Goodbye, Growth Scare; Hello, Growth Spurt! – The Bull & Bear Case

Goodbye, Growth Scare; Hello, Growth Spurt! – The Bull & Bear Case by Evergreen Gavekal

“We really can’t forecast all that well, and yet we pretend that we can, but we really can’t.” – Alan Greenspan


Bullish Summary

  • The latest growth scare is over, and the US economy is set to accelerate.
  • The risks that drove the latest panic in global markets (US growth, oil oversupply, and a Chinese currency devaluation) were overblown and have begun to recede.
  • Credit spreads (the gap between what corporate and government bonds yield) peaked in February and have narrowed considerably in recent weeks. Given their extreme importance to the economy and financial markets, this is great news.
  • – This environment is more like the 2011 correction than the 2008 with a lot of upside left to come.

Bearish Summary

  • While sentiment has improved with the global market melt-up, economic and earnings fundamentals have not changed.
  • Risks are rising in the US economy and around the world as the Fed tightens after years of misallocation and foreign central banks scramble to address their own growth problems via competitive easing.
  • The ability of central banks to exert a “shock and awe” influence on stock markets is clearly fading.
  • This environment is more like the run-up to the 2008 crisis (but, hopefully, without the risk of a financial system collapse) than the 2011 correction.

The following commentary is from the Evergreen Investment Team:

The Bull Case

Goodbye, growth scare; hello, growth spurt!

While global markets sold-off violently in January and February, on growing fears of a weakening US economy, a flood of new Middle Eastern oil production, and a Chinese currency devaluation such concerns now appear to be overblown.

For starters, US economic growth and inflation are reaccelerating with the Atlanta Fed’s “GDP Now” forecast for Q1 economic growth nearly doubling to 2.2% over the course of the last month and the core consumer price index (which excludes food and energy) currently running well above the Fed’s 2% target.

With unemployment now below 5%, auto sales near their highest levels since 2005, and nationwide home price indices back to their strongest levels since 2007, we are seeing few signs of an imminent recession.

Yes, the strong US dollar has clearly weighed on manufacturing and mining (including oil production), but the rest of the US economy – which is heavily dominated by services – has continued to expand even in the face of rising corporate borrowing costs.

Moreover, those headwinds may be fading now that the Federal Reserve is reassuring that any future rate hikes will be cautious and gradual. This has led to clear reversals in both corporate credit spreads (how much more corporations have to pay to borrow money in the bond market than does the US government) and the trade-weighted US dollar.
If these emerging trends persist, it could breathe new life into cyclical US stocks, stem the tide of China’s troubling capital outflows, and support a continued reflation in major commodity markets… particularly oil, which has been one of the biggest drivers of the recent panic.

The “lower for longer” outlook for global energy markets has worked its way into the consensus over the past six months with fears that a price war between Saudi Arabia and Iran would leave the world awash with oil. However, we’re already seeing a number of signs that non-OPEC production is falling amid ongoing depletion, substantial cuts in planned investments by major energy companies, and a steady decline in active oil rigs across the United States (the US rig count is now down 75% from its 2014 peak).

The 2 million barrel per day (bpd) production glut may sound like a huge number, but the fact of the matter is that it’s only about half the annual depletion rate of roughly 4 million bpd. Therefore, all we need to see is a modest fall in daily production rates for global supply to start coming back in line with global demand, which may accelerate if the US dollar continues to weaken.

It’s a slow process to be sure, but something the markets may already be anticipating with WTI crude oil up more than 45% since the $26 per barrel bottom in mid-February as the strong US dollar has started to roll over. Today’s announcement by the International Energy Agency (IEA) that non-OPEC crude output is falling faster than expected is an indication the oil market may be coming into balance sooner rather than later.

With the sharp snap-back in everything from the S&P 500 and junk bonds to emerging market currencies and commodities, global financial markets are now telling us that the intense pessimism at the beginning of the year was overblown. Rather than resembling 2008 for the global economy and financial markets, the latest panic looks more like 2011 where markets struggled after the end of QE2. Even yesterday’s market fizzle in response to the European Central Bank’s latest extreme stimulation measures is being reversed today.

Instead of falling into a US equity bear market, we’ve just been working through a normal correction, or as Gavekal’s Anatole Kaletsky offered earlier this year, “a pause that refreshes.” And if these trends (weakening US dollar, falling corporate credit spreads, reflating commodities) persist, it won’t be long until depressed pockets of the US equity market take off as earnings bounce back.

The Bear Case

Despite the powerful short-covering rally we’ve seen since mid-February, not much has changed in terms of the underlying economic and/or earnings fundamentals.

Here in the US, we’re still living in a stop-and-go economy as the Federal Reserve’s ever-changing guidance on interest rates fuels big swings in the trade-weighted US dollar and corporate credit borrowing costs. A hard “stop” could very well mean outright recession in 2016 or 2017, but even the “go” periods aren’t very exciting as our rising debt burden (now 350% of GDP) keeps real GDP growth capped at roughly 2%.

Yes, economic growth appears to be strong and durable enough with low and falling unemployment, strong auto sales, and cycle highs in home prices, but these are the same classic lagging indicators that characterized the late stages of the last business cycle in 2007.

A deeper dive into the economic data suggests the consumer is still quite weak with a large portion of new job creation coming from lower-quality, part-time gigs. For sure, low gasoline prices have helped to offset the rising costs of healthcare and education. But, the net effect is still negligible as the balance sheet effects from the commodity crash create headwinds for employment as more US energy firms suspend some or all of their operations. In the process, these reeling oil and gas producers are eliminating many of the best paying jobs created during this expansion.

Years of ultra-low interest rates and aggressive money printing have made the rich richer by fueling asset price bubbles around the world. Meanwhile, the American middle class is under siege as a result of the downward wage pressures from globalization (e.g. offshoring of manufacturing jobs) and automation (e.g. software and robots replacing human workers).

In fact, recent data shows that 46 million Americans are now on food stamps (compared to the long-term average of 2.9 million). Considering that the labor force participation rate is now back to levels not seen since the late 1970s, it’s clear that there are a growing number of