Friday, February 6, 2015

February Macro Update: A Trend of Consistently Better Growth

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. Our monthly review of the data has consistently shown this expectation to be premature.

This post updates the story with the data from the past month. We are now starting to see consistently better growth. Highlights:
  • Employment growth has been over 200,000 per month for 11 months in a row. This is the strongest stretch of employment growth since 1993-95
  • Moreover, the 4Q14 employment cost index was the highest since the recession
  • Real personal consumption (70% of GDP) grew 2.8% in 4Q14, at the high end of the post-recession range
  • The manufacturing component of industrial production grew 5.2% in December, one of the highest rates in 4 years  
  • Single family housing starts in December were the highest since the recession. Home sales were also the highest in 7 years
  • However, the inflation rate continues to decelerate. It has fallen to its lowest level since 2009  
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.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The January non-farm payroll (257,000 new employees) followed the incredible 423,000 in November, the highest since May 2010. NFP has been above 200,000 every month for 11 months in a row. It hasn't been above 200,000 that many months in a row since 1993-95.

In the past 12 months, the average gain in employment was 267,000, the highest since 1998.

What is remarkable is that monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000 (circles). That has been a pattern during every bull market.  The consistent strength in monthly NFP recently is therefore noteworthy.

Volatility in NFP 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. It shouldn't be a surprise - or necessarily a concern - if NFP should weaken over 1-2 months in the future. That would be, in fact, quite normal.

For this reason, it's better to look at the trend; in January, trend growth was 2.3% yoy, the highest since May 2000. The trend in NFP employment has not much exceeded 2% growth yoy since 2000, so the strength of the recent trend is noteworthy. In order to reach the 3% growth of the 1990s, NFP will need to consistently average over 250,000 per month.

Released together with NFP is a report on average hourly earnings. In January, this showed growth of 2.2% yoy, near the high end of the post-recession range. There hasn't been any notable sustained acceleration in wages.

The employment cost index shows modest growth in compensation, but the trend is clearly improving. For 4Q14, it was 2.3% yoythe highest since the recession; this is good news, especially as there is a trend of sequently quarterly improvements.

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

CPI dropped to 0.66% in December, the lowest since 2009. The more important core CPI (excluding more volatile food and energy) grew 1.6% the lowest since February 2014. 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 were 0.75% and 1.3% yoy, respectively, in December . 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 closely.

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

On an annual basis, real (inflation adjusted) GDP growth through 4Q14 was 2.5%. 4Q growth was slightly above the middle of the post-recession range (1.5-3.0%). It's positive, but lower than what the US is used to; prior expansionary periods since 1980 experienced growth of 2.5-5% yoy. There's also no obvious acceleration taking place.

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 4Q14, this grew 2.2% yoy, down from 2.8% in 3Q14 which was the highest in 8 years (since 4Q 2006). A sustained break above 2.5% would be noteworthy. Not yet.

Similarly, the "real personal consumption expenditures" component of GDP (defined), the component which accounts for about 70% of GDP, grew at 2.8% yoy in 4Q14, at the high end of its post-recession range (2-3%). This is approaching, but still 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 December, growth was 2.8% yoyThis was the fourth highest rate of growth in 4 years.

Real retail sales grew 2.5% yoy in the past month. The range has been 1.5-4% yoy for most of the past 20 years. The latest print was down from 3.8% in November, which was the highest since June 2013.

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) grew at 2.5% yoy (nominal) in December. This follows four strong months of 8-9% yoy growth from June through September.  During the heart of the prior bull market, growth was typically 7-13%.

The typical range for annual growth in Industrial Production has been 1.5-5% through the past 15 years. During much of the 1990s, the range was higher: 3.5-7%. In December, it was 4.9%, down slightly from 5.2% in November, which was the highest rate of growth since January 2011. The manufacturing component (excluding mining and oil/gas extraction) grew 5.2%, one of the highest rates since early 2011.

Finally, let's look at two measures of housing. Housing data continues to improve but the levels of construction and sales are small relative to prior bull markets.

First, new houses sold was 481,000 in December, the highest since mid-2008, 7 years ago. 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.

Second, overall starts in December were the 4th highest in the past 6 years. The overall level of construction is well off those during the prior two bull markets, but the trend is positive.

Single family housing starts in December were the highest since the recession (blue line). Meanwhile, the growth in  multi-unit housing (red line) to be tapering off.

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 year has been positive but only 3.5% (nominal).

The consensus expects sales growth of about 3-4% per annum (nominal) thru 2016; the macro data presented here 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 8% in 2015 and 12% in 2016.

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 and now into 2015.

There has been, for some reason that's not clear to us, a tendency for macro data to underperform expectations in the first half of the year. A possible heads up for the next several months.

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