Monday, March 16, 2015

Why "Missed Expectations" Are Not What They Seem

Question: What do the following have in common: falling inflation, soaring bond prices, disastrous corporate earnings, plunging retail sales and "the worst US macro relative to expectations since 2009"?

Answer: The price of oil.

Crude oil prices have dropped 60% since June. This single event has wrecked havoc across a number economic and financial barometers. As a result, many are saying the US is headed into a recession.

Let's explore each.

Consumer price inflation is now negative. This looks like the start of deflation, just like in the recession of 2008. It's ominous.

But if energy prices are excluded, inflation is running 1.6% per annum, the same as it was a year ago and the same as two years ago. It's below the Fed's target, but it's not alarming and its certainly not deflation.

Bond prices have soared. Yields, which move opposite to prices, recently fell to the lowest level since 1950s and 60s as inflation expectations have fallen. This would normally indicate very weak demand.

But almost all of the fall in inflation expectations is due to lower oil prices. The correlation, especially with the rise in oil during February, is unmistakable.

The earnings for the S&P 500 are disastrous, falling 15% since last quarter alone. This is the kind of thing that only happens ahead of a recession.

But this has been driven almost exclusively by one sector alone, energy, whose earnings are expected to fall 54% this year. All of the other sectors are expected to report growth in 2015. If energy is excluded, actual earnings in 4Q14 double to 6.8%. That's very healthy growth. 

Retail sales in February plunged to their lowest in 5 years. Consumers aren't shopping. As the chart makes clear, this only happens during recessions (shaded sections).

But nearly all of this is due to one thing: retail gas sales. Spot the moment last autumn when oil prices fell apart, crushing the dollar value of gas sales.

If you exclude gas from retail sales, the rate of growth is nearly 5%, in the middle of the range over the past four years. The consumer is just fine.

All of the above have led pundits to proclaim that stock market fundamentals - both macro and earnings - have completely disconnected from the equity market. The current meme is that the US economy relative to expectations is the weakest since 2009 (top panel).  But measures like the Economic Surprise Index cannot distinguish a wide spread slowdown with one influenced solely by a 60% drop in oil prices, even though that is the obvious case at present (lower panel).

There is a lot of scaremongering going on right now. Deflation, disastrous earnings, plunging consumption, huge misses relative to expectations. It's true that these things happen heading into and during recessions. But if you look outside of energy, the rest of the economy is just fine: prices are not falling, companies are growing their profits and consumers are shopping.

In the past month, we have seen the following: employment gains that are the highest in 20 years; personal consumption (70% of GDP) with the highest growth in 8 years; new home sales at the highest level in 7 years; manufacturing production with the highest growth in 4 years. These are not signs of a coming economic collapse.

None of this is to say that US equities are not overvalued. They are, and this could well present an ongoing headwind to equity appreciation. But bear markets are mostly associated with recessions and a fair-minded view of the data does not indicate that the US is headed into a recession. For now, bears should remain in hibernation.

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