As we have discussed over the past few years, it is the consumer who is the main driver for the rest of the economy. Consumer spending, at about 70% of GDP, is the determining variable for the direction of industrial production, capital spending (Capex), and corporate profits. Quarterly earnings and to a lesser extent interest rates are the key factors to the direction of stock prices. Consumer spending drives employment, not vice-versa, as is generally believed. Therefore, an increase in spending will lead to rising employment and wage and salary growth. Currently this growth remains sluggish as the surplus of available labor persists. Serious structural problems have increased the natural rate of unemployment to 6%, up from 5% prior to the “Great Recession.” However, even monthly increases around 200,000 net jobs (204,000 average in 2013) will gradually reduce the labor overhang and broaden consumer spending.
With employment gains expected to remain lower than previous business cycle recoveries, the releveraging of consumer debt is another potential source of consumer demand. After peaking at a record 135% of disposable personal income in 4Q2007, debt has stabilized at about 110%. It is revolving credit (primarily credit cards) which has fallen markedly since the financial crisis. After net liquidation in 2009-2010, credit growth was flat for two years and up only 0.8% in 2013. To put this in perspective, revolving credit grew on average 10% annually from 1987-2007. Since much of the use of credit card debt depends on labor market conditions and the level of consumer confidence, we would expect gradual increases in credit releveraging in line with moderate increases in employment.
The financial health of US corporations remains excellent. In fact, according to the Federal Reserve Flow of Funds, the net worth of nonfinancial corporations was a record $120 trillion at the end of 2013. Of this total, slightly more than $2 trillion was cash. To date, the much anticipated increase in Capex has not materialized. Historically, Capex, mainly outlays on plant and equipment, are closely tied to the production cycle which is dependent on consumer spending. Although consumers are spending, it is well-below (normal levels) and it has been erratic. Also, technological advances have kept the capacity utilization rate, 78.8% in February 2014, at levels below the 80.1% long-run average (1972-2013). Recent government and private surveys suggest a pickup in 2014, but so too did those surveys last year. The Capex cycle, when it begins, is long term and peaks two-to-four quarters after the peak in industrial production. Needless to say, corporations when ready, have ample funds on hand to finance these fixed investments.
Along with the consensus, we believe 2Q2014 will be the “snap back quarter” as the economy grows above trend. A 4% real GDP rise is not out of the question. Going beyond the quarter, we expect to transition from the “new normal” to the “old normal” to become more apparent as private sector growth returns to its historical relationships. The housing recovery is maturing and home price increases will slow. Inventory levels remain low and housing starts will begin to fill the gap as we move through the spring and summer. We expect housing affordability to remain high as incomes rise and mortgage rates remain historically low. Longer term we anticipate the institutional participation in the buy-to-rent market will turn to a consumer rent-to-buy phenomena.
The return to the business cycle as we historically know it will not be smooth. The global economy, heralded as the growth engine of the future only a few short years ago, is experiencing growing pains and geopolitical problems. Among these are:
• China’s policy modification is shifting toward reform with more tolerance for slower growth in the short run. Forecasts for GDP have come down from 7.6% -7.8% to 7.2%-7.3% for 2014. As China continues to fine tune policy fears of a hard landing, along with rising US interest rates, could set off another Emerging Market meltdown.
• Developing markets will continue to experience erratic growth as their external vulnerability to interest rates and inadequate domestic policies go unattended. Such conditions lead to uncertainty and in some cases, political unrest.
• The potential of economic instability in Europe as low inflation levels (+0.7%) and marginal real GDP (+0.5%) leave the EU vulnerable to any external shock which may come from a protracted period of security tension with Russia. The possibility of interruptions to the European gas supply (Gazprom supplied 30% of EU gas in 2013) and upward pressure in military budgets are potential negatives to already weak growth.
Our investment policy remains long-term optimistic on corporate equities. The recent stock market sell-off following the new Chairman’s news conference highlights the technical vulnerability of equities, but is not indicative of any change in Fed policy. The sell-off was centered around momentum stocks, such as biotech and high beta technology issues whose valuation prompted high short positions by trading firms. This adjustment, when completed, will offer a buying opportunity. Contrary to most strategists, we believe that continued economic growth, accompanied by rising real interest rates, will result in a multiple expansion for equities.
Hutchens Investment Management
Hutchens Investment Management