CAPTRUST Chief Investment Officer
The fundamentals of the U.S. economy are strong. Corporate profits have increased, while unemployment has declined. We are heartened to see corporations reinvesting in their businesses. In response to the incentives provided in last year’s Tax Cuts and Jobs Act, companies are funding projects that have the potential to fuel future growth, productivity gains, profits, and wage increases.
We are grateful for these sunny conditions even as we recognize some implications, such as employers’ difficulties in recruiting and retaining skilled workers and the impact of rising mortgage rates and home prices for first-time buyers. And we are mindful of clouds on the horizon, including the potential impacts of trade disputes, slowing growth outside the U.S., and higher interest rates.
In our investment strategy review, we will examine three themes. They are:
- So far, corporations have been able to reinvest their tax reform windfalls in both stock buybacks and capital expenditures, a good sign for future growth prospects.
- The global economy shows strong fundamentals, but unease over trade tensions could hamper business and consumer confidence.
- Higher interest rates are a mixed blessing—with savers benefitting and borrowers feeling the pinch—and should be viewed as normal for the level of economic growth and inflation we are experiencing.
Both Stock Buybacks and Capex
Following the passage of the Tax Cuts and Jobs Act last December, many pundits wondered how corporations would invest the windfall created by lower corporate tax rates and repatriated foreign profits returning to the U.S.
In recent years, companies have increasingly chosen to use profits to buy back their own shares in lieu of reinvesting in facilities, equipment, technology, and other projects that fuel future growth. Although it is still too soon to tally the results, early data suggests that companies have been able to find room for both on their plates.
In the first half of 2018, S&P 500 companies spent $380 billion on share repurchases, a 50 percent year-over-year increase. These buybacks have modestly increased earnings per share and pushed up stock prices. Recent share buyback activity has been concentrated in large-cap technology companies, driven by repatriation of foreign profits.
While a $125 billion increase in stock buybacks is meaningful, this amount reflects just 25 percent of total fiscal stimulus that companies have received so far this year. Even after funding share repurchases, companies have plenty of cash to fund other activities, including pension contributions, merger and acquisition activity, dividends, debt repayment, and capital expenditures. This business reinvestment through capital expenditures is vital to gross domestic product (GDP) growth and, potentially, the extension of the business cycle.
U.S. companies have reported a sharp acceleration in capital expenditures in the second quarter of 2018, a 22 percent year-over-year increase and the fastest pace of reinvestment since 2011. This level of reinvestment equates to almost 14 percent of second-quarter GDP. Further, business reinvestment has occurred across a variety of business categories, with greater activity from the sectors that benefitted the most from last year’s tax reform.
Figure One: Property and Equipment—Average Age (in Years)
Source: Strategas, Cornerstone Macro
The average business machine in use today is 16 years old. Not since the mid-1960s have companies used such aged equipment. Just imagine reading this article on the screen of a 16-year-old Nokia 6600 cell phone, circa 2002. A refresh cycle of corporate reinvestment should improve efficiency and expand production and result in wages growing alongside profitability.
Several trends could extend the reinvestment cycle into 2019 and beyond, including high levels of business confidence—a necessary ingredient for businesses to commit to investing and funding expansion—and a trend toward on-shoring manufacturing in reaction to trade tensions with China.
Mostly Sunny, Partly Cloudy Economy
This year, the U.S. economy has seen an acceleration in growth, with second-quarter real GDP growth of 4.2 percent, the highest level in the past 15 quarters. In September, we saw record levels for both National Federation of Independent Businesses Index of Small Business Optimism and manufacturers’ optimism.1 Positive sentiment like this creates an environment that supports continued growth.
Figure Two: Small Business Optimism Index
Source: National Federation of Independent Businesses
Other measures of economic activity have also strengthened, including an uptick in the Purchasing Managers’ Index, an indicator of activity within the manufacturing and service sectors, and an increase in truck orders, which many view as a leading indicator of future activity.
Against this backdrop of strong economic growth, the U.S. unemployment rate has continued its decline to a level of 3.9 percent, relative to a 50-year historical average of 6.2 percent. This tightening of the labor force has made it increasingly difficult for companies to hire the right people, which could become a headwind for future growth. Survey data from the National Federation of Independent Business show business owners reported finding no qualified applications for roughly 50 percent of positions in 2018, compared to 40 percent in 2013.
Figure Three: Level of Difficulty in Finding Qualified Applicants for Job Openings
Source: National Federation of Independent Business
A strong job market is pressuring businesses to raise wages for lower-skilled workers. Several large retailers have raised their minimum wages in the tight labor market, and policymakers in several states are working to increase the levels of hourly pay. In California, the state’s minimum wage is set to rise to $15 an hour in 2022. Such a boost in wages could lure some non-participating workers, who have been sitting on the sidelines since the financial crisis, to return to the workforce.
One recent example is the online retail giant, Amazon, that recently announced an increase of its nationwide minimum wage to $15 an hour, up from $11 an hour, for warehouse jobs in some markets. Amazon employs almost 600,000 workers. Such increases signify a high level of business confidence on the part of employers and represent a welcome income boost for some hourly workers who have not participated in the past decade’s recovery.
Looking into 2019 and beyond, we expect the U.S. economy to continue growing but at a slower pace as the stimulating effect of the corporate tax cuts begins to fade. Further, rising interest rates and trade concerns could begin to erode consumer and business confidence, taking some wind out of the economy’s sails.
In contrast to the mostly sunny skies in the U.S., the rest of the world is experiencing cloudier conditions, as reflected in global stock market returns. So far in 2018, international developed market stocks are slightly negative, while emerging market stocks experienced a sharper decline, hurt by a strengthening dollar, trade conflict concerns, and softening conditions in China.
The Chinese government has taken steps to stabilize the economy and expressed an interest in stabilizing its currency after a 10 percent yuan devaluation over the summer sparked turmoil in emerging markets. Developing countries, including Turkey, Argentina, and Russia, are also putting in place more responsible, stabilizing policies.
China has also announced massive expansionary policies, including interest rate cuts, tax cuts, and inducements for lending. These measures may help buffer companies from the potential impact of U.S. tariffs and boost corporate earnings. Because Chinese companies make up more than 30 percent of major emerging markets stock market indexes, a recovery in the Chinese market could improve the performance of emerging markets assets.
For long-term investors, the silver lining in emerging markets may be their more attractive valuations relative to other parts of the world. And although emerging market stocks do not typically represent a large weight within portfolios, they remain an important strategic tool for diversification.
As in previous quarters, trade concerns remain a source of worry, and tariff imbalances could be damaging to domestic producers. For example, domestic automobile production declined by 22 percent from 1990 to 2017 because of tariffs, even as Americans continued to purchase cars at record levels.
The stakes are high; free trade is of vital importance to increase consumers’ access to higher-quality, lower-priced products, while reducing production cost for businesses, thus promoting economic growth and enhancing standard of living. It promotes competition and allocates workers and resources more efficiently as businesses adapt to meet the demands from global markets.
Higher Interest Rates—A Mixed Blessing
The U.S. Federal Reserve has raised short-term rates eight times since December 2015, with an increase each time of 0.25 percent. Higher rates can have both positive and negative effects—benefitting savers seeking income, while causing borrowers’ mortgage and other debt payments to rise.
Figure Four illustrates the mixed blessings of higher interest rates by examining the rising income generated by $250,000 of savings compared to the rising cost of a $250,000 mortgage. With the increase in short-term rates from 2015 to 2018, the saver would benefit from $5,085 more in annual income. The homebuyer, on the other hand, would see his mortgage payment increase by $1,229 per year, based upon the increase in mortgage rates over the same period.
Figure Four: Impact of Rising Rates on Savers and Borrowers
Source: Bloomberg, Treasury.gov
The fed funds target rate is currently at 2 to 2.25 percent, and market participants expect one more hike in 2018 and two or three more hikes in 2019 as the Fed brings rates back to the long-term neutral level. As former Fed Chair Janet Yellen noted, “The neutral real rate depends on a variety of factors—the stance of fiscal policy; the trend of the global economy, which shows up in our net exports; the level of housing prices; the equity markets; the slope of the yield curve or the term premium built into the yield curve. So it changes over time.”2
Recent inflation data—with the core Consumer Price Index at 2.2 percent—appears healthy and manageable and remains close to the Fed’s 2 percent target. We do not expect that we will enter an era of high inflation any time soon. In fact, the Fed’s pattern of rate increases reflects expectation of a strengthening U.S. economy and the end of an accommodative low-interest-rate policy that is no longer appropriate for an economy out of recession. These higher rates should be viewed as normal for the level of economic growth and inflation we are experiencing.
So far, the Fed has been cautious and patient in raising rates, and unlike the bond “taper tantrum” of 2013, we believe that gradually increasing rates won’t surprise the markets.
As interest rates have risen unevenly, with rates for shorter maturities rising faster than longer maturities, many market watchers have pointed to the possibility of an inverted yield curve as a recession warning signal. Although an inverted yield curve has preceded every recession of the past six decades, it does not cause an immediate recession or market sell-off, and positive stock returns can persist for some time after an inversion occurs. As Figure Five shows, there are often opportunities for significant stock market returns even after the yield curve inverts.
Figure Five: Last Five Recessions and Subsequent Stock Market Returns
Source: Strategas, Federal Reserve
Overall, measures of economic activity show a strengthening economy. Several trends could extend corporations reinvesting in their businesses into 2019, including high levels of business confidence and a trend toward onshoring manufacturing in reaction to trade tensions with China.
For 2019 and beyond, we expect continued growth but at a slower pace. While record levels of optimism have created an environment that supports continued growth, the tightening of the labor force is making it difficult for companies to hire the right people.
Rising interest rates and unease over trade tensions could begin to erode consumer and business confidence, while steps taken by China to stabilize and stimulate its economy could help reduce the pressures faced within emerging markets.
We continue to watch for an inverted yield curve, although we do not see it as an indicator of an immediate recession or market sell-off. Further, positive stock returns can persist for some time after an inversion occurs.
1 “2018 Third Quarter Manufacturers’ Outlook Survey”, National Association of Manufacturers, 2018.
2 “What Is Neutral Monetary Policy?”, Federal Reserve Bank of San Francisco, 2005.