“No More Financial Crisis in Our Lifetime.” —Janet Yellen
The second quarter of 2017 ended with consumer and business sentiment still strong. Q1 corporate earnings much improved from the earnings recession of 2016, S&P 500 earnings expected to increase 6% in Q2, and the US equity markets at or near their all-time highs. Moreover, green shoots of economic growth are showing up outside of the US and the OECD (Organization for Economic Cooperation and Development) is now predicting that the global economy is on pace for its fastest growth in close to six years. The European Central Bank (ECB) is now signaling that it may be time to begin scaling back its ultra-loose monetary policy and begin normalizing interest rates, a sign of growing economic confidence. And, in the US the Federal Reserve raised interest rates 25 basis points for the second time this year and has laid out a plan for reducing the size of the Fed’s bloated balance sheet. In fact, at the end of the quarter Fed Chair Yellen was so upbeat that she made the bold prediction that there would be no more financial crises in her lifetime.
Before we all begin to feel warm and fuzzy we do well to consider the economic facts and trends that are a real contrast to the rosiness of the paragraph above. To wit, while soft data readings such as consumer confidence and purchasing manager indexes have been strong since the US election in November, the hard data such as retail sales, industrial production, business investment and GDP tell a mixed story. Soft data is derived from the opinions and impressions of consumers and purchasing managers and one can’t help but conclude that “hope” plays a big role in their outlook. However, hard data tends to give a more accurate view of current economic reality and growth. Given the relative positivity reflected in the soft numbers and the words and actions of central bankers, a closer look at some of the more hard data is instructive and provides some perspective.
The employment picture has been pointed to by many as demonstrative of recovery and continued strength in the economy. The June non-farm payroll number came in above expectations at 220,000 and job gains have now averaged 194,000 jobs over the past three months, which is just above the average over the past 12 months. However, it is important to realize that many of the new jobs created this year have been low-pay, low-quality jobs in the part-time economy and the HES (Health, Education, and Social Services) complex. Providing real perspective to the job-growth story is a simple calculation of payroll and income tax receipts (some say a more accurate read of employment growth), which shows just 0.70% annual growth for the last decade, roughly one-third of the historic norm. Furthermore, the current 4.4% unemployment rate is less meaningful considering the percentage of low-quality jobs in the calculation.
GDP growth is another hard data metric and the numbers over the past 8 years reflect the slowest U.S. recovery since World War II. GDP growth in Q1 2017 was 1.4% and Q2 GDP growth is estimated at 2.7%, so 2017 YTD annualized GDP growth stands at just 2.05%, about equal to the 2.1% average annual GDP growth rate since Q1 2014. What makes this particularly woeful is that such subdued economic growth follows a decade of the greatest combination of monetary and fiscal stimulus ever, driven by an increase in the Fed’s balance sheet from $750 million to $4.5 trillion. The domestic equity markets have traded to all-time highs on hopes that the Trump administration can replicate the Reagan-era deficit-financed tax cut and spark real economic growth of 3.5%. What makes this unlikely is that in the Reagan-era interest rates were being cut dramatically to stimulate the economy, while today the Fed is on a path of interest rate normalization (raising rates). Moreover, in addition to raising rates the Fed has laid out a plan to shrink its balance sheet, which is likely to exacerbate the rising interest rate environment. Furthermore, debt-to-GDP in the Reagan-era was about 30%, which made deficit-financed tax cuts more palatable. However, today our debt-to-GDP is 106% and we have $1 trillion budget deficits for as far as the eye can see. This fact-set makes any tax-cut legislation extremely difficult to pass considering the opposition of many GOP budget hawks and virtually no support from the Democrats. Nevertheless, equity investors seem to be pinning their hopes on the White House estimate that GDP will grow 67% faster in the next 10 years than the last 10 years. High hopes, indeed!
The consumer economy is built upon the foundation of home and auto purchases and all of the related economic activity, such as consumer and mortgage loans, insurance policies, and other home and auto-related goods and services, as well as the jobs relating thereto. The severity of recessions and the strength of recoveries have historically been measured by the performance of these two industries. It is therefore instructive to note that despite the historically strong housing and auto industries since the financial crisis, the current economic recovery is the slowest since WWII. This tells us that the balance of the economy has been far weaker than in the past and that if the housing and auto industries weaken the economy will suffer and recession may raise its head.
Accordingly, the discouraging hard data relating to the auto industry should be of great concern to all. Despite record cash incentives on the part of car makers in June (12% of a car’s selling price at GM) there was a 5% decline in year-over-year sales and dealer inventories have swelled significantly. A Bloomberg article back in February of this year noted that for the first time in 37 years a New Jersey car dealership had to rent extra space to store unsold new Honda vehicles. The chart to the right shows what new car inventories have done at GM since February.
Unfortunately, the sad state of the auto industry is not limited to bloated inventories. According to Edmonds the cars that are moving off dealer lots are being sold with financing that has stretched to a record average loan term of 69.3 months. Moreover, because of the decline in used car prices, over 30% of consumers wishing to buy new cars are trading in cars that have “negative equity,” which means that the car has less value than the loan balance. As such, in order for the dealers to move new cars off the lot, they often include the trade-in vehicle’s negative equity in the financing of the new car, resulting in an overwhelming number of auto loans with advance rates in excess of the value of the new car. It is also important to note that sub-prime auto loans now represent about 28% of all auto loans and sub-prime auto debt is now at an all-time high. Keep in mind that this underwriting process focuses on the collateral value of the car rather than a borrower’s credit score or cash flows. The chart to the right shows the J.D. Power index down 13% as of April 2017. Combine this with a record number of cars coming off lease and flooding the used car market and the prognosis for the collateral value of used cars is dismal.
In fact, Morgan Stanley’s auto team issued a note in June that called for a 25%-50% decline in used car prices over the next 3-5 years. All told the auto loan market, including lease finance, is approximately $1.5 trillion in size, much of which is held by institutions in search of yield. While different in magnitude it is not a stretch to make the comparison between the auto market today and the real estate market in 2008.
With unemployment at 4.4% it is unlikely that the auto-loan market will unravel quickly, but the deteriorating quality of the loan market is showing up in escalating default rates and notice should be taken. Given the current circumstances in the auto loan I can’t help but think of Hemingway’s dialogue in The Sun Also Rises: Bill asks Mike “How did you go bankrupt?” and Mike responds “Two ways, gradually and then all of sudden.”
Q2 AND MID-YEAR REVIEW
Geopolitical
The geopolitical landscape remained rocky during Q2 without resolution in any of the global regions. The populism movement faced some headwind in the first half of the year as Theresa May’s call for an election in the UK to demonstrate greater support for a “hard” Brexit backfired and the result was marginally positive for pro-EU forces and will make for a more nuanced Brexit negotiation. In addition, Macron’s En Marche party built momentum in France and may end up with nearly 70% of the seats in the French Parliament. Meanwhile the Five Star Movement party in Italy suffered losses in municipal elections, but is still running close with the center-left Democratic Party in the national election. In Germany, Angela Merkel has shown surprising strength ahead of their September election, but the race is still expected to be very close.
During Q2 six Arab countries cut ties with Qatar over alleged support of terrorism. Saudi Arabia, UAE, Bahrain, Egypt, Libya and Yemen accused Qatar of supporting ISIS, al-Qaeda, and other terrorist groups. The dispute has mainly caused some logistical problems as OPEC deal with the extension of and adherence to their oil production cuts in an effort to support global oil prices. China appears to be holding it together as it continues its debt-fueled expansion, but the IMF cautions that deep reforms are needed to avoid the instability of such huge amounts of debt.
Meantime, the US political climate has not improved at all and the Trump / Russia fiasco will likely continue for the foreseeable future. Probabilities remain low for any bipartisan legislation relating to any meaningful budget resolution, healthcare and tax reform, and infrastructure spending. The next GOP/Dem legislative test will be the debt ceiling, a very complicated issue, especially given all the other issues on the legislative plate.
Interest Rates, Inflation & Bonds
The Fed raised interest rates by 25 bps at their June meeting pushing the fed funds rate to the range of 1.00 -1.25%. This marks the second 25 bps rate hike this year and the fourth since 2015, largely influenced by an average growth of 190,000 jobs a month over the past two years and an unemployment rate that has dropped to 4.4%. However, the Fed action has been taken even though inflation has remained stubbornly below the Fed’s 2% target. Core inflation in May fell to a two-year low of 1.7%, which marks the third consecutive monthly decline in underlying prices. Nonetheless, the Fed indicated it intends to continue raising rates in light of the current economic environment, but will adjust their actions in accordance with their economic outlook.
Moreover, the Fed said that it expects to begin implementing a “balance sheet normalization program” some time this year, which means they will gradually reduce Federal Reserve holdings by decreasing the reinvestment of principal payments it receives from Treasury, Agency and Mortgage-backed securities it holds. They intend to reduce reinvestments at $10 billion per month and increase the amount by $10 billion per month each quarter until they reach a cap of $50 billion per month. It is important to note that this is a never-been-done-before task, so there is room for error and unintended consequences. The gradual unwinding the Fed has outlined may cause upward pressure on interest rates, which combined with actual Fed rate hikes will create meaningful tightening in a market that has become overly dependent on easy money.
Directly following the Fed’s June rate hike the 10-year US Treasury yield dropped from 2.20% to 2.13%, the 5-year dropped from 1.78% to 1.73%, and the 30-year yield dropped from 2.86% to 2.78%. However, over the last four days of Q2 the 10-year Treasury rose from 2.14% to 2.27%. The Barclays Aggregate, intermediate, and long-term indexes were up 1.6%, 1.0%, and 4.33%, respectively during Q2 and were up 2.4%, 2.5%, and 6.4% during the first half of 2017. Subsequent to the end of the quarter the 10-year yield has climbed to 2.37% as the world’s central banks have signaled a move away from excessive monetary easing. Muni bond prices climbed as well as fund flows continued positive, driven by a flight to safety and the increased probability of a delay in any tax reform legislation.
Interest rates in Europe and Asia declined in the first half of the year, but as noted above, have recently climbed as global central banks signal less monetary easing. Europe’s economy continues to improve and the outlook for inflation for the balance of the year is about 1.5%. Inflation in the UK is running between 2.5 – 3.0%, which is one of the only developed countries with inflation beyond the 2% level. Inflation in Japan is expected to tick up to 0.5% in 2017 vs. slightly negative last year, but this is woeful considering extreme and unprecedented monetary easing over the past many years. The average inflation rate in advanced economies is likely to be close to 2% over the next 12 months. Interestingly, all of the G7 countries have posted positive GDP in the past three years and Capital Economics expects this to continue until 2019, which would be the third-longest period in which all have grown simultaneously since 1870.
Currencies
Notwithstanding the Fed interest rate hikes in the first half of the year, which should support US dollar appreciation, continued economic improvement in Europe and talk from the European Central Bank of a plan to end quantitative easing, the Euro rallied 6.4% against the USD in Q2 and is now up 7.9% YTD through June 30, 2017. In addition, as measured by the six-currency DXY index the USD was down 4.85% in Q2 and is down 6.6% YTD. Against the Japanese Yen the USD was flat in Q2, but is up 4.7% YTD. Relative to the British Pound the USD was up 1.5% in Q2 and is now up 3.1% YTD. Given the economic improvement outside of the US and the mixed economic signals within the US, the USD rally may have run its course. Further and sustained economic improvement abroad as well as the course of the extended US recovery will determine directional moves in currencies for the balance of the year.
Oil & Commodities
Oil prices have weakened throughout the year as global inventories have built, despite the reported adherence by OPEC members to their production cuts announced in Q4 of 2016. Adding to global inventories are US fracking companies that have cut their drilling cost break-even through technology-driven efficiencies. The US fracking industry continues to drill despite the fall in WTI crude from $53 at the beginning of the year to the mid-$40s at the end of Q2. WTI Crude finished Q2 at $46 per barrel, down 8.9% for the quarter and down 12.1%YTD. We expect oil prices to remain at current levels, if not a bit lower, until such time as global demand absorbs excess supply or a geopolitical event threatens production supplies.
The GSCI Commodity Index was down 4.2% in Q2 and down 6.42% YTD. We do not expect commodities to rally unless or until global growth absorbs current excess capacity.
Equity Markets
With the exception of the Chinese Shen Zen Index, the equity markets across the globe were up in Q2 and YTD through June 30, 2017. The NASDAQ led the US markets up 3.87% in Q2 and up just over 14% in the first half of the year. However, the lack of breadth in the market run up has been noted regularly with reports of the huge out-performance by the FAANG relative to the rest of the market. US equity markets remain near their all-time highs, but valuations are stretched relative to almost every historical benchmark.
A number of the major investment banks have begun to show caution and Goldman Sachs recently referred to the S&P 500 rally above 2,400 as a “hope-driven” rally. Similarly, BankAmerica Merrill Lynch commented recently that the market was exhibiting “internal inconsistencies” that are “not sustainable.” Below is an excerpt from the Goldman note:
“Rates and equities are pricing two very different scenarios for the US and the world economy more generally. Rates are pricing a very slow pace of Fed hikes and the end of the tightening cycle after only one more hike next year, with a relatively high probability for a US recession. Equities, on the other hand, are the only Trump trade still alive and, at all-time highs, are pricing fast growth ahead. Implied market volatility is also at historic lows, suggesting no concern about a sharp adjustment. US data is mixed and do not give a clear indication of whether rates or equities will have to adjust.”
Earnings in Q1 2017 were much improved from the 2016 earnings recession with 75% of S&P 500 companies beating the mean EPS estimate and 64% of S&P 500 companies beating the mean sales estimate. According to FactSet S&P 500 earnings are expected to grow at 6.6% in Q2 2017. The forward 12-month P/E ratio for the S&P 500 is 17.7X, above the 15.3X five-year average and the 14X 10-year average.
As noted above, U.S. equity market valuations are approaching historically high levels. There are a number of different valuation methods used to measure whether the U.S. equity markets are under or over-priced. The chart below shows a simplified summary of valuations by plotting the average of four geometric series along with the standard deviations above and below the mean. What this chart tells us is that the current market valuations are 96% above the mean going back to 1900, which is higher than the market valuations just prior to the Great Depression and the Great Recession. Only the valuations at the time of the dot.com crash in 2000 have been higher than today’s valuations.
The Buffett Indicator today reveals much of the same as the chart above. The current market cap to GDP is at 129%, which is greater than the 87% and 110% readings in the Great Depression and Great Recessions, respectively, but lower than the 156% in the tech bubble of 2000.
Why do we focus so much on market valuations? The reasons are two-fold. First, when market valuations are extended they tend to correct as they revert to the mean. As such, recognizing that U.S. equity market valuations are rich allows us to “under-weight” domestic equities in client portfolios, which we have done over the past couple of years. Secondly, the outlook for forward U.S. equity-market returns is vital for us to understand, to plan for, and, most importantly, to set client expectations. To wit, the chart below shows the investment return on a $1,000 investment in the S&P500 on March 24, 2000 through June 30, 2017. As you can see, investing at the top of the market in March 2000 resulted in a compounded annualized return of 4.6% and a real (inflation adjusted) compounded annual return of 2.44% over a 17-year period.
Below average expected returns for U.S. equity allocations for any meaningful time period can be problematic if not factored into forward planning. As such, it is important to realize that 10-year forward returns for U.S. equity market allocations are likely to return less than historical averages. Additionally, economic growth going forward is expected to be subdued relative to historical averages, which will further weigh on forward equity returns. Accordingly, for planning purposes we are now assuming nominal 10-year forward U.S. equity returns well below the approximate 10% long-term average. As noted in our 2017 forecast, we believe that 10-year forward returns in the bond market will also fall below historical returns.
CONCLUSION
A combination of extended U.S. equity market valuations, a hardening of Fed monetary policy, and mixed domestic economic data, as well as the lack of any traction with the Trump legislative agenda lead us to conclude that 2017 will likely end without further gains in the equity or fixed income markets. As a consequence of our valuation concerns and the expectation for below average returns in the traditional investment markets, we continue to allocate capital to alternative investments that have low or no correlation with equity and fixed income returns, such as reinsurance, life insurance settlements, first-mortgage real estate credit, etc. We believe that these allocations provide portfolio decorrelation, better risk management, and more impactful diversification. We also reiterate our view that in the current environment that cash provides the best hedge against market volatility and potential market dislocations. While we are confident in the diversified nature of our portfolios, we remain focused on the changing financial market landscape to determine if, and when, appropriate changes are needed or necessary.
As always, we appreciate your continued partnership with us and welcome your questions, comments, and insights at any time.
