Tuesday, November 11, 2014

November Macro Update: Growth Is Still Missing

In May we started a recurring monthly review of all the main economic data (prior posts are here). At the time, the consensus view was that growth in wages and employment were accelerating and that this would soon lead to a meaningful increase in inflation above the Fed's 2% target. So far, this has been wrong.

This post updates the story with the latest data from the past month. Highlights:
  • The inflation rate continues to drop. It's well below the Fed's target of 2% yoy. PCE is now less than 1.5%. 
  • Several measures of consumption continue to show demand growth of 2-2.5% yoy (real). A sustained improvement in growth remains elusive.
  • A bright spot is employment: the 3Q14 employment cost index was the highest since the recession. 
Our key message has so far been that (a) growth is positive but modest, in the range of ~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. This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

With the latest data, our overall message remains largely the same. Employment is growing at ~2%, inflation and wages are growing at ~2% and most measures of demand are growing at ~2.5% (real). None of these has seen a meaningful and sustained acceleration in the past 2-1/2 years. The economy is continuing to slowly repair after a major-financial crisis. This was the expected pattern and we expect it to continue.

We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The October non-farm payroll (214,000 new employees) was in the middle of a 10-year range. (The past 12-month average of 220,000 was also in the middle of the range). This follows prints of 84,000 in December and 288,000 in June. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, NFP prints near 300,000 have been followed by ones near 100,000 (circles).

This is not a recent phenomenon. The 1980s and 1990s bull markets were the same, only the range was higher. If anything, the swings were more extreme.

For this reason, it's better to look at the trend; in October, trend growth was 1.93% yoy, down slightly from September. The trend in NFP employment has not much exceeded 2% growth yoy since 2000; the monthly prints shown above have been noise within a growth trend between 1.5% - 2.0% 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%. In order to reach the 3% growth of the 1990s, NFP will need to start printing 400,000 per month.

Released together with NFP is a report on average hourly earnings. In September, this showed growth of 2.0% yoy. By this measure, wage growth is not accelerating; 2% is the middle of its range over the past 5 years.

The employment cost index shows modest growth in compensation, with a caveat. For 3Q14, it was 2.2% yoy. In the last six quarters, yoy growth has been 1.9%, 1.9%, 2.0%, 1.7%, 1.9% and 2.2%. The latest print is the highest since the recession; this is good news, but prior pops higher have not been sustained. It's too early to say the trend has improved, but this is a possible light at the end of the tunnel.

These employment and wage reports suggest only modest pressure from labor on inflation. In the event, inflation has been decelerating in recent months and remains well below 2%.

CPI and core CPI (excluding more volatile food and energy) are growing at 1.7% yoy. Neither has been much above 2% since 2Q 2012; each time it has approached 2%, the rate has declined in the months ahead. In other words, there has been no sustained acceleration in inflation, yet. This is in contrast to 2003-07, when inflation was consistently closer to 3%. Consensus expectations are that inflation will accelerate but it hasn't happened.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; core and total PCE both sank to 1.4% yoy in September. Neither has been above 2% since 2Q 2012. Like CPI, there has been no sustained acceleration in inflation, and the rate is well below levels in 2003-07.

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 very closely.

Next, let's look at several measures of demand growth. Regardless of which data is used, real demand has been growing at about 2.0-2.6%, equal to about ~4% nominal.

On an annual basis, real (inflation adjusted) GDP growth through 3Q14 was 2.3%, up from 1.9% in 1Q14 but down from 3.1% in 4Q13 and also lower than the 2.6% growth of 2Q14. 3Q growth was slightly above 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 2.5-5% yoy.

Stripping out the changes in GDP due to inventory gives you "real final sales". This is a better measure of consumption growth than total GDP.  In 3Q14, this grew 2.5% yoy. In 1Q14, with the effects of winter, it was 1.8%. Aside from a bump higher in 4Q13, the trend in annual growth has been 2.0-2.5% every quarter the past 2 3/4 years (since 1Q12). That was also the growth rate at the end of the prior bull market, starting in 2Q06. A sustained break above 2.5% would be noteworthy; until then, the growth rate is not accelerating.

Similarly, the "real personal consumption expenditures" component of GDP (defined), the component which accounts for about 70% of GDP, grew at 2.3% yoy in 3Q14, in the middle of its range (2-3%) since 2Q 2010, but below the 3-5% that was common in prior expansionary periods after 1980.

On a monthly basis, the growth in real personal consumption expenditures remains in a 2-3% annual growth range: in September, growth was 2.1% yoy, down from 2.6% in August. Again, the growth rate has not sustained any acceleration.

Real retail sales grew 2.6% yoy in the past month. The range has been 1.5-4% yoy for most of the past 20 years. The latest print is in the middle of this range.

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) grew at 8.9% yoy (nominal) in September. This follows a strong 8.1% jump in June and 7.8% in both July and August. The last four months are a big improvement from the 0-3% growth seen in prior months in 2014.  During the heart of the prior bull market, growth was typically 7-13%. If recent growth can be sustained in the months ahead, it will mark a noteworthy improvement.

The typical range for annual growth in Industrial Production has been 1.5-5% through the past 15 years; in the last four months it has been at the high end.  It was 5% in July, the best since January 2011, but it has fallen the past two months to 4.3% in September. During much of the 1990s, the range was much higher: 3.5-7%. Excluding mining and oil/gas extraction, the manufacturing component of industrial production is growing at 4.1% yoy.

Finally, let's look at two measures of housing. After a weak winter, housing data has improved. Like other data, growth is positive, but tepid relative to prior bull markets.

First, new houses sold was 467,000 in September; it's virtually unchanged from January 2013. The overall level of sales is still meager relative to prior bull markets. 30 years ago, 600,000 would have been at the low end of the range for monthly sales. The widely expected recovery from winter weakness has been modest.

Second, after a decline in winter, growth in housing starts is positive but volatile and the latest starts are below those of December 2012, almost two years ago. Growth was 18% yoy in September, down from 25% yoy in April. This followed a 4% yoy decline in March. The overall level of construction is well off those during the prior two bull markets, but the trend is positive.

As an aside, the growth in housing starts is being driven by multi-unit housing. These grew by 30% yoy in September while single family housing grew at 11% yoy.

In summary, the major macro data so far suggest positive, but modest, growth. This is consistent with corporate sales growth.  SPX sales growth the past 3 years has been positive but has only averaged 3% (nominal) per annum.

The consensus expects sales growth to accelerate slightly to 3-4% (nominal) in 2014; the macro data presented makes this seem reasonable.

With valuations at high levels, 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 7% in 2014 and 10% in 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 flattening spread in yields have been signaling for all of 2014.

Macro expectations usually improve in the second half of the year; this will likely carry through the end 2H14. That doesn't mean growth above 3-4%, but data that meets or exceeds lowered expectations.

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