Friday, July 7, 2017

July Macro Update: Recession Risk Remains Low

SummaryThe macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least a year and in several instances as long as 2-3 years. On this basis, the current expansion will last well into 2018 at a minimum. Enlarge any image by clicking on it.

Unemployment claims are also in a declining trend; historically, claims have started to rise at least 6 months ahead of the next recession.

That said, there are two watch outs that bear monitoring closely:
The first is employment growth, which has been decelerating from over 2% last year to 1.6% now. It's not alarming but it is noteworthy that expansions weaken before they end, and slowing employment growth is a sign of some weakening in the current expansion. 
The second watch out is demand growth. Real retail sales excluding gas is in a decelerating trend. In May, growth was just 1.7% after having grown at more than 4% in 2015. Personal consumption accounts for about 70% of GDP so weakening retail sales has a notable impact on the economy. 

Macro data headlines from the past month:
Employment: Monthly employment gains have averaged 187,000 during the past year, with annual growth of 1.6% yoy.  Full-time employment is leading. 
Compensation: Compensation growth is among the highest in the past 8 years - 2.6% yoy in 1Q17.  
Demand: Real demand growth has been 2-3%. In May, real personal consumption growth was 2.7%.  Real retail sales (including gas) grew 1.9% yoy in May, after making a new ATH in April. 
Housing: Housing sales made a 9-1/2 year high in March. Sales grew 9% yoy in May. Starts and permits are flat over the past two years due to weakness in multi-family units. 
Manufacturing: Core durable goods growth rose 4.8% yoy in May. The manufacturing component of industrial production grew 1.7% yoy in May. 
Inflation: The core inflation rate remains near (but under) the Fed's 2% target. 

Our key message over the past 5 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), 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. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.

Macro data should be better than expected in 2H17. Why? Macro data was ahead of expectations to start the current year. During the current expansion, that has led to underperformance of macro data relative to expectations into mid-year and then outperformance in the second half of the year (green shading). 2009 and 2016 had the opposite pattern: these years began with macro data outperforming expectations into mid-and then underperforming in the second half (yellow shading).

A valuable post on using macro data to improve trend following investment strategies can be found here.

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Let's review the most recent data, focusing on four macro categories: labor market, end-demand, housing, and inflation.

Employment and Wages

The June non-farm payroll was 222,000 new employees plus 47,000 in revisions.  In the past 12 months, the average monthly gain in employment was 187,000. Employment growth is decelerating.

Monthly NFP prints are normally volatile. Since the 1990s, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low print of 50,000 in March and 43,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.

Why is there so much volatility? Leave aside the data collection, seasonal adjustment and weather issues; appreciate that a "beat" or a "miss" of 80,000 workers in a monthly NFP report is equal to just 0.05% of the US workforce.

For this reason, it's better to look at the trend; in June, trend employment growth was 1.6% yoy. Until spring 2016, annual growth had been over 2%, the highest since the 1990s.  Ahead of a recession, employment growth normally falls (arrows). Continued deceleration in employment growth in the coming months continues to be an important watch out.

Employment has been been driven by full-time jobs, which are at a new all-time high (blue line), not part-time jobs (red line).

The labor force participation rate (the percentage of the population over 16 that is either working or looking for work) had been falling but has more recently stabilized. The overall trend down has little to do with the current recovery; the participation rate has been falling for more than 17 years. Participation is falling as baby boomers retire, exactly as participation started to rise in the mid-1960s as this group entered the workforce. Another driver is women, whose participation rate increased from about 30% in the 1950s to a peak of 60% in 1999.

Average hourly earnings growth was 2.5% yoy in June. This is a positive trend, showing demand for more workers. Sustained acceleration in wages would be a big positive for consumption and investment that would further fuel employment.

Similarly, 1Q17 employment cost index shows compensation growth was 2.6% yoy. This is near the highest growth rate since the recession.

For those who doubt the accuracy of the BLS employment data, federal tax receipts have also been rising to new highs (red line), a sign of better employment and wages (from Yardeni).


Regardless of which data is used, real demand has been growing at about 2-3%, equal to about 4-5% nominal. One concern is real retail sales growth: excluding gas, growth has decelerated to under 2%.

Real (inflation adjusted) GDP growth through 1Q17 was 2.1% yoy. 2.5-5% was common during prior expansionary periods prior to 2006.

Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP.  In 1Q17, this grew 2.3% yoy. A sustained break above 2.5% would be noteworthy.

The "real personal consumption expenditures" component of GDP (defined), which accounts for about 70% of GDP, grew at 3.0% yoy in 1Q17. This is approaching the 3-5% that was common in prior expansionary periods after 1980.

On a monthly basis, the growth in real personal consumption expenditures was 2.7% yoy in May.

GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. A growing body of research suggests that GDI might be more accurate than GDP (here).

Real GDI growth in 1Q17 was 1.3% yoy.

Real retail sales reached a new all-time high in April; in May, annual growth was 1.9% yoy. The range has generally been centered around 2.5% yoy for most of the past 20 years.

Retail sales in the past two years have been strongly affected by the large fall in the price of gasoline. In May, real retail sales at gasoline stations rose by 4% yoy after having fallen more than 20% yoy during 2016. Real retail sales excluding gas stations grew 1.7% in May. This is a weakening trend.

The main negatives in the macro data have been concentrated in the manufacturing sector, as the next several slides show. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance. Even within manufacturing, the weakness is concentrated; most sectors are not contracting (more on this here).

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) rose 4.8% yoy (nominal) in May. March had the best annual growth rate since mid-2014. Weakness in durable goods has not been a useful predictor of broader economic weakness in the past (arrows).

Industrial production (real manufacturing, mining and utility output) growth was 2.2% yoy in May. The more important manufacturing component (excluding mining and oil/gas extraction; red line) rose 1.7% yoy. This is a volatile series: manufacturing growth was lower at points in both 2013 and 2014 than it was in 2016 before rebounding strongly.

Weakness in total industrial production has been concentrated in the mining sector; the past two years had the worst annual fall in more than 40 years. It is not unusual for this part of industrial production to plummet outside of recessions. With the recovery in oil/gas extraction, mining rose 8% yoy in May. 


Housing sales grew 9% yoy in May.  Housing starts and permits are flat over the past two years due to weakness in multi-family units.  Overall levels of construction and sales are small relative to prior bull markets, but the trend is higher.

First, new single family houses sold was 610,000 in May; March sales were at the highest level in the past 9-1/2 years. Growth in May was 9% over the past year after growing 11% yoy in May 2016.

Second, housing starts are flat over the past two years. Although starts in February were at the second highest level since August 2007, starts in May were the second lowest in the past two years and 2% lower than a year ago.

Building permits had been on an improving trend but are now down 1% in the past year (red line). The trend is flat over the past two years.

The weakness in starts (and permits) is in the multi-unit category. Single family housing starts (blue line) reached a new post-recession high in February and was only marginally lower in May. Meanwhile. multi-unit housing starts (red line) was flat over the past four years; this has been a drag on overall starts.


Despite steady employment, demand and housing growth, inflation remains stuck near (but under) the Fed's target of 2%.

CPI (blue line) was 1.9% last month, a steep fall after being over 2% the prior five months in a row for the first time since April 2012. The more important core CPI (excluding volatile food and energy; red line) grew 1.7%, the lowest rate in 2 years (since May 2015), although still just oscillating near 2%.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core PCE were 1.4% and 1.4% yoy, respectively, last month. February was the first (and only) month since 2Q 2012 that total PCE was above 2%.

Some mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index; yellow line). It has tracked both CPI (blue line) and PCE closely.


In summary, the major macro data so far suggest positive, but slow, growth. This is consistent with corporate sales growth.  SPX sales growth in 2017 is expected to only be about 5% (nominal).

With valuations now well above average, the current pace of growth is likely to be the limiting factor for equity appreciation. This is important, as the consensus expects earnings to grow about 10% in 2017 (chart from Yardeni).

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