November market musings breakdown:
- The true rate of unemployment
- The deterioration of the bottom 60% of consumers and core expense growth
- The misleading nature of average hourly earnings (AHE) / forward outlook on personal income
- Tightening in consumer credit / forward debt service payments
- Donald Trump and the numbers
- Light technical picture
The strength of the US consumer continues to be highly debated given that they represent 70% of GDP. Admittedly, we were consumer bulls in late 2014 and early 2015, as the backdrop of:
- falling jobless claims
- improving average hourly earnings (AHE)
- rising payrolls
- and low levels of leverage relative to disposable income
was quite favorable for higher rates of consumption. While this was our working thesis, the data failed to back it up, as the y/y change in retail sales ex gas moved from the upper left to the bottom right. This divergence led to a piece we put out a few months ago that attempted to bridge the gap.
We contended that the strength of the labor market is misrepresented due to those that dropped out of the labor force, which has in turn reduced the unemployment rate, shown in the chart below.
With that premise, we went back to 1960 to understand how the current level of unemployment comps. Since 1960, when the unemployment rate was at or below 5%:
- GDP growth averaged 5.35%
- Average hourly earnings grew at a 4.4% clip
- And discretionary consumption came in at 6.42%
Over the trailing twelve months:
- Nominal GDP averaged 2.9% (46% discount to historical comp)
- AHE grew at 2.3% (48% discount)
- And discretionary consumption has come in at 3.7% (42% discount)
Based on the historical data, we see there is a clear disconnect between the current market narrative and reality, or roughly a 45-46% difference, as highlighted above. If we back into the historical unemployment rate given the current level of average hourly earnings (~2.5%), we find that the unemployment rate has historically been around 6.9%. This is also in-line with discretionary consumption, which is indicating the rate is slightly higher at 7.2-8%, but less than the indicated 10% in the chart above.
In the write up, we outlined how the disconnect is a result of the top 40% of earners who have accrued 84% of all new income and only 34% of new debt since 2013. We view this strength as the primary driver of growth, which masked the deterioration of lower income brackets, as they have progressively taken on more debt than income since Q313, shown in the chart below.
This is not widely acknowledged by the market for a few reasons:
- The material income gains of the top 40% boost the denominator in debt/disposable income, as well as debt service payments/disposable income, bringing the ratio to 20 year lows
- The fall in mortgage balances [70% of household liabilities] since 2008 has materially reduced debt, while the cost of housing in the form of rent expense has moved ‘off balance sheet’, which is also drowned out by income gains of the top
- Difficulty of calculation
- And it fails to conform to headline figures such as unemployment, which indicate consumer strength
Rising average hourly earnings are also indicating consumers are growing stronger. We think this again is misleading and false due to the calculation of AHE.
AHE is a ratio of earnings to hours worked, and due to the nature of the ratio, large moves can skew it in one way or another. For example, if earnings are constant and hours worked decline, AHE rise. This is what is going on today as we illustrate below.
Earnings growth is stagnant.
Hours are declining y/y.
But AHE is rising due to the ratio.
That said, this number is essentially useless as there is no positive correlation with consumption (retail sales), as shown below.
The correlation is actually negative.
So a rise in AHE as shown above has historically corresponded to a fall-off in consumption.
If we recalculate the ratio to adjust for aggregate consumption [average hours x average earnings], we find there is a positive correlation between the two and the trend is much different, as shown below.
To us, the declining trend of aggregate earnings makes sense, as the best forward indicator of personal income (PI) – corporate profits – has been rolling for over 4 quarters. Historically it has led PI by 12 months, indicating that we should see a fall-off over the next three quarters, before some stabilization.
On top of these misleading metrics, we explained in our previous write-up that consumers are getting squeezed from higher rental costs
And medical care inflation
Which has previously led to a fall-off in consumption, as shown below by our leading consumption indicator.
Though these costs are initially funded via internal cash and credit
But there comes a point in the cycle where they can no longer finance higher costs, at which point revolving credit begins to roll, as consumers pay back outstanding balances. We think this is around the corner as banks begin to tighten CC conditions.
Which is leading to higher rates of financing
Also being seen on the private side towards lower grade consumers, as Lending Club illustrates below.
And rising rates are putting some pressure on the BBG Barclays CC ABS index.
Consumers will also feel additional cost pressures over the next few quarters from the effects of LIBOR rising. As shown below, LIBOR has historically led debt service payments by 2-3 quarters.
We think the market has the consumer thesis completely wrong. While we are open minded to being wrong ourselves, we don’t see continued strength in consumption until after the enactment of tax legislation in September of 2017, which will be a modest positive.
That said, we have outlined areas that will signify to us that our thesis is wrong over the next 5-8 months.
- Continued move higher in retail sales through February
- Sharp uptick and continuation in aggregate earnings
- Fall off in LIBOR
- Divergence in personal income and corporate profits
- Continued strength in revolving credit growth y/y
- Sharp fall in core expense growth
Until 80% of these manifest, we find it difficult to be bullish on a market that is trading at the highest multiples since 2001.
We find it quite amusing that the man who would end the world now appears to be the panacea for all market woes. While we had Trump winning the election, we did not see as strong of a move to the upside in such short order. That said, we do see the Trump win being bullish for the economy given that Republicans now hold the House, Senate, and White House.
However, this is over a much longer time horizon of 2-3 years, as these processes do not happen overnight, which the market seems to be pricing in. In our view, once the market understands what Trump and the reflation trade mean for the Fed, the next big move will play out. This revelation is possible before years end.
Assuming that the reflation trade does manifest [which we have a hard time getting behind (outlined below)] the Federal Reserve will be forced to pull the punch, disproving the current rhetoric of low interest rates justifying equity valuations.
This move in rates will increase the cost of credit for consumers and corporations, a scenario we have not seen since pre-crisis, outside of company specific credit risk. With 17% of all SPX debt maturing over the next two years [note: chart from this piece 1 year ago] and consumer debt at an all-time high relative to GDP, its seems EPS will be pressured from higher rates.
This however could be offset by the positive implications of a Trump tax cut. Goldman estimates that each percentage point drop in the effective US corporate tax rate equates to $1.5 in SPX earnings power, which yields the following results.
That said, the bear case (10-15% effective) on corporate tax rates seems less probable given that:
- The current budget deficit stands at 3.2% of GDP
- The House put through a budget blueprint at the beginning of the year looking to reduce the deficit by $7T over the next 10 years
- Kevin Brady, the Chairman of the Ways and Means committee sees tax cuts being revenue neutral
- A large-scale infrastructure project will add to the current deficit, under the assumption of revenue neutrality
- Federal Government interest payments currently make up 22% of total revenue, as shown below.
With effective rates at the lowest levels in history.
If there is a 200 basis point move in effective rates, total Government interest payments as a percentage of revenue climb 14.2% to 36.4%, a level last seen in 1997, which is 13.2% off the all-time high set in 1985. A 390 basis point rise to 6.9% brings the ratio to all-time highs (~50% of revenue).
The current budget deficit, coupled with rising rates puts significant pressure on getting through a trillion-dollar infrastructure project and material tax cuts. The market seems to be off again on the benefits of a Trump presidency, in the shorter term.
Goldman sees Trump’s cash repatriation increasing buybacks by $150b at a 10% repatriation rate, bringing buybacks to 30% of total corporate cash use, as shown below.
We view this as quite optimistic for the following reasons:
- The top 10 companies in the SPX have 39% of total cash, with the top 20% holding just over half. Given that corporations have enacted large scale buyback programs, we see the probabilities of the incremental dollar going towards additional buybacks as low, meaning over 50% of the cash repatriated will likely sit on the sidelines.
- If the reflation trade is real, the probabilities favor corporations putting capital towards CAPEX, as it would be a better use of cash
In addition, buybacks seem less likely to be expanded due to:
- Higher rates increasing debt funding costs
- And corporate pension funding deficits pulling buyback cash use, as Jay Pelosky points out
Stocks at all-time highs is not bearish; however, there are a few other areas that we’re paying attention to.
The market may be beginning to lose its leadership, as shown below by the price overlay of AMZN(red) and AAPL (blue).
Breadth is also not as strong as price, as the number of stocks above the 200 day moving average is currently lagging.
And the recent move resulted in a 3+ standard deviation move in the number of stocks with an RSI above 70.
We see the market lower, but we’ve been wrong. That said, we think we’ve disproven the current narrative, and as our long-term value friends would say: ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’