Friday, May 9, 2014

Macro Review: Positive But Moderate Growth

There are two very different story lines in the market.

One is that the economy is on the threshold of a 1980's-style boom, driven by latent demand and rising wages and employment. For proponents, last Friday's NFP data, which clocked in at the highest level since January 2012, is exhibit 1. And exhibit 2 is surging equity prices.

The other story line is that the economy is teetering on the precipice. Housing demand is plummeting and gas/food inflation is eating into disposable income. For proponents, last week's GDP data, showing 1Q14 growth surprisingly weak at just 0.2%, is exhibit A. And exhibit B is falling treasury yields.

Most of the discrepancy of opinion in these story lines can be traced to volatility in month to month data. NFP is the best example: it has varied from 84,000 to 288,000 in just the past 4 months. Investors with a strong bias or a short memory ignore the underlying trend, which is positive but modest growth.

This post will look at the main economic data, using a list of priority releases from Calculated Risk (here). It's a selective, not comprehensive, review.

There are three key messages:
  1. Macro data has been sending a consistent message that growth is positive but modest, in the range of 3-4% (nominal), with a bias to the higher end of the range. 
  2. Current growth is lower than in prior periods of economic expansion. A return to 1980s or 1990s style growth does not appear to be in the cards, so expectations about equity appreciation like in those periods should be tempered. The consensus expects earnings growth of 10% in 2014 and 2015.
  3. Monthly, and even quarterly, data has been oscillating around this trend. Focus on the annual pace of growth; it provides a cleaner perspective on growth than individual 'prints.'

Why look at macro data
First, why should investors care about macro data at all? Macro growth correlates with corporate performance: better top line growth, all else being equal, translates into better earnings (chart from Yardeni).

Beating macro growth expectations correlates generally with equity outperformance: earnings and earnings multiples both tend to expand when expectations are being exceeded, and vice versa.

Next, let's review the most recent macro data. We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The April non-farm payroll (288,000 new employees) was very solid. The fact that it had been just 84,000 in December was lost in the general excitement. More to the point, moving between extremes like these has been a pattern for 14 years.

If you assume continued higher prints in the months ahead you also assume a pattern very different from the past. Since 2000, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).

It's better to look at the trend; in April, trend growth was 1.7% yoy. The trend in NFP employment has not exceeded 2% growth yoy since 2000; the monthly prints shown above have been noise within a growth trend between 1.5% - 1.9% since the start of 2012. It wasn't much different in the 2003-07 bull market, so be careful assuming a trend with much higher growth than 2%.

Released together with NFP is a report on average hourly earnings. In April, this showed growth of 1.9% yoy. Wages are not accelerating; 2% is the middle of its range since late 2009.

Similarly, the employment cost index shows modest growth in compensation. For 1Q14, it was 1.7% yoy. It is also not accelerating.

These employment and wage reports do not suggest much increasing pressure from labor on inflation.

CPI and core CPI (excluding more volatile food and energy) are both growing at 1.6% yoy. Neither has been much above 2% since 2Q 2012. Moreover, there is no apparent acceleration in inflation, yet. This is in contrast to 2003-07, when inflation was consistently closer to 3%.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; both core and total PCE are near 1.2% yoy. Neither has been above 2% since 2Q 2012. Like CPI, there is no apparent acceleration in inflation, and the rate is well below levels in 2003-07.

Next, let's look at several measures of demand growth. Regardless of which data is used, real demand has been growing at about 2%, equal to about 3-4% nominal.

As mentioned, 1Q14 GDP showed growth of just 0.2%. But this was quarter on quarter. On an annual basis, real (inflation adjusted) growth was 2.3%. This is right in the middle of the post-recession range (1.3-3.3%). It's positive, but lower than what the US is used to; prior expansionary periods since 1980 experienced growth of 2.5-4.5% yoy.

Stripping out the changes in GDP due to inventory gives you real final sales. In 1Q14, this grew 2% yoy. This is on the low end of the range (1.7-2.7%) since 4Q 2010. This is a better measure of consumption growth than total GDP.

Similarly, the real personal consumption expenditures component of GDP grew at 2.5% yoy in 1Q14, in the middle of its range (2-3%) since 2Q 2010, but below the 2.5-4.5% that was common in prior expansionary periods after 1980.

Real retail sales grew 2.2% yoy measured on a monthly basis. This data can be volatile month to month; smoothing it by using 3-month data gives annual growth of 1.1%. It's likely this will show improvement in the months ahead. The range has been closer to 1.5-4% yoy for most of the past 20 years.

Industrial production is an important measure but it travels in a wide range. The typical range has been 1.5-4.5% yoy through the past 15 years; last month it was 3.8%.

Finally, let's look at two measures of housing. If there is a red flag in any of the macro data, it's in housing.

First, new houses sold declined 3.3% yoy (measured on a 3 month basis) in 1Q. While that was a weak report, note that it had similar declines in 1994 and 2004. It will likely bounce back in the months ahead, but this deserves close monitoring.

Second, new housing starts also declined by 3.5% yoy (measured on a 3 month basis) in 1Q. Same comments apply.

In summary, the major macro data so far suggest a positive, but tepid recovery. This is consistent with corporate sales growth.  SPX sales growth the past 3 years has been positive but modest, averaging about 2% per annum. That's the trend, although there is considerable variation around trend each quarter. This variation is usually noise; the low growth of 1Q14 and the high growth of 4Q14 are recent examples.

The difference between SPX sales growth of 2% and domestic macro growth of 3-4% is the ex-US activity of US corporations; European economic (and earnings) growth has been close to zero.

Until valuations return from high levels, we think 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 at close to 10% in 2014 and 2015.

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. It is also what the spread in yields have been signaling for several months.

If there is a bright spot, it's that macro expectations usually improve in the second half of the year; the tepid data recently will likely transition to better data in 2H14. That doesn't mean growth above 3-4%, but data that meets or exceeds lowered expectations.