Wednesday, April 24, 2019

April Macro Update: Employment and Housing Rebound

Summary: It's been a noisy few months for macro. The prolonged government shutdown in December significantly delayed many data reports. Into this mess, several reports were ugly:
Retail sales in December fell into yoy contraction for the first time since 2009. 
New employment in February fell to the lowest level since 2010. 
New home sales growth in November dropped 14% yoy, the lowest rate since 2011.

That weakness now looks anomalous: the data from the past month mostly point to positive growth. A recession starting in 2019 is unlikely.

The bond market sees continued growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. On this basis, the current expansion will likely last through 2019 at a minimum (from JPM). Enlarge any image by clicking on it.

Likewise, high yield spreads never blew out during the market correction and have since declined/normalized. Default rates remain well below average. This part of the bond market is not signaling trouble (from JPM).

Unemployment claims are back in a declining trend. Historically, claims have started to rise at least 7 months ahead of the next recession: claims reached a 49 year low this month, a big positive.

Less positive is recent consumption data. Real retail sales declined on a yoy basis in December, but rebounded to 1.7% growth in March. The trend flattened in the period prior to the past two recessions and there is some risk that the same is beginning to happen now. Continued improvement in the months ahead is needed.

Housing has been the primary macro concern. In March, housing starts fell 14% yoy and building permits fell 8%. But new home sales in March showed a strong rebound, growing 3% yoy and notching the second highest sales level of the 10 year old expansion. A continuation higher will be a major positive: in the past 50 years, a median of 28 months has lapsed between new home sales' expansion high (arrows) and the start of the next recession; so far, the cycle high was in November 2017, 17 months ago.

New home sales have rebounded 23% in the first three months of the year. The peak in home sales came after mortgage rates troughed in late 2017, and sales seem to be rebounding as mortgage rates have fallen from 5% in November to 4% this month.

The Conference Board's Leading Economic Indicator (LEI) Index reached a new uptrend high in March. This index includes the indicators above plus equity prices, ISM new orders, manufacturing hours and consumer confidence. This index can fluctuate during an expansion but the final peak has been at least 7 months before the next recession in the past 50 years (from Doug Short).

Why does any of this matter for the stock market?

Equity prices typically fall ahead of the next recession, but the macro indictors highlighted above weaken even earlier and help distinguish a 10% correction from an oncoming prolonged bear market. On balance, these indicators are not hinting at an imminent recession (a recent post on this is here).

Here are the main macro data headlines from the past month:
Employment: Monthly employment gains have averaged 218,000 in the past 12 months, with an annual growth of 1.8% yoy.  Employment has been been driven by full-time jobs, which rose to a new all-time high in February. 
Compensation: Compensation growth is on an improving trend. Hourly wage growth was 3.2% yoy in April, while the 1Q19 employment cost index grew 3.0% yoy, nearly the highest growth in the past 10 years.  
Demand: Real demand growth has been 2-3%. In 1Q19, real GDP grew 3.2% and real personal consumption grew 2.7%.  Real retail sales grew 1.7% yoy in March, just below a new all-time high. March PCE made a new all-time high.
Housing: Macro weakness has been most apparent in housing. New home sales rose 3% yoy in March, but housing starts fell 14% yoy and permits fell 8% yoy in March. Multi-family units remain a drag on overall development. 
Manufacturing: Core durable goods rose 0.4% yoy in March. The manufacturing component of industrial production grew 1.3% yoy in March and is just below a 10-year high. 
Inflation: The core inflation rate remains near the Fed's 2% target. 

    Our key message over the past 6 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 simple fact is that when the economy is expanding, the historical risk of a greater than 10% annual (not intra-year) decline in the stock market is just 4% (from Goldman Sachs).

    The highly misleading 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.

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

    * * *

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

    Employment and Wages

    The April non-farm payroll was 263,000 new employees plus 16,000 in net revisions for the prior two months.

    Employment growth has accelerated in the last year. The average monthly gain in employment was 240,000 in 2015, 211,000 in 2016 and189,000 in 2017 but it increased to 204,000 in 2018. In the past 12 months, the monthly average has further improved to 218,000.

    Monthly NFP prints are volatile. Since the 1990s, NFP prints near 300,000 (like in January) have been followed by ones near or under 100,000 (like in February). That has been a pattern during every bull market; NFP was negative at times during 1993, 1995, 1996 and 1997. 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 120,000 workers in a monthly NFP report is within the 90% confidence interval (explained here).

    For this reason, it's better to look at the trend; in April, trend employment growth was 1.8% yoy. Until spring 2016, annual growth had been over 2%, the highest since the 1990s.  Ahead of a recession, employment growth normally falls (arrows).

    Employment has been been driven by full-time jobs, which rose to a new all-time high in February (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) has stabilized over the past 5 years. The participation rate had been falling since 2001 as baby boomers retire, exactly as participation started to rise in the mid-1960s as this demographic 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, and younger adults staying in school (and thus out of the work force) longer.

    A better measure is the prime working age (25 to 54 year olds) labor force participation rate; it stands at 82.3%, down only slightly from its peak in 2000 at 84%, and much higher than anytime prior to the 1980s.

    Average hourly earnings growth was 3.2% yoy in April; February's rate of 3.4% was the highest in 10 years. 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, 1Q19 employment cost index shows total compensation growth was 3.0% yoy, nearly the highest in the past 10 years.

    For those who doubt the accuracy of the BLS employment data, federal individual income 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.

    Real (inflation adjusted) GDP growth through 1Q19 was 3.2% yoy, the best growth rate in nearly 4 years.

    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 1Q19, this grew 2.7% yoy. A sustained break above 3% would be noteworthy.

    The "real personal consumption expenditures" component of GDP (defined), which accounts for about 70% of GDP, grew 2.7% yoy in 1Q19.

    On a monthly basis, real personal consumption expenditures grew 2.9% yoy in March, notching a new ATH.

    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. Some research suggests that GDI might be more accurate than GDP (here).

    Real GDI growth in 4Q18 was 2.7% yoy.

    Real retail sales grew 1.7% yoy in March. Sales declined yoy in December but last month's sales are just below the ATH set in November. Sales fell yoy more than a year ahead of the last recession.

    Retail sales in the past three years have been strongly affected by the large fall and rebound in the price of gasoline. In March, real retail sales at gasoline stations grew by 1.2% yoy after having fallen more than 20% yoy during 2016. Real retail sales excluding gas stations grew 1.8% in March, making a new ATH.

    This expansionary cycle is not like others in the past 50 years. Households' savings rate typically falls as the expansion progresses; this time, savings has risen and remains at an elevated level.

    The next several slides look at manufacturing. It's important to note that manufacturing accounts for less than 10% of US employment, so these measures are of lesser importance.

    Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) rose 0.4% yoy (nominal) in March. 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 2.8% yoy in March. The more important manufacturing component (excluding mining and oil/gas extraction; red line) rose 1.3% yoy. Growth has moderated for both, with the cycle peak (so far) in December 2018. Industrial production is a volatile series, with negative annual growth during parts of 2014 and 2016.

    Importantly, 57% of industrial production groups are expanding. A drop below 40% will imply widespread weakness that typically precedes a recession (from Tim Duy).

    Weakness in total industrial production in 2015-16 was concentrated in the mining sector, with 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 11% yoy in March. 

    Companies are often wrongly accused of underinvesting in lieu of greater share repurchases (buybacks). But capacity utilization is still under 80%, so there is plenty of room for production to expand within existing capacity. 


    Macro weakness has been most apparent in housing. Both new sales and starts peaked more than a year ago.

    First, new single family houses sold was 692,000 in March - the second highest level of the current expansion - with growth of +3% yoy. The cycle high was in November 2017, 17 months ago. Overall levels of construction and sales are small relative to prior bull markets.

    Second, housing starts fell 14% yoy in March. The cycle high was in January 2018, 14 months ago; the cycle high has typically been well over a year before the next recession (arrows).

    Building permits (red line) fell 8% yoy in March after rising 8% yoy in March 2018.

    Single family housing starts (blue line) fell 11% yoy in March; multi-unit housing starts (red line) fell 22% yoy and have been a drag on overall starts for more than 4 years.


    Despite steady employment, demand and housing growth, core inflation remains near the Fed's target of 2%.

    CPI (blue line) was 1.9% last month. The more important core CPI (excluding volatile food and energy; red line) grew 2.0%.

    The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core PCE were 1.5% and 1.6% yoy, respectively, in March.

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


    On balance, the major macro data so far suggest continued positive, but modest, growth. This is consistent with corporate sales growth.  SPX sales growth in 2019 is expected to be about 5% (nominal).

    Valuations are slightly above their 25 year average. The consensus expects earnings to only grow about 3% in 2019 but there is room for faster equity appreciation through valuation expansion (chart from JPM).

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