Our Summer Outlook comes a bit late this year as we were traveling in the weeks after July 4th. Our itinerary included the San Francisco area, the Washington DC area, Castle Rock and Colorado Springs. While we travel a bit every year for business, it struck us that each of these locales displayed a skyline that was bespeckled with cranes and other equipment generally found in abundance when economic sentiment is sound, and investor risk appetite is strong. Of course, our own city of Boston’s Seaport District continues to show dramatic growth as well. Perhaps it was the more relaxed pace of vacation that freed our senses to notice. We thought about the gloom which was very present in the market narrative as recently as last year, and the multitude of cranes, construction equipment and growth presents a very different, and vibrant picture.
Year-to-date, the US stock market seems to belie the underlying economic data (~2.1% GDP), yet seems to justify the animal spirits at work on the skyline across the country. Already the S&P 500 is up 9.34% year to date, exceeding its 90-year average annual return. In the royal we, our life experience includes schooling in the 1980’s, and a career beginning in the 1990’s. So yes, we’re accustomed to higher average GDP growth than we have in fact experienced over the preceding eight years. Herein lies the conundrum some of us feel given GDP growth rates in the 2% range. With the US economy expanding at a pace well below multi-decade averages and the stock market having posted so many new highs just on a year to date basis, there must be a disconnect somewhere, right? Or is that our bias?
US GDP Growth Rate (nominal)
Perhaps more worrisome is the “Black Swan” fears some of us harbor. Nassim Taleb, one of our favorite authors, describes the statistical significance and inherent unpredictability of calamity which tends to elude all people prior to striking, even those who search for it, in his book “The Black Swan”. Michael Gayed, CFA, a portfolio manager with Pension Partners whom we read frequently recently wrote about the Black Swan in his Week in Review:
“…this is a highly troubling environment. Markets have been absurdly boring. Bond yields haven’t spiked despite reflation hope. Emerging markets have been on a tear, and volatility in the S&P 500 and in the small-cap Russell 2000 is quite literally at all-time lows. This has been the most peacefully quiet (and boring) stock market in history.”
Boring markets might describe the lead-up to the 2008 financial crisis which sent things into a significant tailspin. But we think low volatility needn’t conjure calamity in the markets. We also think the underlying fundamentals of the US market are fine, but one simply needs to shift the paradigm a bit to understand that the “new normal” outlook no longer includes GDP growth edging toward 4%, 5% or even 6%. It also includes prolonged periods of low inflation. Hence “lower for longer” interest rates around the globe. In other words, the severity of the financial crisis and the unusual policy response, both in the US and globally, has resulted in trend-shift in the gap between the “optimal” growth in our economy and what is actually possible—at least for now. We would add that this is entirely our theory. The US is, after all, near the “full employment” mark. So while the low growth rate (in historical context) is persistent, it also seems durable.
We subscribe to Capital Economics research as a third party source of macro-economic thought and we extract three points from their Q3 Outlook which we believe are salient in supporting a positive economic outlook in the short run:
- Two of the biggest drags on growth last year should provide small boosts this year. After the prior surge in the Dollar weighed heavily on exports, the Dollar has declined by 5% on a trade-weighted basis this year. As a result, export growth has rebounded and the survey evidence points to further acceleration soon (See Chart 3). Mining investment has also been rebounding strongly (See Chart 4). And even if lower oil prices weigh on mining activity over the rest of the year, business equipment investment should continue to recover.
- Employment growth has continued to trend lower this year, but that is what we would expect to see when the [labor] market is getting closer to full employment. It has also been more than enough to keep the unemployment rate on a downward trend.
- After stalling at just below 5% for most of 2016, the unemployment rate has fallen sharply this year, reaching a 16-year low of 4.3% in May. The surveys suggest that it will fall even lower soon (See Chart 6.0.) This presents a dilemma for the Fed and its dual mandate because core inflation (and hourly wage growth) has recently dropped back…And with core inflation having been weak for several months now, it is hard to claim this is just a temporary lull.
Capital Economics comes to an out-of-consensus conclusion that the drop in inflation, while likely transient, will keep the Fed from raising interest rates again in September (though not December). If this plays out, we can take the Fed out of the list of boogeymen that could put a dent in this market in the near term. In our view, this leaves Fiscal Policy (or lack thereof) as perhaps the last logical cause for concern.