economic perspective

April 2017

  

As the United States economy continued its slow growth through the first quarter of 2017, the financial markets began to move sideways beginning in March after solid advances during the first two months of the year. Thomas Dillman, President of Mutual of America Capital Management LLC, explores some of the key factors behind the market movements, various issues affecting accelerated growth in the domestic economy, and a global economy that appears to be in recovery mode.

U.S. Markets Rise and Pull Back

The S&P 500® Index advanced 12% between Donald Trump's election as President of the United States on November 8, 2016, and March 1, 2017. Since then, the market has traded sideways and slightly down. So far this calendar year through mid-April, the S&P500® Index is up 4.8% on a price basis and 5.5% on a total return basis. Most other domestic indices have advanced in a range of 3%–8%, with the better results generated by growth-oriented indices. Emerging markets have been the standout, advancing 11% year-to-date, while developed markets other than the U.S. have performed modestly better than the S&P 500®, with the exception of Japan, which slightly underperformed.

In short, it has been a good start to the year for equities. However, the recent loss of momentum and an internal shift away from value-oriented stocks toward growth-oriented stocks suggests a shift toward a less enthusiastic outlook. Value stocks are attractive to investors when the economy is expected to accelerate, while growth stocks are more attractive when economic prospects become uncertain. The U.S. Treasury market recently began to reflect a similar perspective.

Yields on the 10-year Treasury bond rose from a low of 1.36% in July of 2016 to a peak of 2.63% on March 20, 2017, but have receded over 40 basis points to around 2.20% in recent days. Bond yields rise (fall) when growth prospects accelerate (decline). In short, the bond market appears to share the recent skepticism of the equity market regarding weaker than previously expected economic prospects. This is particularly noteworthy given the Federal Reserve's expressed intention, depending upon the data, to raise the Fed Funds rate at least two more times this year following the March increase.

Challenges Facing Markets

There are two reasonable explanations to account for this recent pause and pullback in markets. The first is the increased expectations of the difficulty President Trump may face to secure the legislative victories necessary to achieve tax reform and increased infrastructure spending, the most attractive parts of Trump's platform for investors. This difficulty was underlined by the failure of the Republicans to secure passage of legislation to repeal and replace the Affordable Care Act. Doubt regarding the quick passage of legislation on tax reform, or at least tax cuts, and an infrastructure program, may have undermined growth expectations.

The second possible reason for recent lackluster market behavior is that the promise of accelerating growth implicit in almost every opinion survey generated over the past few months has failed to be confirmed by the incoming data on the real economy. Consumer confidence is at cycle highs, as are surveys on production, orders and business confidence. Nearly all regional Federal Reserve Bank reports show improvement. But most of the data on the real economy (after inflation) remains sub-par and below expectations.

Domestic auto sales, one of the early-cycle drivers of this economic recovery, recently dropped from over 18 million units on an annualized basis in January to 16 million in March. Auto production is key to a large number of other industries within the economy, including parts manufacturers; machine tool manufactures; the steel, aluminum and rubber industries; and increasingly, the technology sector.

Credit expansion, a vital ingredient for growth, recently slowed from its already sub-par rate in this expansion relative to earlier expansions. While overall credit growth has been slow, student loan and sub-prime auto lending have expanded dramatically, with outstanding balances of over $1 trillion each. Both categories are also experiencing rising default rates, a clear danger signal for the financial system.

On the jobs front, the March non-farm payroll number was a disappointment. Newly created jobs totaled 98,000 versus an expectation of 180,000, and the prior month's strong number was revised downward by 16,000 workers. Perhaps a slowdown in jobs growth is to be expected given an unemployment rate of 4.5%, near an all-time low. However, one would expect to see wages accelerating in a tight employment market, which they have not, registering 2.3% year-over-year, well below increases of any prior cycle and within the same lackluster range that has persisted over the past two years.

Keeping an Eye on Inflation

Admittedly some of the real data has been solid, albeit only in line or slightly ahead of consensus. While home prices are up substantially, sales continue to increase only modestly, and at rates of growth well below pre-crisis levels. Rising home prices and slow sales are likely due to the shortages of labor and of inventory. As a consequence, housing's slow expansion is adding less than usual to growth. Inflation, one of the Fed's key benchmarks for raising rates, has reached the annualized 2.0% range with respect to the consumer and producer prices indices, and nearly that level on the Fed's preferred inflation measure, the PCE Core Inflation index. However, much of the recent advance to this target has been generated by the year-over-year 50% recovery in the price of oil, a key component of all of these inflation indexes. Going forward, oil prices are not expected to advance as dramatically, and thus its contribution to the inflation rate will be significantly reduced.

In short, there have been few signs so far this year that the promise of accelerating domestic economic growth suggested by the extremely strong survey data will be realized. The Blue Chip Gross Domestic Product growth forecast for the first quarter declined from 2.2% at the beginning of the year to 1.4% currently. But many Wall Street strategists are looking for potentially weaker results in the 1.0% area. The Atlanta Fed has forecast a 0.5% number, although the New York Fed has forecast growth of around 2.0%. The important point here is that expected GDP growth remains very slow and within the disappointingly sub-par range for most of this recovery.

Earnings Season May Yield Insights

Optimists are touting the upcoming earnings season, which is expected to show the strongest year-over-year growth in 10 quarters for both sales and earnings. However, the comparison is against the trough quarter of the seven quarter earnings recession that began in the first quarter of 2015. For the first quarter of 2017, sales are expected to advance 6.5% year-over-year while earnings are expected to jump 8.5%. First quarter sales and earnings from a year ago were down year-over-year by 0.2% and 6.5%, respectively. Despite the easy year-over-year comparisons, current first quarter expectations do represent a positive direction. And if history is consistent, the actual reported numbers are likely to be a bit stronger. Still, the question is the same as for the economy in general: Can the growth accelerate from this point for a sustainable period of time?

Given the fact that the S&P 500® is selling at lofty valuations that are not supported by the current level of earnings, even including estimates for the current year, it is vital that earnings advance at a strong pace over the next two to three quarters to justify stock prices at current levels.

Global Economy in Recovery Mode?

One major positive is that the global economy seems to be in recovery mode. European measures of industrial production, unemployment, spending and employment are slowly improving. Emerging markets are experiencing resurgence in exports, their lifeblood. China just reported first quarter GDP growth of 6.9%, the first increase since the third quarter of 2013. And there are signs that Japan is experiencing stronger than expected corporate earnings growth thanks to easy money policies and, as a result, a weaker yen.

In summary, the global economy is healthy and improving slowly. On a relative basis, the rest of the world is catching up to the U.S. economy, but growth remains at a historically modest rate, and will probably remain so over the next 12-to-24 months. However, the current economic cycle is the second longest in post-World War history and will not last forever. The sluggishness of the expansion has probably allowed normal cyclical excesses to take longer to develop. As noted previously, however, bubbles in credit (subprime auto loans and student loans) and in stock valuations have developed in the US, and China continues to struggle with its housing bubble. The Fed has begun to tighten monetary policy, and Europe is likely to begin to scale back its quantitative easing program sometime within the next 12 months. Additionally, President Trump's anticipated fiscal stimulus policies of tax reform and infrastructure spending plans are being delayed by partisan divisions, as well as factionalism within the Republican ranks in Congress.

Issues Impeding Accelerating Growth

Longer term, many structural impediments stand in the way of a return to accelerating growth. In all developed economies, working-age population growth is slowing as the large cohort of experienced workers leaves the work force to retire. Despite the president's aspirations to bring jobs back to America, many of those jobs have already disappeared forever as robotics and automation, in general, take those positions while providing precision at a lower cost. Advances in health care are increasing lifespans, while retirement savings remain insufficient for protracted retirements. Longer lifespans with meager savings and a shrinking workforce is not a good formula for high and sustainable economic growth. Such a situation portends greater dependence on government largess, but extremely high debt levels without income growth to generate more tax revenue will remain a major constraint.

The future will depend on developing economies maintaining high growth rates and taking an increasing share of global output. India is especially important to future global prospects because it is in the early stages of adopting a dynamic market economy that is globally embracing and also has such a large and growing population. It is the one nation capable of repeating what China accomplished over the past 25 years. And, of course, China's growth, though slowing, remains among the highest in the global economy.

Outlook

Despite this rather bleak longer term outlook, the global economy continues to expand, albeit at a slow pace. A recession does not appear likely over the next 12-to-18 months. We will, however, be on the lookout for signs of a cycle peak, such as short term interest rates rising above long term rates, corporate margin declines, widening credit spreads, loan credit quality deterioration, and/or a declining trend in leading indicators, to name a few predictors of an economic slowdown. At this time, none of these portents of recession are giving warning signals. As for equity markets, a correction seems highly likely given high valuations and rising uncertainty over U.S. economic policies that raise doubts about the sustainability of growth. But as long as growth continues its slow crawl, a bear market is unlikely.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.



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