December Economic Update
The US economy has been showing signs of weakness lately, which made the Fed’s decision to hike rates on Wednesday a bit of a head scratcher. In early December Citibank announced that given the turn in corporate profits and concerns over margin sustainability, it had raised the probability of a recession within the next year to 65%. Shortly thereafter JP Morgan put the probability of a recession within three years at 76%.
Durable goods orders have recently been at levels not seen outside of a recession.
ISM Manufacturing PMI Composite Index just moved into contraction territory and is at its lowest level since June 2009. This is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.
When this data came out, many claimed that in the more service-oriented domestic economy, it can be disregarded because manufacturing has become a smaller part of the U.S. economy over the years. That is true, but there is also a strong correlation between the PMI index and the S&P 500, as is evidence in this next chart. Manufacturing itself may be a smaller portion of the economy, but it is still meaningful. This is all about probabilities, so I like to look at a wide range of data points to develop a perspective, this is a metric that many ignore, but to me looks like a fairly reliable indicator.
Retail sales have also been flashing warning signs, with the three month moving average of year-over-year changes in retail sales at levels not seen outside of a recession. I use the three-month average because retail sales are notoriously volatile on a month-to-month basis, materially affected by seasonal events such as Valentines Day, Easter, back-to-school and the holiday season.
If we also look at the economic cycle length, we can see that the economy is likely in the later stages of this business cycle, as we are 78 months from the last trough.
On Friday December 11th, we learned that November retail sales were weaker than expected, marking the twelfth consecutive month that sales were below expectations. The miss was driven by declines in auto and gas station sales. Over the past year, we’ve seen declining purchases at gas stations, for clothing, electronics and appliance but we do seem to be going out more as sales at bars and restaurants are up, as are motor vehicle and parts dealer sales. Overall though, retail sales are not painting a very robust picture relative to typical growth, but given weak wage growth, this isn’t surprising.
The headlines for employment have been looking pretty solid lately and are much of the reason behind the Fed’s rate hike, but I still see reasons for concern, wage rates are still well below their highs from over 15 years ago and there are a lot more people employed part-time, that want full time work. The chart below shows the percent of employees working part time because they couldn’t get a full time job began rising dramatically since the financial crisis and remains at levels not seen in the past 20 years; a reminder that headline numbers can be misleading. According to Hillary Clinton, this is partly due to incentive in the Affordable Care Act.
Many have been looking at housing starts claiming these indicate rebounding strength in the housing market, but I like to look a bit further as I suspect there is more to the story. In fact, according to the National Association of Realtors, first-time homebuyers make up just 32% of all purchasers, lowest level since 1987! If we look at the typical first-time homebuyer, Millennials, it isn’t tough to see why. This group is saddled with unprecedented levels of student loans and have been facing one of the toughest job markets in decades. Yes, unemployment levels have been improving, but the mix of new jobs for these younger workers is skewed towards lower paying ones. They have lots of debt and are getting paid less than prior generations early in their careers, making it exceptionally hard to put together a reasonable down payment. Meanwhile home prices have been rising faster than median income levels thanks in large part to low inventory levels, making that first home more and more out of reach. This means that many Millennials are effectively cut off from what has traditionally been a solid path to building wealth in America, which will have long-term consequences as the senior generations look to downsize their homes, or their heirs look to sell their inherited residences.
Bottom Line: While some parts of the economy are still looking decent, like employment, there are more concerning signs of underlying weakness, which is reasonable given that we are in the later phase of the business cycle. We’ve already experienced three consecutive quarters of declining year-over-year revenues and two consecutive quarters of falling year-over-year earnings for the S&P 500, which makes specific security selection all the more important as the market in aggregate isn’t likely to grow dramatically in the near-to-mid term.
