Bad vs. Less Good: The U.S. Economy
On Friday, the S&P 500 closed at 2873.34. For those of you keeping track at home, that’s a whopping 0.02% return since the January 26, 2018 peak. (If you prefer the Total Return measure, that’s enough annualized return to keep even with the current inflation rate.) When it comes down to it, stocks have done next to nothing for almost 18 months. It might seem that given a relatively unchanged equity market, the economic environment must also be relatively unchanged. That isn’t the case.
The year 2017 was highlighted by ‘synchronized global growth’ – economic activity increased around the world, accompanied by stock prices. The good times continued throughout the first month of 2018, and, even after a global equity selloff in February, data for most of last year indicated that underlying fundamental growth would continue. New highs for U.S. stocks in September seemed to confirm that everything was fine, but then a steep 4th quarter selloff and the ensuing rally brought us right back where we started.
Following the trend in year-over-year equity returns, the economic data has more recently softened. But is the data actually bad, or just less good? Let’s take a look.
You can’t get much broader than GDP. After breaching 4% in the middle of 2018, growth in the United States declined to 3.2% in Q1 2019 just above the 2.3% average since 2010. The St. Louis Fed’s GDPNow estimate points to continued slowing in Q2 2019 (1.39%), but no contraction.(Click charts to enlarge)
The unemployment rate is at 3.9%, the lowest in nearly 50 years and much better than the 70-year average of 5.8%. But the rate of jobs growth is slowing. Friday’s BLS report showed a subpar addition of only 75,000 jobs. A similarly weak print in January was written off as a ‘blip’, but two blips start to resemble a change in the trend. Moreover, a separate measure of payrolls from ADP showed a decline of 35,000 jobs in construction, accompanied by losses in manufacturing and natural resources. Those aren’t things we want to see in May, when outdoor activity should be picking up. Weather might have been the cause, but weather is like alcohol – it tends to get blamed for a lot of things it didn’t do.
Survey data doesn’t inspire much confidence either. While the services side has held up better, the Markit Manufacturing PMI has declined from its 2018 peak of 56.5 to 50.5 – still above the 50.0 flatline, but the lowest reading since 2009. The New Orders component of the survey, generally considered a leading indicator, is in contraction.
Profit margins for companies in the S&P 500 peaked last year (in case you haven’t noticed, this is a recurring theme). Rising labor costs and tariff impacts, among other things, have reduced margins from 12% to 10.9%. On the bright side, that’s the same nominal benefit received from the 2017 tax cuts, so the net change over the last 2 years is essentially zero.
We round it out with earnings. S&P 500 earnings per share are estimated to set a new all time high in 2019, which has helped reduce the forward P/E multiple from 18.5x to 16.2x. Year-over-year growth in earnings is less exciting. The first quarter of 2019 actually saw earnings decline according to FactSet’s blended calculation, and almost all of the anticipated gain for the calendar year is expected to come in the final months. Additionally, consensus EPS estimates typically trend down over time, so full-year growth projections should always be treated with skepticism.
The weaker data has caused a major shift in expectations for Federal Reserve action. After 3 hikes in 2018, Federal Funds futures markets in October had priced in, with over 90% certainty, at least one more hike by December 2019. The forecasters have since reversed course – not only are they pricing a 0% chance of a hike, the odds now suggest a 99% chance of an interest rate cut.
The aforementioned easing in monetary policy has been categorized as an ‘insurance cut’, intended to offset tariff impacts and stimulate inflation rather than counter an economy already in decline. As reinforcement, FOMC members have been careful to say that no recession is imminent, but economists don’t have the best track record when it comes to predicting recessions (more on that later).
To sum it up, most of the data is still just less good, as opposed to being outright bad, and the Fed seems to have our backs if things do deteriorate further. A weaker economic outlook suggests a cautious approach to equities, but remember, equities discount the future. A break to new highs for the S&P 500 may foreshadow an improvement in data, just like it preceded the slowdown in 2018 (alternatively, a break to new lows might signal a coming recession). But as of today, neither is the case – equities are still rangebound and economic data is mixed. We aren’t out of the woods yet.
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