Markets Say Recession Over, But No Trump Boom Yet
Business recessions can happen when business contracts, but government spending and consumer spending do not contract along with it. GDP, which is the most widely used metric for determining recessions (indeed one of the dictionary definitions of a recession is two consecutive negative quarters of negative GDP growth), consists of consumption, investment, government spending and our foreign trade balance for the year. GDP does not count all the intermediate production steps by which businesses turn raw materials into finished goods. Instead, it only counts the purchase of the finished goods. This means that GDP is ‘biased’ towards the consumer sector and against the business sector.
Therefore, many business recessions are not identified by GDP-only based economic models, because quite often business contracts, but the overall economy does not. That’s because consumer spending is more stable than business production. Business tends to react with more agility to changing conditions, cutting back on output in response to economic conditions, gearing back up when conditions improve. However, consumers are less responsive to the economic cycle. As Milton Friedman proved (and this is what he won his Nobel for), people tend to spend according to their expectations of their long-term income. This is called the ‘permanent income hypothesis’. Unless people are really frightened by economic conditions (such as they were in the panic of 2008), they basically don’t change their behavior much in response to business cycles. Businesses on the other hand, by definition, do respond to business cycles
The above chart shows that we entered 2016 in the midst of a business recession which was held over from late 2015, but by the time 2015 ended, we likely were no longer in a business recession. Let’s look at profits
Profit Growth By Quarter
When we look towards the final consumption numbers (GDP), we see that the business recession of late 2015 to early contributed to a near technical overall recession. This is where GDP gorwth was brought down below 2% annualized for a couple of quarters. This means that government and consumer spending counterbalanced lower business output during this time.
This year-straddling, business contraction caused both years to end up with an average growth rate of GDP of 1.9%. This took what was already a sub-par recovery and made it worse. In the long-term annual GDP growth chart below, the gray bars represent recessions. Compare the periods between recessions to our period since 2009 and it is evident that the past seven years’ growth rates do not measure up.
So what about 2017? Markets are signaling an improved outlook, especially since the election, as we argued last year. So far the markets are signaling the same thing: copper prices, probably the best single comodity indicator of global gowth spike after the election.
Monthly Average Copper Price As of the End of the Year 2016
Prices increased by roughly 5% since the beginning of the year, which means market participants in the copper market became more optimistic about global growth in January.
When we adjust for inflation and for supply increases, our model shows that copper is signaling a slower than historical average global growth rate, but an improved outlook compared to a year ago.
Copper Real Price/Supply Forecasting Model
The difference in valuation between US stocks and US Treasury Bonds is a good measure of the level of growth expectations that investors have for US companies’ earnings growth rates, which are closely related to expectations of US economic growth rates. The reasoning is pretty simple: when investors are worried, they buy bonds (a ‘sure’ thing) and sell stocks (the earnings of which vary with economic conditions). This means that stocks get priced more cheaply than bonds. On the other hand, when investors are optimistic about the economy, they sell bonds (the low yield ‘sure’ thing) and buy stocks (a chance to cash in on future growth) and that makes stocks more highly valued than bonds. We use the Earnings Yield Premium (EYP), which is the difference between the stock yield and the 10 Year Treasury Bond Yield, to measure this effect. When investors are pessimistic, the EYP gets very large, reflecting the fact that they are only willing to own stocks when the earnings are very high in comparison with the price.
Earnings Yield Premium (EYP)
The data points shows that outlooks have improved quite a bit since the election, but that in the past month some of that optimism signal has reversed. Backing this up is the real 10 Year US Treasury Rate (chart below), which spiked after the election (a sign of growth expectations), but has been dropping since mid-December.
The bottom line is that the market outlook, and my base case, is that we are moving out of sub-par recovery territory into normality. A booming economy is out of the question, it’s just a little premature to make that call given the volatile political policy environment. Furthermore, if the White House embraces some sort of strong trade protectionism agenda or proposes radical moves like debt defaults or provokes hostile actions from countries which hold large quantities of US bonds (e.g. China) all bets are off. This period of policy uncertainty is a good time to be strongly diversified.
Originally published on Vident Financial.
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