Thursday, August 1st, 2019
US economic expansion becomes longest in history. This bull market has been built on low rates. Is time up?
The US economy is enjoying its longest uninterrupted stretch of expansion since the 1850s, despite the eurozone crisis, slowdown in China, and now trade wars. Recessions are typically defined as two consecutive quarters of shrinking gross domestic product. The National Bureau of Economic Research (NBER) — the semi-official arbiter of US booms and busts — reckons the current expansion started in June 2009. That means that this month the US expansion has now hit its 121st month, making it more than twice as long as the average post-WWII expansion.
Source: FT, NBER
This year, the US economy expanded at an annualised rate of 3.2% in the first quarter, and has since slowed, but still growing by about 1.5% according to the Atlanta Fed’s “nowcasting” model.
A weak and patchy recovery
The chart below, from RBC Capital Markets, compares the length of different economic expansions by time with the total percentage growth achieved while they lasted. The expansions associated with Presidents Ronald Reagan (brown line) and Bill Clinton (blue line) were shorter, but more robust. Couple the slowness of this recovery (the yellow line) with the lack of wages growth and the deepening of inequality and we can see why this expansion is far less convincing than its predecessors.
Source: RBC Capital Markets, Bloomberg
Some commentators worry that the expansion will probably end soon. As uncertainty around trade policy remains unresolved, manufacturing data around the world drops markedly, and inverted yield curves signal disturbing trends, concern about the outlook is becoming more pronounced. Business confidence and corporate investments have slowed to multiyear lows. Major global institutions like the World Bank highlight trade tensions and subdued investment.
According to the World Bank’s economists,
“Global growth has continued to weaken and momentum remains fragile. Downside risks to growth predominate, including rising trade barriers, a build-up of government debt, and deeper-than-expected slowdowns in several major economies. Substantial challenges are clouding the global economic outlook in both the near and long term. Global growth in 2019 has been downgraded to 2.6%, a reduction of 0.3% from previous forecasts, reflecting weaker than expected international trade and investment at the start of the year. Growth is projected to gradually rise to 2.8% by 2021, predicated on continued benign global financing conditions.” … World Bank Global Economic Prospects (June 2019)
The post Global Financial Crisis recovery has been weaker than most other economic recoveries since the second world war. US GDP is now about 20% bigger than its pre-GFC peak. In contrast, the 1990s boom increased the size of the US economy by about 40%.
Global manufacturing recession
One of the major economic concerns is the global manufacturing slowdown. Manufacturing indicators are showing worsening conditions across the globe, especially in the US, China, Japan and Europe. Pressures in the auto sector and concerns over tariffs have played a big role here. The global manufacturing Purchasing Managers’ Index (PMI), a survey of manufacturer sentiment, suggests a global manufacturing recession.
Source: Thomson Reuters, Evans & Partners
So far, the downturn has been concentrated in the manufacturing and construction sectors while the much larger services sector has shown resilience. Services tend to be less cyclical than manufacturing, and the expansion of services output and employment is one reason why the economic cycle has been so elongated.
High levels of employment and rising household incomes, characteristic of the late stages of the business cycle, have combined to sustain services sector growth over the last nine months. But it is unclear if the services sector can continue to keep the economy out of recession if manufacturing and construction continue to contract.
China leads the world in terms of manufacturing output, with over $2.01 trillion in output, followed by the US ($1.86 trillion), Japan ($1.06 trillion) and Germany ($700 billion). China, the US and Japan comprise 48% of the world’s manufacturing output.
The global economy is soft, even as markets rise. What about equity valuations?
Valuations are not at extreme levels, certainly nowhere near the levels they got to during the Tech Bubble in 2000, but they are above historical averages. High valuations are also why equity markets would be vulnerable to earnings disappointments.
US Price Earnings Ratio – 12 months out. If earnings come in lower than expected, the PE ratio will rise sharply (meaning shares become even more expensive) and/or prices will fall.
Source: Thomson Reuters Datastream, Evans & Partners
Similar factors apply in Australia. The forward PE ratio is trading at around 16x, close to the highest levels of recent years, and also vulnerable to any disappointment in earnings.
Source: Thomson Reuters Datastream, Evans & Partners
Just to complicate matters, if one were to measure the recovery of global sharemarkets since the GFC in terms of the gold price, the picture looks quite different. The chart below implies that the global sharemarket, if measured in units of gold, is vulnerable (but that could mean simply that the gold price is likely to rise more than sharemarkets). If you had held the majority of your assets in gold over the last 10 years, the share market might be looking rather cheap to you right now.
Source: Refinitiv Datastream, Stock Board Asset, Petra Capital
Markets are expensive. But what is the alternative?
Extreme valuations are not in themselves usually the cause of collapse in share markets. Not if history provides the guide. Typically, bear markets in Australian shares (a fall of more than 20%) follow declines in US markets. Over the last six decades, the ASX All Ordinaries Index has suffered 8 bear markets, where stocks fell on average by 37%, and lasted on average for 16 months. Bear markets have typically occurred every 7 or 8 years.
US bear markets usually coincide with American economic recessions. This appears from the chart below, where the pale grey vertical bars represent recessions. The chart illustrates a correlation between recession, rising bond prices (falling yields) and declining share prices. We have circled a few past recessions in red to highlight this relationship. Note this chart refers only to the US experience.
Source: Haver Analytics, U.S. Treasury Department, Guggenheim Investments
There is, as you would expect, a correlation between corporate earnings and stock prices. Thus if the US economy experiences a recession, and corporate earnings collapse, it seems likely that stock prices in the US (and probably also in Australia) will fall as well.
Source: Alpine Macro Global Strategy
Over the last few quarters, corporate profit growth has slowed sharply, and there are fears that earnings could contract over the next year. If this were to occur, moderately high PE ratios would suddenly look very stretched indeed.
In a poll of fund managers by Absolute Strategy Research’s Multi-Asset Survey, only a minority of 48% thought global corporate earnings would rise in the next year, the lowest percentage recorded since the survey began.
Source: ASR Ltd, Datastream from Refinitiv, Bloomberg
While the central banks maintain their dovish stances, investors will probably continue to embrace risk-taking, even if it means share prices are expensive. But we should pay attention to the various risks, including the slowdown of growth rates (especially manufacturing and more importantly, services), the difficulty of further reducing interest rates from already ultra-low levels, and rising trade and geopolitical tensions.
Although equity valuations are somewhat expensive, a sensible fund manager will still be able to find pockets of value – even when markets are generally stretched, driven by the “reach for yield” as alternative sources of income, like term deposits, decline. For equity markets, the weaker macro environment has not yet had a material impact on earnings, but this may become evident in the next reporting season.
A recession is far from inevitable – but the capacity for a decisive response (such as occurred in 2008/9) has been reduced. Back then, central banks either cut rates, bought up bonds, extended government backing to the financial sector, or did all of those things. This time around, it may be more difficult.
Central bankers have a mantra: “fix the roof while the sun is shining”. Investors should adopt the same strategy: review your asset allocation with your Financial Adviser while the markets are strong, and before a storm hits. It pays to be prepared.