Uncertainty Escalates

We are living in truly turbulent times. Police officers are being shot in the United States. A man drove a truck through a crowd and killed innocent children and others in the south of France. An attempted coup in Turkey has been followed by violent retaliation by the challenged leadership. The United Kingdom voted to sever its relationship with the European Union. A gunman went on a shooting rampage in Orlando. The two candidates running for the U.S. presidency have recorded the highest disapproval ratings in history. Earnings so far this year have been disappointing, yet the Standard & Poor’s 500 is at an all-time high. How do these macro and micro pieces fit together?

You could argue that interest rates and monetary policy explain why the market is ignoring the troubling events. Central banks around the world have been flooding their economies with liquidity. Yields on higher grade bonds, corporate and government, are at an all-time low. Over half the stocks in the S&P 500 yield more than the 10-year U.S. Treasury. Stocks compete with bonds. In the 1980s and 1990s, when I was a strategist at Morgan Stanley, I used a dividend discount model that was based on a formula I devised to forecast the level of the S&P 500 based on operating earnings and the 10-year Treasury yield. It stopped being helpful in the late 1990s. If it were operative today, it would be forecasting a level for the index of above 2500, and that’s why it is locked away in a filing cabinet.

One of the great advantages of stocks over bonds is that earnings have the prospect of growing and the coupon on bonds is fixed. In recent years, however, S&P earnings have been struggling. Operating earnings were $118 in 2014, $116 in 2015 and are projected to be $115 in 2016. There are estimates of $125 for 2017, but a similar number had been forecast for 2016 and has been steadily revised lower as the year has progressed because of margin pressure caused by limited volume growth and rising wages. I expect margin compression to continue into next year. Stock prices are driven by earnings, and with the uncertain outlook, I believe the second half of 2016 will be a rough period for equities and the indexes will end down somewhat for the year.

I do not see a severe sell-off or a bear market. The yield curve is not inverted and investor sentiment is cautious rather than euphoric, so we have yet to see two conditions that are ordinarily in place just before a bear market begins. Moreover, the fundamental economic background remains favorable. Consumer spending has been strong, with real retail sales up 4.8% in the second quarter and up 25% since 2011. Housing is also a positive. Starts are at 1.2 million, up from just above 500,000 in 2010. Starts were above two million in 2005 when the housing bubble was forming. Nobody expects a recovery to that level, but 1.5 million starts (annual rate) is definitely a possibility. Employment of those in the 25–34 age group is consistently trending higher. Given that is the segment of the population where most family formations occur, I would expect housing to continue to be a contributor to the growth outlook.

Capital spending has been a negative in this cycle. The sharp decline in the price of oil brought spending on exploration and development to a standstill. The rig count dropped at one point to 431 from over 2000. It is 466 now, and the fact that it may have bottomed is favorable for capital spending generally. The rise in the price of West Texas Intermediate oil from $26 a barrel to $50 this year encouraged energy companies to begin spending again. The pullback to $44 should not cause those expenditure programs to stop unless the price descends into the $30s and stays there. In any case, we should not expect a surge in capital spending. Operating rates for American manufacturers are 75%, down from 78% in 2015. Plenty of spare capacity is out there and that will restrain capital projects.

One factor that should encourage investors is the leading indicator index. This measure reached peaks prior to the recessions of 2001 and 2008-9. The lead time has been one to two years. The leading indicator index is still edging higher and has not reached a definitive peak yet. When it does, we will still have some time before the next recession and perhaps the next bear market. The recent action in the junk bond market is also encouraging. Yields have dropped two percentage points from their peak earlier this year, indicating that investors are gaining confidence that the economy is doing better. Finally, there has been some improvement in the performance of commodity prices and the emerging markets. This may be related to China’s strong second quarter economic report, which showed nominal GDP increasing at a 7.3% annual rate.

Knitting these major economic observations together, I still believe the U.S. economy will grow about 2% for 2016, which has been my forecast since the beginning of the year. I do worry that violence in America cities and geopolitical turmoil abroad may dampen consumer spending somewhat, but it is hard to quantify that risk. Growth at the 2% level is not bad for a mature economy, but it is down by one-third from the 3% level that we have experienced in the post–World War II period, prior to the recession of 2008-9. I attribute the slowdown to globalization and technology, and those factors are not going away. The two candidates for president will promise a resumption of real growth to 4% or more, but I believe that will be hard to achieve without aggressive fiscal spending, which the Republicans are unlikely to propose and the Democrats are unlikely to get passed as long as the House of Representatives has a Republican majority. If we have a slow growth environment, demand is not likely to offset an increase in wages and this will be a continuing problem for corporate earnings. Interest rates are unlikely to go lower, so the prospect of price-earnings ratio expansion is unlikely. That’s why I believe the indexes will be down in 2016.

Much of the strength of the financial markets since the end of the recession in 2009 has been related to monetary expansion by the Federal Reserve. The balance sheet of the Fed has expanded from $1 trillion in 2008 to $4.5 trillion today and, in my opinion, three-quarters of that increase has gone into financial assets, keeping interest rates low and expanding equity valuations. The Fed said it would increase the Federal funds interest rate as many as four times during 2016, but so far it has kept rates flat because of the inability of the economy to demonstrate any significant positive momentum. I believe the Fed will stay on hold until December, when it may raise rates modestly again as it did last year, but we should not count on any significant monetary accommodation to lift stock prices.

I continue to believe that productivity is one of the key problems for the economy. According to Strategas Research, on a rolling five-year basis productivity peaked at 3.5% in both 1967 and 2005. Its trough was in 1982 at 1% and it is approaching that level now. The increase in regulation has contributed to this decline, but you would think that technology would be having a greater influence in increasing output per worker hour. Productivity is the driving force for standard of living improvements and profitability increases. This may be too abstract for the political campaign but it is critical to understanding why we are having so much trouble increasing the growth of the economy and earning power.

In view of all of these factors, why is the U.S. stock market rising? I have already cited yield as one reason. Bonds do not provide an inspiring alternative. There is also the belief by many investors that the first quarter was the trough in earnings and subsequent quarters will be stronger, but I am skeptical of that view. There is some evidence that institutional investors (particularly hedge funds) were cautious earlier in the year and short covering accounted for part of the move. The S&P 500 is up 6% at this point and that gain could diminish quickly if the earnings outlook darkens. The current level of the index is one standard deviation above the historical median valuation.

The major unexpected event that took place in the past quarter was the U.K. referendum on leaving the European Union. While the EU may be costly to maintain, over-regulated and inefficient, thereby providing strong reasons for its members to go their own way, I thought British voters would opt to “remain.” The implications of this could be significant for the U.K. and Europe but minor for the U.S. In any case, however, the impact should not be immediate, although some weakness has occurred in the U.K. already. Britain has two years to develop a departure plan once it invokes Article 50 of the Lisbon Treaty. There are some members of the European Union who would like to punish Britain for its decision, but my hope is that a more reasoned approach will be taken and the U.K. will not be treated as (in Henry Kissinger’s phrase) an “escaped prisoner.” Both the U.K. and the continent have something to lose through harsh policies, because trade between the two entities is heavy. As for the prospect of other defections from the Union, the early signs are good. The vote in Spain on the Sunday after the British referendum increased the number of representatives for the establishment party. Polls show a significant amount of antipathy toward the EU across the continent and a general drift toward populism, but the advantages of free trade and free travel are important and not likely to be given up easily. As a result, I don’t expect Europe to suffer a severe case of contagion because of the U.K. departure.

The unsuccessful coup in Turkey has many implications. President Recep Erdogan consolidated his power, which was already headed toward the point of authoritarianism. The flow of oil through the Bosporus decreased by more than a million barrels a day. Turkey is a part of NATO and its reliability in defending other members of the alliance when threatened is being questioned. As a passageway for Middle East refugees trying to emigrate to Europe, Turkey plays an important role. The unsettled political situation there puts another cloud over Europe when growth prospects had already been dampened by the Brexit referendum.

Between now and the end of the year, the election in the United States is likely to have an influence on the economy and the financial markets. I believe the electorate cares most of all about the economy and is likely to support the candidate who is most likely to stimulate growth and job creation. The major issues that have surfaced so far are law and order, immigration and trade. Indirectly each of those is related to the pace of the economy, but I am curious to see the extent to which either candidate advocates a greater use of fiscal stimulus and infrastructure spending. This type of spending would have a direct favorable impact on economic growth. The character of the campaigns of both parties has reflected the dissatisfaction of more than 70% of the electorate with the direction the country is heading. This has given rise to the populism that has dominated the political discourse. Domestic issues are, however, clearly leading foreign policy in the thinking of most Americans. Since voters also have a predominately negative view of both candidates you would think the campaigns would be searching for a positive issue, like stepping up growth, that could create enthusiasm. I am hard pressed to see how you win an election by being the candidate whom voters feel less negatively toward than your opponent. Independents at 42% represent a larger component of those expected to go to the polls than any time in the last thirty years. If you want to attract them, give them something to feel excited or good about.

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