I would not be surprised if this title has been used repeatedly in the last several years by various commentators on the markets. But it would be difficult to find a more apt illustration of the state of the global economy over the last few years, or rather, the psychology of investors. In particular, most Fed watchers can identify with the frustration of a child in the backseat of a car, on a seemingly endless car trip. In September, Janet Yellen signaled that the Federal Reserve will begin reducing its balance sheet next month to the tune $10 Billion. In yesterday’s Fed statement, they continued to signal they will hike one more time this year, and that reduction of the balance sheet remains on course. Fed Fund futures are signaling a 92% chance of a hike at the December meeting. Certainly, these are hawkish moves at the margin, but the Fed has been signaling these moves for some time, and markets did not seem surprised. After the Fed announcement in September, the initial knee-jerk reactions in the market were to sell U.S. Treasuries, sell gold, buy the U.S. dollar and sell equities. None of the asset class moves were extraordinary, and only the downward move in gold has had significant follow through. The S & P 500 has gone on to new highs, as global economic data has been surprising on the upside. Two year treasury yields have moved out about 24 basis points, and the ten year only about 13 basis points.
Despite what would seem to be a watershed moment in the Federal Reserve’s great “monetary experiment”, there is scope for skepticism. The Fed has consistently been forced to back off from more hawkish policy as both growth and inflation have repeatedly disappointed. For now, I want to concentrate on the state of the world, rather than the causes. Below is a chart I call, “U.S. Organic Growth” (Chart 1). It shows U.S. Nominal GDP minus the Federal Budget Deficit as a percentage of GDP. The gist here is that a growth rate in a healthy economy should be substantially above the Federal Budget deficit, since government spending is an inherent component of GDP. From the late 1960’s to the advent of the financial crisis (end 2007) this measure has averaged approximately +5%. In the post crisis era, +5% has been the high, and presently, we are hovering just under 2%. It should be noted that some of this differential is a function of inflation, given that in previous decades nominal economic growth would be higher due to higher inflation, but if you back out inflation, the trend is the same. I believe the inability of the economy to produce growth above the level of debt-financed government spending is a sign that we have not reached escape velocity at this point, and that aggressive removal of monetary accommodation risks a potential relapse in growth. The muted response in the market to recent Fed announcements implies that market players do not believe the Fed will move at a rapid pace, and that once again, forecast moves may not actually take place.
U.S. Organic Growth (Nominal GDP minus Federal Budget Deficit)
Source: U.S. Bureau of Economic Analysis and U.S. Treasury
The fueling of economic optimism for both the U.S. and the world this year has its origin in a modest synchronized global expansion which began in the 3rd quarter of last year. We have had two global growth scares in this cycle, 2012 and 2015/16. In 2012, Chinese growth slowed sharply in concert with the Eurozone, and Eurozone political tensions were high enough to make investors wary of a possible breakup of the European Union. Once again in 2015, Chinese growth slowed sharply, and global growth skirted with recessionary levels in developed countries. Chart 2 shows the OECD Composite Leading Indicator, which is a good proxy for global growth momentum. After weakening through much of 2015 into early 2016, global economic momentum has been on a solid uptrend. In the U.S., after reaching a low of 48 at the beginning of last year (marking worsening conditions below 50), the ISM Manufacturing Index printed at 58.7 for October, which is near the highest level since early 2011! There is little reason to be worried about growth momentum at the moment, and it’s easy to see why the Fed feels confident in beginning the process of reducing its balance sheet.
OECD Composite Leading Indicator
Source: Organization for Economic Co-operation and Development
A Triumph of Hope
But while these survey based measures are reassuring, some caveats are in order. The PMIs for example, are diffusion indexes. Participants are asked whether conditions are better or worse than the previous month, not how much better or worse. As trend growth has been consistently weaker in this cycle, the typical strength we might expect when the ISM Manufacturing PMI reaches present levels is well below that of the past. GDP growth year over year for the U.S. is only running at 2.3%, which remains considerably below historical levels. A persistent theme for 2017 has been real economic data remaining weak, while survey-based data has rocketed higher.
So far, a substantial amount of hope has been built into U.S. markets. It seemed quite reasonable after last year’s elections, with Republicans controlling both houses of congress and the oval office, that pro-business policies would be implemented, spurring growth. After witnessing the chaotic machinations out of Washington this past year, it’s difficult to believe that such optimism could still be prevalent. Nevertheless, there’s an ebullience emanating from the business sector, and not surprisingly, that has filtered into equity markets. I’ll discuss equities in later posts. First, I’d like to address the issue of inflation.
Central Bank Impotence
Along with the consistently mediocre growth since 2008, there has been a surprising lack of inflation. Given that major central banks have conducted quantitative easing totaling approximately $13 Trillion, many have expected (including the Fed) both higher growth and inflation, only to be invariably wrong. Companies have been loath to invest in capital expenditures due to their worries about sustainable demand. Excessive debt and ageing demographics in developed economies is not allowing for robust organic growth. With capacity utilization running at 76% versus a 50 year average of around 80%, there is no sign of production constraints that should fuel inflation. Excess labor through much of this cycle has kept wages depressed, which constrains buying power, as well as, inflation. Technology continues to be implemented in lieu of labor in many areas of the economy, which further dampens wage increases. Below is a chart of the U.S. PCE (Personal Consumption Expenditure) Price Index YoY (Chart 3). Despite the recent economic acceleration, the Fed’s favored inflation measure has rolled over hard. Certainly, it may bottom here, and head back higher, but there seems to be little reason for the Fed to be worried about inflation.
U.S. PCE Core Inflation YoY
Source: Bureau of Economic Analysis; Federal Reserve
Returning to my initial question posed in the title, “Are We There Yet”? At the risk of sounding too cute, I’d say that depends on what you mean by “there”. For the Fed, and for most people, “there” would mean a return to what would be considered normal economic dynamics. In that vein, my answer is a resounding no. The reasons are legion, and will fill economic journals for decades to come. I look forward to expounding on the various issues over time. On a more immediate basis, we can say there is a reasonable basis for the Fed to begin reducing its balance sheet, as economic growth is solid. However, there is little reason to expect the Fed to be particularly aggressive. In particular, the anchoring of long-term interest rates at lower levels seems right to me. I believe bond bears will continue to be frustrated with yields having limited upside. U.S. equities have repeatedly been supported by this disinflationary backdrop, and little has shaken investors’ resolve. Despite excessive valuations relative to history, equities continue to be supported by the prospect of a continuation of the “Goldilocks” scenario. This is the status quo. And despite the historic nature of the Fed’s move to reduce its balance sheet, I don’t believe there will be much change in the short-run.