs Crude Oil
The gaping budget deficit requires the US Treasury to raise more than $1 trillion annually in new debt and refinancing existing obligations. The biggest increase in demand has come from domestic buyers, most notably funds, which surpassed forging government purchases in 2016 (Exhibit 4). The shift toward professional investors increases the likelihood that buyers could push for higher rates, a return of bond market vigilantism.
Holder of US Treasury Securities
Foreign government purchases, which are not typically yield sensitive, have fallen for several reasons. Our trading partners, who typically recycle their current account surpluses into US Treasuries, have smaller domestic reserves owing to diminished trade activity. China, in fact, was a net seller of US Treasuries for most of last year because of smaller reserves and a strong dollar (Exhibit 5). Russia’s demand for US Treasury paper ebbed in response to US sanctions. Though the domestic shift in Treasury buying has had little impact on yields so far, that could change with higher inflation or continued government disfunction; it would not be the first time that bond market buyers have gone on strike.
Chinese Net Transactions in US Treasury Notes and Bonds (3 Month Avg.)
New home sales are disappointing at 544,000 annualized units. Despite the resurgence in economic activity, the annualized number of new homes sold through November remains more than 60 per cent below the pre-crisis peak hit in March 2005 (Exhibit 6). Experts point out that Millennials, who should in theory be the prime buyers of new homes, are not interested in home ownership, preferring to rent instead. While demographic differences are important, a new study by the Federal Reserve concludes that student debt, which has doubled over the last decade to $1.5 trillion, also contributes to the disappointing ownership rate among younger Americans embarking on their careers, accounting for up to 20 per cent of the decline (Exhibit 7).
Student loan debt inhibits home ownership in two ways. First, it makes it difficult for young people to amass a down payment: the median new home price is $315,000, requiring $63,000 for a 20 per cent down payment. Second, it inhibits their ability to simply qualify for a conventional mortgage. The Fed estimates that as many as 400,000 Millennial households were prevented from buying a home between 2005 and 2014. Even though college is a path to prosperity in America’s knowledge economy, student loan debt represents a significant financial setback, at least in graduates’ early years on their own.
US Housing Market: New and Existing Home Sales
US Home Ownership Rate by Age
Extreme investor pessimism enveloped market trading during the last several weeks of the year, driving the S&P 500 to its worst December since the Great Depression and capping off an ugly quarter for US equities. The S&P 500 shed 6.2 per cent over the last three months of 2018, with the energy sector hit hardest. Energy shares plunged more than 20 per cent because of a precipitous decline in oil prices. Economically sensitive materials stocks weren’t far behind, shedding more than 16 per cent for the quarter. US equity movements have been increasingly tied to the vagaries of oil prices, thanks to the growing importance of domestic energy production (Exhibit 8).
Oil and the Equity Market
By early 2019, investors woke up on the right side of the bed: ordinarily neutral news was viewed positively since expectations were so low. Conciliatory comments from Fed Chairman Powell, combined with stability in energy prices, helped lift investors’ spirits and prices. Year to date, all 11 economic sector groups are in the green with the S&P 500 up more than 6.5 per cent. Last quarter’s biggest losers are this year’s biggest gainers so far: energy shares are more than 11 per cent higher and financials are more than 9 per cent higher.
Earnings season is underway, and some companies are warning that their results might not be as strong this year as analysts expect. As recently as September, analysts anticipated earnings among S&P 500 companies to expand nearly 17 per cent over the past 12 months through Q4/18. That number was knocked down to 11.8 per cent in recent weeks as a result of downbeat company outlooks (Exhibit 9). This decline, which represents the steepest pullback in estimates since 2017, is another indication that the government shutdown and the trade war with China are affecting corporate profitability.
S&P 500 Earnings and Sales Growth
This earnings season will be both a barometer of the current health of corporate America as well as a gauge of management optimism about the rest of the year. While the equity market downdraft late last year was fueled by recession fears, Q4/18 earnings reports will offer clues into the resiliency of today’s economy. Despite the recent sharp reduction, S&P 500 earnings growth remains solid: an 11 per cent increase would represent the fifth straight quarter of double-digit profit gain. S&P 500 firms boosted their profits in Q3 at the fastest rate of the year. Investors increasingly believe that peak profit growth is behind us. As of today, analysts are penciling in a scant 1.8 per cent profit advance in Q1/19 with incremental improvement through the end of the year.
We see several factors in equities’ favor as we enter 2019. Valuations are reasonable, particularly in view of forward earnings. The S&P 500’s forward price-earnings ratio, a favorite of market bulls, at 15.4x is situated just below its historical median, suggesting the market is fairly priced (Exhibit 10). It should also be noted that peak growth and deceleration is not that same as contraction. Investors are slowly adjusting to that fact.
S&P 500 INDEX: Best P/E Ratio
As the global cognoscenti gather once again in Davos, Switzerland for the World Economic Forum, many are pondering a sobering report penned by value investor Seth Klarman, often referred to as the “Oracle of Boston”. The 61-year-old billionaire investor warned in his annual letter to shareholders that “the seeds of the next major financial crisis (or one after that) may well be found in today’s sovereign debt levels.” This comes at a time when economists reconsider how much debt governments can take on (Exhibit 11). Klarman also cautioned about the risks of escalating social tension and receding American leadership.
Developed Markets Debt-to-GDP Comparison
Mainstream economists are beginning to question their proclivity to debt aversion. Economists have historically believed that excessive government debt would “crowd out” productive capital away from the private sector. Yet real interest rates, the true cost of government borrowing, have been falling over the past 40 years – suggesting there are too few potential investments competing for available savings, not too many (Exhibit 12). A concept called “modern monetary theory,” an increasingly popular position, questions the long-held view that government spending must be paid for by taxes, opening the possibility of higher debt capacity among sovereign nations. In fact, many conclude that public spending on infrastructure might raise the returns on private investment. The argument reached a crescendo recently when International Monetary Fund Chief Economist Olivier Blanchard asserted that “public debt may have no fiscal cost.” Meanwhile, America’s federal government piled on an additional $317 billion of debt – about 6 per cent of GDP – over the last three months of 2018, according to a recent report in The Economist report. Last quarter’s borrowing exceeded the total amount of debt accumulated by our federal government in 2006.
FOF US Corporate Debt Outstanding
Modern monetary theory’s quixotic views are flawed. First, while real yields have declined over the last several decades, the theory assumes that the US government will be able to borrow at low rates indefinitely (Exhibit 13). It also assumes that America’s nominal growth rate will exceed its borrowing rate. History’s boneyard of defaulted sovereign debt tells us that once a country’s debt breeches 100 per cent of its GDP, the relationship between the interest rate on its debt and its nominal growth rate will determine whether or not it can grow out from under its debt burden. The perils of inexorable borrowing and leverage are insidious. They’re not risks until suddenly they are, and working our way out from too much debt would jeopardize our economy.
Interest Expense as a % of the Government Budget
Financial Market Strategy
Equity markets have launched a stunning rebound since Christmas: the S&P 500 has rallied about 12 per cent since the last week of 2018. Perhaps extreme investor pessimism and feelings that Fed Chairman Powell was out of touch have given way to something a bit more realistic. All economic sector groups have gained ground since the last week of last year, with economically sensitive groups like energy and financials leading the charge higher; defensive sectors like utilities and consumer staples are trailing behind.
Nothing builds investor confidence like market gains, so investor attitudes have vigorously improved. Bullish investors were hard to find last December: according to a survey by the American Association of Individual Investors, the number of respondents characterizing themselves as “bullish” was at its lowest point since the financial crisis. Since then, a number of bulls have emerged from their bomb shelters and bullishness reached the 50th percentile (median) of its historical range by January 11.
Notwithstanding improving markets and more positive attitudes, liquidity, as measured by lenders’ willingness to extend credit, remains low compared with recent history. Credit conditions – the availability of money to borrow, spend and invest – are an important environmental indicator. Right now, our liquidity indicators are bucking the market’s bullish trend, suggesting caution (Exhibit 14).
10-Yr BBB Bond Yield less 10-Yr Treasury Rate (%)
We gauge the yield differential (spread) between 10-year, BBB-rated corporate notes and 10-year Treasury notes. When the differential widens more than 10 per cent above its 200-day moving average, the metric turns negative. Liquidity conditions turn positive when the spread drops more than 10 per cent below its 200-day moving average. Historically, the market tends to rally when liquidity conditions are favorable and tends to struggle when liquidity conditions are tight (Exhibit 15). While we welcome the most recent market move, we’re not ready to don our equity market rally caps until liquidity improves.
Credit Spread Strategy