Today’s commentary
Most economic analysts are in a bullish frame of mind regarding the outlook for 2014. I believe 2014 will be better than 2013. Nevertheless, there are risks to this optimism, both regarding the real economy and the valuation of shares. Below are some highlights on where some of the hidden risks lie. I am relatively bullish on the cyclical data. So that puts me in the consensus. However, some of the analysts I speak to regularly have a much more cautious view and I wanted to write this post to frame where their caution is coming from.
Most analysts looking at the global landscape see the traditional risks of slow job growth, particularly in Europe, as the main risk to the economy. So I will start here. Jobs matter because consumers contribute two-thirds of the consumption within an economy and everything follows from there.
Business Cycle
The way I look at the economy, there are four horsemen. And you can sum it up this way:
- How much we work: employment, jobless claims
- How much we earn: real wage growth
- How much we spend: retail sales, personal consumption expenditures
- How much we make: GDP, output, industrial production
If people don’t have jobs, they can’t spend. And that spending matters because households are the engine of growth, in North America and Europe at least. So, a good way to think about this is that real wage growth and jobs are they key input to the business cycle in terms of cause and effect. The sequence goes: job and wage growth to consumer spending and retail sales growth to more output and higher GDP to increased capital spending and corporate profits to more jobs and higher wages. At some point that cycle reverses but that’s how it works in the up-cycle.
Wages and Jobs
As I have noted repeatedly, wage growth in the US and the EU has been abysmal. For example, in the UK, living standards are expected to be lower in 2015 than they were in 2010 because inflation has outstripped wage growth. This year is the fifth on the trot in which inflation outpaced wage growth. In Europe, the economic model is built on suppressing wages to remain competitive externally. And while this gooses GDP growth via a positive external balance, it harms domestic demand and acts as a deflationary anchor within the economy. Yesterday, I noted that while Germany has led the way in enacting this model, others in Europe are following suit, even while Germany has lifted some of the wage suppression tactics. Bottom line: Low wage growth is bad for growth, both in Europe and the US.
But of course job growth has been suspect as well. Canada, the US and the UK have fared well. But Europe is not doing as well. For example, overall eurozone employment was stagnant, showing no growth in the third quarter. In Greece unemployment rose to a record 27.4% in September. In Italy, it is at 12.5%, with youth unemployment at a record high. And while the fourth quarter looks better, with France showing its first job increase in 30 months, Irish unemployment at the lowest since 2009 and eurozone unemployment falling for the first time since 2011, there are a lot of new problems. Germany, for example, is showing weakness here with unemployment at the highest level in 2 1/2 years. The structural issue of youth unemployment could mean these issues last for years. Youth unemployment in the eurozone is at a record high 24.4%.
Bottom line: the numbers still look awful in Europe and it is not at all clear they are improving. The risk here is that they are not. And since cyclical upturns begin and end with jobs and wages, that’s the major risk for Europe.
I believe we are seeing enough improvements to make this cyclical recovery durable. But I could easily be wrong. We will just have to wait and see.
Retail Sales and GDP
In the US, where we see better jobs numbers, my biggest concern is retail sales. An article in the LA Times points to heavy discounting by retailers who are apparently seeing slower than anticipated sales and want to slash inventories before the holiday season ends. Polling data suggest that US retail sales intentions are modest. But the latest concrete data show sales climbing above expectations. But because Q3 was all about inventory restocking in the US, retailers are going to be wary about being caught out with excess. They have to be cautious about fourth quarter demand. For more on this and on business investment, see my thoughts from last Thursday.
Bottom line: it isn’t clear how bullish the demand picture in the US is. If retailers get caught out with excess inventory, we are going to see an inventory purge and that will mean both weakness in terms of GDP growth and in terms of job growth. It could also negatively affect business capital investment. I expect this quarter to end near 2% on GDP growth, shading toward the lower side.
The good thing going forward in the US is that the fiscal drag is diminishing. The deal that was just cut on Capitol Hill means that there will be no shutdown and that the cuts to government spending will be even less than anticipated; they are lower than the sequester. This has to boost GDP estimates for 2014. The FT reports:
Michael Gapen of Barclays in New York said his estimate of the drag on growth from fiscal policy next year would fall from 0.5 to 0.25 percentage points, creating “upside risk” to his 2014 growth forecast of 2.4 per cent.
Right now, the latest Reuters poll shows a median GDP forecast for the economy to grow at an annualized 2.5% rate in the first quarter, reaching 3 percent by year-end.
Credit
The missing factor in all of this is credit because debt-fuelled consumption is a big factor in our economies. During the bubble days, credit growth far outpaced wage growth because households leveraged up on the back of improving balance sheets due to the increase in house prices. There is some indication in Canada, the US and the UK that this is helping sustain this upturn. For example, in the US, both mortgage and consumer credit are expanding. In Canada, household debt is at record highs. And in the UK, where house prices are rising at ten times the pace of wages, growth estimates are being revised sharply higher.
This speaks to credit growth due to improved household balance sheets spurring consumption. Therefore, I was surprised to see this:
When thinking about how cycles change, year-over-year rates of change are the critical factor. And second derivative for credit growth numbers are down. Don’t look at the absolute levels, focus in on the change — the delta. I did not expect to see this, frankly. And I see the fall in credit growth as the most important sign demonstrating risks.
Russell Napier explains this as a deflationary phenomenon emanating from Asia.
Napier wrote recently:
Inflation has fallen to 1.1% in the USA and 0.7% in the Eurozone and we are now perilously close to deflation. Reflation is needed to relieve debt burdens throughout society and in doing so to bolster corporate equity. Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt. In a market where such bad news has been seen as good news (as it leads to more QE), the reality of QE’s failure will become bad news as we head towards deflation.
When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past.
[…]
Deflationary winds are strengthening. Japanese corporations continue to cut their US-dollar selling prices, forcing Chinese and Korean exporters to follow suit. A further major fall in the yen would ratchet up the pressure. Meanwhile, broad-money growth remains anaemic across the developed world. In the USA, the Fed’s failure to create normal broad-money growth is intensifying as bank credit growth slows rapidly, while in the Eurozone, bank credit to the private sector is now contracting more rapidly than it did in 2009. The failure of monetary policy to defeat deflation is about to become apparent, with dire consequences for equity prices.
Albert Edwards explains that this has meant earnings misses.
Thomson Reuters in its “This Week in Earnings” publication highlights that the rate of negative guidance has rocketed in recent weeks to unprecedented highs. They write, “So far, S&P 500 companies have issued negative guidance 103 times and positive guidance only 9 times. The resulting 11.4 negative to positive guidance ratio is the most negative on record by a wide margin. The highest N/P ratio prior to this quarter was Q1 2001, at 6.8. Currently, analysts expect earnings to grow 7.8% over Q4 2012. This estimate is down from the 10.9% estimate at the beginning of the quarter. Given the 0.4% expected revenue growth, it may be difficult to achieve profit increases of the magnitude currently expected.” If, as we suggested here last week, the margin cycle is turning down, profit forecasts over the next few weeks will be eviscerated. To me, this is consistent with recession.
My conclusion here then is that we should watch the inventory numbers in the US and credit growth in the US and Europe for macro signs that point to weakness. In terms of the market, Edwards’ chart is a good one. Negative to positive guidance ratios this large are alarming and could mean the market stumbles even if the real economy does not fall into recession as Albert thinks. We have been riding a huge wave of multiple expansion, with more than four-fifths of the rise in stocks over the last year coming from multiple expansion while only less than one-fifth has come from actual earnings growth. If the negative to positive guidance metric is a leading indicator of what to expect, it would make the market vulnerable to a long overdue correction.
I will conclude just by noting that, despite the foregoing, I am still positive on the economy, which is supportive of stocks, mildly bearish for bonds.
Detailing some risks to the global economy
Today’s commentary
Most economic analysts are in a bullish frame of mind regarding the outlook for 2014. I believe 2014 will be better than 2013. Nevertheless, there are risks to this optimism, both regarding the real economy and the valuation of shares. Below are some highlights on where some of the hidden risks lie. I am relatively bullish on the cyclical data. So that puts me in the consensus. However, some of the analysts I speak to regularly have a much more cautious view and I wanted to write this post to frame where their caution is coming from.
Most analysts looking at the global landscape see the traditional risks of slow job growth, particularly in Europe, as the main risk to the economy. So I will start here. Jobs matter because consumers contribute two-thirds of the consumption within an economy and everything follows from there.
Business Cycle
The way I look at the economy, there are four horsemen. And you can sum it up this way:
If people don’t have jobs, they can’t spend. And that spending matters because households are the engine of growth, in North America and Europe at least. So, a good way to think about this is that real wage growth and jobs are they key input to the business cycle in terms of cause and effect. The sequence goes: job and wage growth to consumer spending and retail sales growth to more output and higher GDP to increased capital spending and corporate profits to more jobs and higher wages. At some point that cycle reverses but that’s how it works in the up-cycle.
Wages and Jobs
As I have noted repeatedly, wage growth in the US and the EU has been abysmal. For example, in the UK, living standards are expected to be lower in 2015 than they were in 2010 because inflation has outstripped wage growth. This year is the fifth on the trot in which inflation outpaced wage growth. In Europe, the economic model is built on suppressing wages to remain competitive externally. And while this gooses GDP growth via a positive external balance, it harms domestic demand and acts as a deflationary anchor within the economy. Yesterday, I noted that while Germany has led the way in enacting this model, others in Europe are following suit, even while Germany has lifted some of the wage suppression tactics. Bottom line: Low wage growth is bad for growth, both in Europe and the US.
But of course job growth has been suspect as well. Canada, the US and the UK have fared well. But Europe is not doing as well. For example, overall eurozone employment was stagnant, showing no growth in the third quarter. In Greece unemployment rose to a record 27.4% in September. In Italy, it is at 12.5%, with youth unemployment at a record high. And while the fourth quarter looks better, with France showing its first job increase in 30 months, Irish unemployment at the lowest since 2009 and eurozone unemployment falling for the first time since 2011, there are a lot of new problems. Germany, for example, is showing weakness here with unemployment at the highest level in 2 1/2 years. The structural issue of youth unemployment could mean these issues last for years. Youth unemployment in the eurozone is at a record high 24.4%.
Bottom line: the numbers still look awful in Europe and it is not at all clear they are improving. The risk here is that they are not. And since cyclical upturns begin and end with jobs and wages, that’s the major risk for Europe.
I believe we are seeing enough improvements to make this cyclical recovery durable. But I could easily be wrong. We will just have to wait and see.
Retail Sales and GDP
In the US, where we see better jobs numbers, my biggest concern is retail sales. An article in the LA Times points to heavy discounting by retailers who are apparently seeing slower than anticipated sales and want to slash inventories before the holiday season ends. Polling data suggest that US retail sales intentions are modest. But the latest concrete data show sales climbing above expectations. But because Q3 was all about inventory restocking in the US, retailers are going to be wary about being caught out with excess. They have to be cautious about fourth quarter demand. For more on this and on business investment, see my thoughts from last Thursday.
Bottom line: it isn’t clear how bullish the demand picture in the US is. If retailers get caught out with excess inventory, we are going to see an inventory purge and that will mean both weakness in terms of GDP growth and in terms of job growth. It could also negatively affect business capital investment. I expect this quarter to end near 2% on GDP growth, shading toward the lower side.
The good thing going forward in the US is that the fiscal drag is diminishing. The deal that was just cut on Capitol Hill means that there will be no shutdown and that the cuts to government spending will be even less than anticipated; they are lower than the sequester. This has to boost GDP estimates for 2014. The FT reports:
Right now, the latest Reuters poll shows a median GDP forecast for the economy to grow at an annualized 2.5% rate in the first quarter, reaching 3 percent by year-end.
Credit
The missing factor in all of this is credit because debt-fuelled consumption is a big factor in our economies. During the bubble days, credit growth far outpaced wage growth because households leveraged up on the back of improving balance sheets due to the increase in house prices. There is some indication in Canada, the US and the UK that this is helping sustain this upturn. For example, in the US, both mortgage and consumer credit are expanding. In Canada, household debt is at record highs. And in the UK, where house prices are rising at ten times the pace of wages, growth estimates are being revised sharply higher.
This speaks to credit growth due to improved household balance sheets spurring consumption. Therefore, I was surprised to see this:
When thinking about how cycles change, year-over-year rates of change are the critical factor. And second derivative for credit growth numbers are down. Don’t look at the absolute levels, focus in on the change — the delta. I did not expect to see this, frankly. And I see the fall in credit growth as the most important sign demonstrating risks.
Russell Napier explains this as a deflationary phenomenon emanating from Asia.
Napier wrote recently:
Albert Edwards explains that this has meant earnings misses.
My conclusion here then is that we should watch the inventory numbers in the US and credit growth in the US and Europe for macro signs that point to weakness. In terms of the market, Edwards’ chart is a good one. Negative to positive guidance ratios this large are alarming and could mean the market stumbles even if the real economy does not fall into recession as Albert thinks. We have been riding a huge wave of multiple expansion, with more than four-fifths of the rise in stocks over the last year coming from multiple expansion while only less than one-fifth has come from actual earnings growth. If the negative to positive guidance metric is a leading indicator of what to expect, it would make the market vulnerable to a long overdue correction.
I will conclude just by noting that, despite the foregoing, I am still positive on the economy, which is supportive of stocks, mildly bearish for bonds.