Friday, March 4, 2016

March Macro Update: Recession Risk Remains Remote

SummaryThe macro data from the past month continues to point to positive but sluggish growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.
    The main positives are in employment, consumption growth and housing:
    • Employment growth is close to the best since the 1990s, with an average monthly gain of 222,000 during the past year.  Full-time employment is soaring.
    • Recent compensation growth is the highest in more than 6 years: 2.7% in December, dropping to 2.2% yoy in February.
    • Most measures of demand show 3-4% nominal growth. Real personal consumption growth in January was 2.9%.  
    • New housing sales, starts and permits remain near an 8 year high. 
    • The core inflation rate ticked up above 2% and to the highest rate since May 2012.
    The main negatives are concentrated in the manufacturing sector (which accounts for just 10% of GDP):
    • Core durable goods growth fell 2% yoy in January. It was weak during the winter of 2015 and it has not rebounded since. 
    • Industrial production has also been weak, falling -0.7% yoy due to weakness in mining (oil).
    Prior macro posts from the past year are here.

    * * *

    Our key message over the past 2 years has been that (a) growth is positive but slow, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

    Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

    This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.

    A valuable post on using macro data to improve trend following investment strategies can be found here.

    Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.

    Employment and Wages

    The February non-farm payroll was 242,000 new employees plus 30,000 in revisions. In the past 12 months, the average gain in employment was 222,000. Gains since 2014 have been the highest since the 1990s.

    Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low print of 84,000 in March, as well as the 'disappointingly weak' print in September, fit the historical pattern. This is normal, not unusual or unexpected.

    Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues, appreciate that a "beat" or a "miss" of 80,000 workers in a monthly NFP report is equal to just 0.05% of the US workforce.

    For this reason, it's better to look at the trend; in February, trend growth was 1.9% yoy. Annual growth continues to be close to the highest since the 1990s.  Employment growth starting in 2014 has been better than at any time during the 2003-07 bull market.

    Employment is being driven by full-time jobs (blue line), which is soaring, not part-time jobs (red line).

    The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) has been falling. This has little to do with the current recovery; the participation rate has been falling for 16 years. Participation is falling as baby boomers retire, exactly as participation started to rise in the mid-1960s as this group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999.

    Average hourly earnings growth in February was 2.2% yoy; December was revised higher to 2.7%, the highest in more than 6 years. Sustained acceleration in wages would be a big positive for consumption.

    4Q15 employment cost index shows compensation growth was 2.1% yoy. This is down from 2.7% in 1Q15, which was the highest growth since the recession.

    For those who doubt the accuracy of the BLS employment data, federal tax receipts are also accelerating (red line), a sign of better employment and wages (data from Yardeni).


    Despite steady employment growth, inflation remains stuck near the Fed's target of 2%.  But note: CPI and PCE are finally beginning to tick higher.

    CPI (blue line) was 1.3% last month. The more important core CPI (excluding more volatile food and energy; red line) grew 2.2%, the highest level since May 2012.

    The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core PCE were 1.3% and 1.7% yoy, respectively, in January. Neither has been above 2% since 2Q 2012.

    For some reason, many mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index). It tracks both CPI and PCE closely.


    Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 3-4% nominal.

    Real (inflation adjusted) GDP growth through 4Q15 was 1.9% yoy (it was 2.5% in 4Q14, so the yoy comparable is unfavorable). 4Q growth was near the middle of the post-recession range (1.5-3.0%) but lower than the 2.5-5% common during prior expansionary periods since 1980.

    Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP.  In 4Q15, this grew 1.9% yoy (it was 2.6% in 4Q14, so here too the yoy comparable is unfavorable). A sustained break above 2.5% would be noteworthy.

    Similarly, the "real personal consumption expenditures" component of GDP (defined), the component which accounts for about 70% of GDP, grew at 2.6% yoy in 4Q15. The last four quarters have seen the highest growth rate since 2006. This is approaching the 3-5% that was common in prior expansionary periods after 1980.

    On a monthly basis, the growth in real personal consumption expenditures was 2.9% yoy in January (it was 3.8% a year ago, making the yoy comparable unfavorable).

    GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. A growing body of research suggests that GDI might be more accurate than GDP (here).

    Real GDI growth through 3Q15 was 2.1% yoy. This is near the low end of the range of prior expansionary periods since 1980 (2.5-5% yoy).

    Real retail sales reached a new all-time high last month, growing 2.1% yoy (it was 4.1% a year ago, making the yoy comparable unfavorable). The range has generally been centered around 2.5% yoy for most of the past 20 years. The latest month is near the middle of the range.

    Retail sales this year have been strongly affected by the large fall in the price of gasoline. Retail sales at gasoline stations fell by 8% yoy. Real retail sales excluding gas stations grew 3.1% in January. Growth is stronger now than during most of 2011-14.

    The main negatives in the macro data are concentrated in the manufacturing sector, as the next several slides show. It's important to note that manufacturing accounts for less than 10% of US employment and GDP, so these measures are of lesser importance. Even within manufacturing, the weakness is concentrated; most sectors are not contracting (more on this here).

    Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) fell 2% yoy (nominal) in January. During the heart of the prior bull market, growth was typically 7-13%. Weak growth in winter has been a pattern the past three years (arrows), but it did not bounce back in the past year.

    This is a nominal measure and thus negatively impacted by the fall in the inflation rate. On a real basis, growth continues to trend higher (blue line is real; gray line is nominal; chart from Doug Short).

    Industrial production growth was -0.7% in January. The more important manufacturing component (excluding mining and oil/gas extraction; red line) grew 1.2%. It's a volatile series: manufacturing growth was lower at points in both 2013 and 2014 before rebounding strongly.

    Weakness in total industrial production is concentrated in the mining sector, which fell 10% yoy in January. It is not unusual for this part of industrial production to plummet outside of recessions. It's a volatile industry.


    Housing starts and sales in January remained near an 8 year high.  Overall levels of construction and sales are small relative to prior bull markets but the trend is higher.

    First, new houses sold was 494,000 in January. December was an 8 year high. Growth is flat over the past year after growing 16% yoy in January 2015.

    Second, overall starts in January remained near an 8 year high.  The annual growth rate was 2% yoy.

    Building permits remained robust (red line), near an 8 year high in January and up 14% yoy.

    Single family housing starts (blue line) were near the highest since the recession. Multi-unit housing starts (red line) is flat over the past two years.


    In summary, the major macro data so far suggest positive, but slow, growth. This is consistent with corporate sales growth.  SPX sales growth the past year has been positive but only about 2% (nominal) excluding energy.

    With valuations above average, the current pace of sales growth is likely to be the limiting factor for equity appreciation. This is important, as the consensus expects earnings to grow 4% in 2016.

    Modest growth should not be a surprise. This is the classic pattern in the years following a financial crisis like the one experienced in 2008-09.

    There has been a tendency for macro data to underperform expectations in the first half of the year and beat expectations in the second half. For the first time since 2009, macro expectations are below zero to start the year.

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