United States: Newton’s cradle in motion
Market psychology has swung dramatically over the last 12 months. In early 2016, investors were worried about the risks of secular stagnation and a U.S. recession, but the narrative has veered in recent months toward the awakening of animal spirits. We continue to argue that the truth falls in the middle of these two extremes — that the U.S. economy is resilient but mediocre. This view has underpinned our "buy the dips and sell the rallies" investment strategy. As the market pendulum swings closer to euphoria, a more cautious strategy seems warranted.
Not buying into the idea of a 3% growth economy
One of the biggest puzzles that economists are grappling with in 2017 is the growing divide between strong survey-based measures of economic growth and sluggish statistics on actual economic activity, as illustrated in the chart below. Anecdotal evidence suggests that the strength in the surveys is being driven, in part, by anticipated pro-business policy changes from the Trump administration, specifically around corporate tax cuts and regulatory reform.
Large gap opening up between surveys and actual activity data
Source: Institute for Supply Management (ISM), Federal Reserve Bank of Atlanta, Russell Investments' calculations. Data as of March 8, 2017.
*The tracking estimate for final sales is shown (GDP excluding the volatile inventories category). The Composite ISM is a weighted average of the manufacturing and non-manufacturing surveys, which has been translated into an implied rate of real GDP growth using a regression.
Normally, we focus on the business surveys of purchasing and supply executives across the nation because they provide a smoother and timelier read on economic growth. However, because the recent improvement in business confidence appears to be contingent on fiscal policy change, we need to take a step back and look at how the Trump agenda is proceeding through Congress. Thus far, the debates on Capitol Hill around healthcare and tax reform have not been smooth, and both issues appear very contentious and complicated. In our view, fiscal stimulus increasingly looks like a 2018 story that could ultimately prove to be watered down relative to the big promises on the campaign trail. If we’re right about that, the gap in the chart above could close via a downshift in optimism as reflected in the surveys.
This is part of the reason we are stuck at a 2% GDP growth forecast. But there are also other, more fundamental forces driving our mediocre outlook. One indicator that stands out is zero growth in commercial and industrial loans over the last four months. This dynamic typically happens only when the economy is rolling over into recession. While that isn’t our view, we still think that fundamentals are only strong enough to warrant a mediocre U.S. growth outlook.
A less cautious Fed, but still hesitant to hike quickly
The Fed’s decision to hike the federal funds rate in March was ahead of schedule compared to our forecast for two hikes in 2017. Under the surface, it’s clear that the Federal Open Market Committee (FOMC) has become less cautious. Much of the shift can be attributed to their belief that downside risks from the global economy and particularly China have diminished. Nevertheless, we still think that it will be difficult for the Fed to maintain a much faster tightening cycle. As noted above, the U.S. growth outlook is middling. And wage growth — which accelerated meaningfully in late 2016 — has taken a pause. Fundamentals continue to support a gradual process. And in a world of divergent developed markets, an aggressive path risks U.S. dollar strength and damage to the global economy and markets. For now, we stick to a two-hike baseline in 2017. Risks are now skewed to a faster Fed, but the U.S. bond market is already pricing-in three hikes for the year. In our view, this means most of the damage to U.S. Treasuries is in the rearview mirror. We are less negative on bonds than we have been in prior quarters.
Market euphoria: will earnings growth justify it?
The S&P 500 is flirting with all-time highs and the market narrative has shifted from stagnation to animal spirits in a matter of months. Trying to time when market exuberance will meet reality can be more art than science. But our investment strategy building blocks of business cycle, valuation and sentiment clearly indicate that the risks for U.S. equities are now squarely to the downside. Corporate earnings have recovered, but we believe it will be very difficult for growth to push sustainably above 5%. Profit margins are very high and susceptible to downgrades as the labor market tightens. We remain cautious.
- Business cycle: Corporate profits recovered to 5% growth in the fourth quarter reporting season. Most of the earnings acceleration is likely in the rearview mirror at this stage, and consensus expectations at 11% still appear too optimistic. While we don’t see a recession in 2017, we also don’t see enough cyclical support to sustain the U.S. market at these valuation levels.
- Valuation: U.S. equities are very expensive — the Shiller P/E ratio1 for the S&P 500 is higher than ever outside of 1929 and the late 1990s. Our valuation modeling work also shows lower expected U.S. equity returns ahead.
- Sentiment: Our process captures a tug-of-war between strong momentum and an investor psychology that is complacent though bordering on euphoric. On net, our sentiment signals suggest caution is warranted.
- Conclusion: We continue to have an underweight preference for U.S. equities in global portfolios, primarily on the backs of expensive valuations and overbought sentiment signals.
1The Shiller P/E ratio for the S&P 500 is based on average inflation-adjusted earnings from the previous 10 years.