Last week saw a pullback from record highs set in late August. Perhaps we witnessed an infamous “double top” (January 26 and August 29). It is clear that financial markets have become riskier, and, perhaps, it is time for investors to assess the risks inherent in their portfolios versus the prospects of future returns. There is a short-term and a long-term view, neither of which augurs for higher concentrations of equities in portfolios.
The Short-Term View
Look around the world. With chaos emerging almost everywhere, can the U.S. be the only bastion of economic strength? Or, is it just sitting in the eye of the hurricane? Maybe that description is a little too dramatic, after all, the U.S. economy is still healthy, but, the rest of the world isn’t:
- The emerging market economies (EM) are under considerable duress. Besides the melt-down in Turkey, South Africa’s currency plunged as its GDP print for Q2 put its economy officially into recession (two consecutive quarters of negative GDP growth). Indonesia’s currency is reeling, and its stock market is at a three-year low. Argentina can’t seem to shake off its currency woes despite a record level of International Monetary Fund support. China’s stock market remains in bear market territory (down 25% from its peak). And, as of Friday, September 7th, the MSCI EM Index officially entered bear market territory (down 20% from its peak). What makes the U.S. so special? From an historical perspective, there has always been significant fallout on developed economies when EM economies crumble like they are doing today!
- The developed world, outside the U.S., is also clearly decelerating. If you count China as “developed,” there is cause for pause as all of the data indicate significant economic deceleration. The latest data out of Germany, the best barometer for the EU, are flat to negative, clearly showing slower growth (albeit not yet indicating recession). And, we haven’t heard the last of Italy’s budget and deficit issues or the trials and tribulations of the U.K.’s Brexit quandary;
- Then, there is the clear softening of worldwide trade flows, much of which has been attributed to Trump’s tariff policies.
Let’s face reality: there is no such thing as global decoupling. The U.S. is not an isolated island, and there is no doubt that the global economy is rapidly cooling. Once the fiscal stimulus of the tax cuts has run its course, the U.S. economy, too, will slow. Don’t forget, the multinational corporations now have two significant headwinds: 1) the rising value of the dollar which lowers the dollar value of their foreign earnings; and 2) slowing worldwide demand from the global cooling described above. The growth in corporate profits is sure to be impacted.
Employment: Less Than Meets the Eye
The September 7th Employment Report was wildly cheered by Wall Street as showing a continuation of a strong and accelerating economy. But a closer analysis indicates that the changing school year start date likely distorted the data.
- The 201,000 gain in the Establishment Survey’s nonfarm payrolls was slightly above the 191,000 expectation. No one talked about the 50,000 downward revisions to June and July or the fact that the August start to the school year, an accelerating trend in America, biased the seasonal adjustment process (showing a 53,000 boom in the number of education positions, a number that is clearly out of bounds). Adjusting for those two puts the net number closer to 100,000 than 200,000.
- Also, not widely discussed, was the Household Survey’s net loss of 423,000 jobs. The headline unemployment rate (U3), itself, is based on this Household Survey. The consensus expectation was for a fall in U3 from 3.9% in July to 3.8% in August. The only reason that the rate did not rise to 4.0% is because the labor force participation rate and its sister index, the employment/population ratio both fell. Some of the employment decline and fall in the ratios is likely due to the shifting start to the school year and students returning to class earlier than the seasonal factors can explain.
So, all in, the August employment data are too distorted to tell us anything new.
Fed Policy Poses Risks to Equities
In the U.S., housing is weak, auto sales are slumping, and now, the latest data show a significant upsurge in wage inflation. The wage data from the employment survey (up 0.4% in August from July – a 4.8% annualize growth rate) was a significant upside surprise to the consensus estimate of 0.2%, and this has raised the year over year increase to 2.9%. Several more months like August will soon have this year over year rate approaching 4%, making it a near certainty that the Fed will continue its rate raising regime. Increases for September and December are now all but baked in. As I have described in past blogs, the Fed has way overstayed its easy money policy, and now that inflation is clearly emerging, it, the Fed, will have little choice but to continue on its rate-raising course even while the economy is decelerating. The risk here is that, as they have done in every post-WWII economic cycle, because they are guessing at the impact and lags of their policies, they will likely step on the brakes too hard and cause a recession. This isn’t inevitable; they could do something different, but, at the present time, we appear to be in lock-step with the historical pattern. Clearly, Fed policy should be a short-term concern for equity investors.
The Long-Term View
Besides short-term stress, risk can also be viewed on a longer-term basis, especially if the investor is young enough to withstand a bear market or two. The critical focus for this group should be the future economic growth rate/potential of the economy.
In my last blog, I remarked that Wall Street’s new definition of a bull market (the lack of a 20% correction) was manufactured for current consumption and to continue the rosy market narrative. My question was: “If we had a long period of a flat market but with no 20% correction, would that still be a bull market?” For the past 10 years, we have had a great run in equities with the S&P 500 up more than 400% from its ’09 low. Investors should ask themselves why they think this actually could continue.
Economic growth occurs if more people are employed and/or productivity of the labor force rises, both of which appear harder to attain in today’s world:
- The biggest complaint today’s businesses have is the lack of qualified employment applicants. The labor supply is drum tight; the Bureau of Labor Statistics estimates that the labor force will grow by a mere 0.5% annually over the next 12 years. While productivity did advance in Q2 (+2.9%), its long-term trend has been flat since 2015. If that long-term trend continues, the prospects of strong economic growth diminish;
- Most employers will tell you that not only are qualified applicants difficult to find, but the Millennial generation has a different attitude toward work than older generations. Productivity gains, therefore, appear to be harder to achieve;
- No doubt advancing technology is a plus for productivity growth. Normally, we see such advancements when businesses, looking for organic growth, expand with new plant and equipment. Today, there is much more emphasis on a company’s growth through acquisition, not the old organic way. Today’s economy features the Baby Boom generation, who are downsizing and withdrawing funds from retirement accounts, and the Millennials, who eschew ownership and possessions in favor of experiences. As a result, new plant and equipment aren’t needed, and the older technology embedded in older assets is made to last longer.
Conclusions
For all of the short-term reasons (EM issues, worldwide economic cooling, the Fed’s need to raise rates), and long-term ones (demographics and labor force growth, attitudes toward work and ownership, lack of new investment in plant and equipment, retirement fund withdrawals), potential future economic growth appears to be quite modest, if not fragile. Granted, today’s markets are being held up by unusual circumstances like worldwide money printing, but it is a near certainty that the performance of the equity market indexes over the next ten years will not be a repeat of the last ten. What if my scary thought that, “because potential economic growth is slow, the next bull market will be flat” becomes reality? Some data point to that possibility. It is unlikely that, under those conditions, today’s growth multiples like the PE ratio will hold. Perhaps now would be a good time for investors to reassess their portfolio risk.
