CAPTRUST Chief Investment Officer
The U.S. economy had been sleepwalking for almost a decade. Now, caffeinated by the triple espresso of individual tax cuts, corporate tax cuts, and increased government spending, the U.S. economy has been jolted awake and has broken into a jog, which could increase in pace to a sprint if trade tensions don’t weigh it down. Meanwhile, the rest of world is sipping on Sleepytime Tea. International economies are continuing to grow, but at a slower rate.
Goodbye Synchronized Global Growth—Hello Increased U.S. Growth
Over the last two years, we have enjoyed a rare event—synchronized global growth—caused by China, Japan, the European Union and the U.S. all stimulating their economies via very low interest rates. This interest rate stimulus drove growth in both profits and employment. For the first time in a decade, all major economies were growing simultaneously, creating a self-reinforcing cycle that boosted global trade, production, and income. However, as countries began to diverge in their interest rate and tax policies, their growth trajectories have begun to diverge as well.
Figure One shows the Purchasing Managers' Index (PMI), a proxy for growth, for the U.S., Europe, China, and Japan. Beginning in June 2016, you can see a rapid and synchronized increase in growth for all countries, which continued through the end of 2017. However, since year end, you can see that the U.S. has hit new heights of growth, while the pace of growth in the rest of the world has slowed.
Figure One: Purchasing Managers' Index
Why the divergence? In a word: stimulus. The U.S. decided to use fiscal policy—specifically, lower taxes and increased government spending—to stimulate the economy; the other major economies did not.
In the U.S., the Federal Reserve has reversed its policy of extraordinarily low interest rates by increasing short-term interest rates from 0.25 percent to 2 percent and has begun to shrink the amount of Treasury bonds held in its portfolio. Instead of a policy of quantitative easing, the Fed has begun quantitative tightening in an attempt to return interest rates to a more normal level. Meanwhile, major central banks across Europe and Asia are still maintaining policies of very low interest rates.
This policy discrepancy has had the effect of strengthening the U.S. dollar. If U.S. bond yields are much higher than, for example, German bond yields, then more investors will sell their euros to buy dollars and use those dollars to buy U.S. bonds. U.S. bond buying by foreigners increases the foreign exchange value of the dollar (relative to the euro).
Figure Two shows that year to date, the yield on the 10-year U.S. Treasury bond has increased 0.45 percent—or 45 basis points—while the yield on the German 10-year bond has decreased 0.13 percent—or 13 basis points. This divergence has spurred the U.S. dollar to appreciate 2.7 percent against the euro. The stronger U.S. dollar has impacted stock prices, bolstering U.S. stock prices while hindering international stock prices. In short, higher U.S. interest rates led to a higher U.S. dollar, which boosted U.S. stock prices relative to international stock prices.
Figure Two: Divergence in Interest Rates and Exchange Rates
More Jobs Than Applicants
Figure Three illustrates the strength of the labor market, with more job openings than there are people seeking jobs. It would be natural to assume that, if there are more jobs than applicants, then wages would be increasing markedly—at a pace of 4 percent or more per year. However, we have seen much more modest growth in wages, with levels increasing at less than 3 percent per year.
Figure Three: More Job Openings than Job Seekers
Why the disconnect between employment and wages?
Many economists expected a growth spurt in wages two years ago, coinciding with an unemployment rate of 5 percent. But those making this assumption didn’t look across the globe for other examples. We see another major economy, Japan, with lower unemployment and wages that are growing even more slowly. However, while Japan is a major industrialized economy, there are important differences in the work environment. Japanese workers tend to stay with their employers much longer than U.S. workers (12 years versus 4 years). This reluctance in switching employers could explain the low wage growth in Japan.
Another perspective on wage growth comes from the definition of the unemployment rate. The unemployment rate counts only those looking for employment; it does not include discouraged workers who have given up looking for work. The percentage of people of working age who are participating in the labor force—either by working or looking for work—is near a 20-year low.
We are beginning to see some of these discouraged workers return to the workforce. The unemployment report released in the first week of July counted 600,000 people entering the workforce—more than triple the usual number. We estimate another 3 million discouraged workers returning to the workforce in the next two years.
The return of these workers from the sidelines could function as a shadow labor pool and may be one of the reasons that wages are not increasing at a faster rate. Of course, some of these returning workers may not have the most up-to-date skills and might be willing to accept a more modest initial wage in exchange for the training they anticipate receiving. Meanwhile, others already in the workforce remember the searing recession of 2008 and want to play it safe, staying with their current employer rather than taking a chance on a new firm with higher pay.
In the U.S., wage growth roughly equals inflation. With inflation rising to over 2.5 percent, this is a danger. If wage growth doesn’t exceed the inflation rate, consumer spending would suffer. With 70 percent of the U.S. economy driven by consumer spending, this would negatively impact business activity, earnings, and stock prices.
More Reinvestment and Stock Buybacks
The Tax Cut and Jobs Act signed last December granted incentives for corporations to increase domestic reinvestment. This should result in significant benefits over time to both workers and shareholders. Over the past five years, U.S. corporations had been using more of their earnings to buy back stock, thereby boosting stock prices. Meanwhile, their plants and equipment aged, restricting growth of productivity and worker incomes. Since passage of the Tax Cuts and Jobs Act, capital expenditures have grown rapidly. For example, the companies in the S&P 1500 Index have increased their reinvestment by more than 20 percent.
However, even as reinvestment increased, companies are also increasing stock buyback programs. The combination of tax relief and repatriation provide more than enough incentive to do both.
Economic Growth vs. Stock Price Growth
If economic growth is strong and earnings are increasing, then why are stock prices flattish?
Although strong U.S. gross domestic product (GDP) growth has contributed to higher earnings, these earnings have not translated to higher stock prices. Stock prices are influenced both by earnings and the price that investors are willing to pay for those earnings, which is captured by the price-to-earnings ratio—or P/E ratio.
Over long periods of time, stock prices follow the path of earnings. However, in any given year, stock prices and earnings can follow different patterns. In 2017, for example, earnings increased 10 percent, while stock prices increased 20 percent. This year, earnings have increased more than 20 percent, but stock prices have increased just 4 percent or so.
Stock prices are flattish this year because the stock market’s valuation multiple, as measured by the price-to-earnings ratio, has declined. Let’s review how this works. If a company earns $8 per share this year and an investor is willing to pay $80 per share of stock, the P/E ratio is 10. Next year, if the stock earns $9 and the price-to-earnings ratio stays at 10, then the stock would rise to $90.
Stocks with unchanged earnings can still increase in price, if investors are willing to pay a higher valuation—as measured by P/E ratio—for the same earnings. Suppose next year’s earnings stay at $8, but investors are willing to pay a P/E multiple of 11 for the stock. The stock will increase to $88—even though earnings remained the same. P/E ratios can also decline if investor confidence begins to wane.
Valuation multiples have declined for two reasons. First, as short-term interest rates have risen from near zero percent, some investors have reallocated from stocks to bonds to increase the income from their portfolios. In 2015, the 2-year U.S. Treasury note yielded about 0.50 percent, while stocks yielded about 2.5 percent. This compelled many investors in search of income to invest in stocks rather than bonds. In January 2018, for the first time in 10 years, the 2-year Treasury yield surpassed the S&P 500’s 1.9 percent yield, allowing income-seeking investors to obtain their income without the volatility of the stock market. And, as investors shifted from stocks to bonds, the P/E ratio of stocks declined.
Tariffs and Trade Tensions
Global trade and tariff tensions have reduced confidence and increased the perception of risk for some investors. The U.S. is currently engaged in trade negotiations with all our significant trading partners.
Figure Four lists our major trading partners. The first set of columns shows countries that import the most from the U.S.; we would be most vulnerable to imposition of tariffs from these countries. The second column lists those countries from whom we import the most. Some economists believe that the U.S. would have the most leverage over these countries because they have the most to lose. The third column lists the countries in order of trade balance. This column is the most important to President Trump. He has expressed his goal to reduce the balance of payments deficit with China and the European Union.
China exports much more to the U.S. than what it imports from the U.S. with the EU as number two. The administration is negotiating with the goal of reducing the U.S. trade deficit with these countries by leveling the playing field (all countries have the same tariff rate) and by respecting intellectual property (patents, copyrights, etc.)
Figure Four: Largest Trading Partners with the U.S. (in $ Billions)
At present, tariffs are more of a news story than they are a real cause for economic concern. A news headline reporting “$200 billion in tariffs” does not mean $200 billion. The $200 billion is the market value of goods on which the tariff tax rate (typically, 10 to 25 percent) is imposed. For example, a 10 percent tariff tax rate on $200 billion amounts to $20 billion in extra costs, not the headline amount of $200 billion.
Although trade tensions are worrying and could escalate in coming months, at present the impact of tariffs pales in comparison to the amount of stimulus injected into the economy. As shown in Figure Five, the amount of stimulus—estimated at $800 billion—is much larger than the anticipated $120 billion cost of tariffs.
Figure Five: Tariffs and Fiscal Policy – Calendar Year 2018
On balance, while our brief period of global synchronized growth may have ended, U.S. growth remains in full swing, fueled by the triple shot of individual tax cuts, corporate tax cuts, and increased government spending. The labor market looks strong and corporations are setting themselves up for future earnings growth through stock buybacks and reinvestment in their businesses, even if we have not seen significant stock price appreciation this year.
As we weigh the risks and rewards to the economy and the markets, we take note of the spike in foreign trade-related headlines and announcements. But overall, the amount of economic stimulus and growth should be more than enough to outweigh trade problems—unless they escalate substantially. We will be monitoring the trade negotiations, but our baseline forecast is for continued strong economic growth and hiring as the economy fully integrates the benefits of the stimulus laws enacted late last year.