In the fictitious town of Macondo in Gabriel Garcia-Marquez’s One Hundred Years of Solitude, residents accept certain magical anomalies as ordinary, while questioning the veracity of other, seemingly rational, occurrences. One can be forgiven for wondering whether the author presaged a future stranger than fiction. The current global discourse seemingly echoes that construct – a world replete with debates over “fake news” and “alternative facts.” Pundits and internet trolls aside, even serious market observers are divided on whether an apparent divergence between the “Soft Data” of surveys and the “Hard Data” of measured indicators means anything for the future of economic growth and market performance. Further, they wonder whether the incongruity portends a market train wreck if investors decide that the Hard Data will no longer support the reflation trade popular since the US election.
At the end of the traditional 100-day “Honeymoon” period for new US Presidents, the new Administration has established itself as a pugnacious international player, even as its key domestic objectives have gotten off to a slow start. Our principal concern is the effect on markets. We have previously discussed our view that the underpinnings of market optimism rest on a combination of tax reform, deregulation and infrastructure spending. The White House issued a one-page summary of its fiscal reform plans and signed a number of Executive Actions, but had dozens of deregulation riders removed from the funding extension bill. We have not heard much on the infrastructure plan yet. In this context, we review some of the Soft Data/Hard Data below and find the trends inconclusive.
Geopolitical risks pose an increasing threat of triggering an economic shock as the optimistic Soft-Data measures exhibited in consumer confidence and business outlook surveys can rapidly shift downward in the wake of a significant international incident or event. The Fed noted recent economic weakness after its latest meeting in early May. Meanwhile, globally coordinated monetary accommodation continues to drive, or at least contribute to, globally correlated recovery. We stand pat on our most recent Tactical Asset Allocations (see Section 5).
1. Government Avoids Shutdown as the Administration Blinks
The US government avoided a shutdown with a negotiated budget extension that keeps it in operation until the end of the fiscal year on September 30th. The fight we anticipated among Congressional factions over the federal debt ceiling faded in the wake of a deal struck that saw Administration priorities get shunted in what may have amounted to policy triage as the Administration begins again to tackle health care reform. The current deal between Congressional Republicans and Democrats fell short of supporting Administration priorities: no money for a border wall, continued financing for Planned Parenthood and federal arts organizations, increases to some Energy Department units, and a modest 1% reduction in funding for the Environmental Protection Agency (the Defense Department did get alotted $15 billion). Negotiations for the 2018 fiscal budget will be underway by September.
While the President may not have wanted to suffer the indignity of a shutdown to mark the end of his first 100 days in office, he later signaled that he intends to negotiate harder with the 2018 budget deliberations in the fall. By that time, negotiations may turn out more contentious as legislators begin the countdown to Mid-term elections in November 2018. All 435 Representatives must run again to keep their seats and remain in office. Additionally, 34 Senate seats will be up for reelection.
2. Global Coordinated Easing Helps to Maintain Global Correlated Recovery
The Fed met in the first week of May and voted unanimously to keep the Fed funds target rate at 0.75%-1.00%. It noted that while labor market conditions continue to be strong, inflation is still below the 2% objective and consumer prices ex-energy and food have declined recently. The FOMC commented on the slow GDP growth number for 1Q17 in its statement as “likely to be transitory.” The statement did not show any changes or signals on what the Fed intends to do with its $4.5 trillion balance sheet. We note that monetary authorities in Europe, Japan and elsewhere are loathe to increase rates as the threat of inflation remains low.
Looking at the Purchasing Manager Indices (PMI) for manufacturing, the strength in major markets suggests that monetary accommodation has been successful (see chart below). Even though the PMI has rolled over in the US recently, it remains positive above the 50 mark. Meanwhile, Europe continues to improve and China appears range-bound but positive. The overall global trend is positive, especially in comparison to the 2014-2015 period. PMIs reflect a hybrid of Hard Data/Soft Data indicators since they are survey based, but also ask about orders that respondents have placed.
Key Market Purchasing Manager Indices (PMIs)
3. Relevance of the Soft Data/Hard Data Debate
Market observers and investors often try to parse indicators such as industrial production, payrolls and retail sales to form an opinion about the future direction of the economy and, by extension, markets. Some “Hard Data” indicators, such as GDP growth or Non-farm Payrolls, are measured ex post by government agencies. Other, “Soft Data,” are gleaned from interviews, reflecting the outlook of the participants as in the University of Michigan Consumer Sentiment surveys. In a sense, the Soft Data show how people think they’re doing or how they think they’re going to do, while Hard Data show how they actually did. In general, analysts and economists can select any number of statistics to support one or another hypothesis, and even opposing positions can both be “right.”
Prior to the November US elections, consensus had it that a Clinton victory would support the slow-but-steady model that characterized growth and asset returns in recent years, while a Trump win would send markets into a downward spiral. As we know, the post-election markets have shown strength and equity indices in the US have hit new highs. Valuation measures show a stark premium attached to US equities in particular (see Section 4), and the question is whether the Hard Data support this. The recent anemic 0.7% annualized GDP growth for 1Q17 would say “no,” but Consumer Confidence readings that are the highest in many years offer a resounding “yes.” If the consumer turns that optimism into greater spending then the economy should benefit and companies in many sectors should as well. Then, their improved earnings would help to bring valuation multiples down toward the long-term average. We chart below the fluctuation in retail sales, personal savings and the aggregate level of household debt to income. Retail sales picked up fairly well in the last few months.
This may reflect pent-up demand after the austerity of household deleveraging over the last few years. To the extent that households feel comfortable about the future and their ability to withstand a downturn, they may be willing to continue spending at a good pace.
Household Decision Making on Savings vs. Spending
We compare the 5-year trajectory of some Hard Data indicators vs. Soft Data indicators in the chart below. Most notable is how the relative smoothness of consumers’ and small business owners’ expectations contrasts with the up-and-down volatility of Industrial Production and Non-farm Payrolls. Pertinent to the current debate, we see that Non-farm Payrolls, which have been strongly positive (reflected by unemployment falling to less than 5%), have recently slowed. At the same time, Small Business Optimism and Consumer Sentiment experienced strong boosts in late 2016 and have remained at those levels. In essence, the hope remains that the new Administration’s initiatives will lead to higher growth and corporate earnings that can grow into the high valuations implied by equity market pricing. The trend in Industrial Production appears to support a strengthening economy. As such, the mixed message we see leaves us inconclusive on the Hard Data vs. Soft Data debate.
Hard Data vs. Soft Data
4. Market Valuations Remain Lofty
US equity markets continue to set new records as the Dow Jones Industrials and the S&P 500 are up 6%-6.5% on the year through April (see table below). The Eurostoxx Index performance of over 8% YTD meshes well with economic performance coming out of the Eurozone, despite the ongoing political threat to EU cohesion by nationalist parties through an ongoing series of elections. The populist tide may have turned after recent rejections of nationalist candidates in Austria and the Netherlands. French runoff elections on Sunday, May 7th can go either way, though pollsters expect the centrist candidate Emmanuel Macron to prevail. A win by the National Front’s Marine Le Pen would certainly roil markets given France’s size and importance to the EU, and Le Pen’s promise to have France withdraw from the EU.
The strong equities performance still reflects high valuations, as seen in price-to-earnings (P/E) ratios, particularly in the US, which is the only market to show valuations higher than December 2016 (see chart below).
Major Market Price/Earnings Ratios in Late Cycle (avg. 2001-Apr 2017)
Benchmark 10-yr. US Treasury yields have been range-bound at about 2.20%-2.60% since the US elections (see table below). While we expect interest rates to rise along with core rates as driven by Fed monetary policy tightening, technical factors may be at play in keeping yields down. European and Japanese yields remain relatively unchanged from their low levels at the end of 2016.
5. Market Effects and Asset Allocations
The LISI Investment Committee decided to maintain its current Tactical Asset Allocation after changes in the first quarter that included increasing the allocation to equities in the higher risk investment categories. We continue to be wary of heightened market sensitivity to potential geopolitical crises. Accordingly, across asset classes the LISI Investment Committee favors the following in terms of allocation:
- Fixed Income – We recommend shortening duration and accepting somewhat higher credit risk to mitigate the anticipated rate hike cycle. Emerging markets debt may experience higher volatility under targeted tariffs and other market disruptions.
- Equities – We maintain our positive view on equities and recently increased allocations in light of Fed dovishness, expected support from fiscal stimulus, and a strengthening international backdrop.
- Alternatives – While we recently reduced the allocation in Alternatives slightly to move into equity, we continue to favor the inclusion of alternatives for portfolios large enough to accommodate them.
- Cash – We reduced cash allocations somewhat, though still recommend keeping a small allocation in cash in order to keep dry powder for potential market dislocations.
Over the last few months a continuous flow of official statements, news reporting, and editorialized discourse that mimics news reporting have mixed with periodic economic data releases to support a kind of sure-footed uncertainty about growth prospects. We stop short of declaring the US a “Macondo economy” beset with imaginary events in part because things do not turn out so well in the book, but also because we expect, on balance, a positive trajectory for the US economy. Still, we see a new world evolving amid the raucous 24-hour news cycle and do, at times, find “magical realism” to be an apt description of events.
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