In our 2017 Outlook, our earnings forecast for the S&P 500 was $119.45 per share, up from $106.25 in 2016.[1] Based on new data and other trends, we are raising this forecast to $126.44 for this year. There are three reasons for the change.
The spread between Thomson-Reuters and S&P operating earnings is narrowing. This is an issue we have discussed in the past. There are two primary sources of information for earnings, Standard and Poor’s and Thomson-Reuters. Most of the time, the two sources are consistent. However, since the Great Financial Crisis, the latter has tended to report higher operating earnings for the S&P 500 than the former. Explanations for this divergence vary. It does appear that Thompson-Reuters takes a more “relaxed” view on what costs are excluded compared to Standard and Poor’s. Here is the data through Q4 2016:
In 2001 and 2008, the spread between the two series coincided with recessions. Since the Great Recession, we have had two periods where the spread has widened; both are tied to declines in oil prices. As oil prices recover, the current spread should narrow.
Margins are showing some improvement. We compare total S&P 500 earnings to GDP. Our model for this percentage is indicating that margins will improve this year.
The blue line on the chart shows the actual percentage of S&P 500 total operating earnings to nominal GDP. For most of this century, this percentage has been ranging between 5% and 6%. The drop in oil prices led to some margin compression. We also expect improving productivity and a modest widening of the trade deficit to boost margins, shown above as the red line, which is the model forecast.
Finally, the per-share data will be supported by a steadily declining divisor. The below chart shows the S&P 500 divisor; it’s a scaling factor for the index.
To calculate the index, one takes the overall market capitalization and divides it by the divisor. The divisor adjusts to changes in the composition of the index, as well as new issuance, share repurchases and mergers. The rise in share buybacks has led to a steady drop in the divisor; we are now at levels last seen in early 2000. As the divisor declines, the per-share value rises.
Despite this increase in earnings, we have not boosted our S&P 500 target forecast of 2400 for the year. We view the P/E as elevated at this point and so we expect the rise in earnings to mostly result in a weaker multiple. At the same time, this change will make equity markets less expensive and thus less vulnerable to disappointment. If the rise in business and consumer sentiment supports the multiple, we will make appropriate adjustments to our forecast.
[Posted: 9:30 AM EDT] Happy Employment Data Day! We cover the data in detail below but the payroll data, showing only a 98k rise, was quite disappointing. We suspect seasonal factors played a role as February weather was unusually mild while March was colder. It should also be noted that the unemployment rate fell to 4.5% (-0.2%), which is actually bullish. Initial market reaction has been bullish bonds and bearish equities and the dollar. However, we see lots of noise in the numbers so reversals throughout the day would not be a surprise.
At the same time, we have had heavy news flow over the past 24 hours. Here’s what we see going on:
The U.S. bombs Syria: President Trump ordered a moderately sized cruise missile strike on an airbase in Syria in response to the Assad government’s use of nerve gas against rebels with high levels of civilian casualties. Since the 2013 deal with Syria was thought to have ended Syria’s chemical weapons program, it is disappointing to see the regime use these weapons. It is unclear if they hid these weapons during the period when they were supposed to have eliminated them or if they have reconstituted their WMD industry. The U.S. response was limited but it is possible that escalation could follow.
Market reactions: Markets acted as one would expect—equities fell, gold and Treasuries rallied and oil prices jumped. Although Syria is a minor oil producer, the attack involves three major oil producers, the U.S., Russia and Iran. Thus, any escalation could affect oil prices; the most likely catalyst would have been if Iranian or Russian security personnel were killed in the attack. Given that Russia was warned of the strike, the odds were lessened that such an action would happen. We expect this attack to be limited and thus the overnight trends will likely reverse over time.
International and domestic reactions: European governments were supportive. China’s reaction was mostly neutral while Russia reacted harshly, as one would expect, calling the action a “significant blow” to U.S./Russian relations. However, if this is a one-off attack, which we believe it is, the Russians won’t escalate the situation. Russia can’t afford to go to war with the U.S. On the other hand, if the Kremlin thought it had its man on Pennsylvania Avenue, this attack undermines that position. Within the U.S., the reactions were interesting. Establishment figures across the aisle praised the attack; populists, especially on the right, were rather critical of the missile strikes.
Takeaways: We expect Trump to be mercurial and this action is clear evidence of this characteristic. It has been less than a week since the administration indicated that regime change in Syria was no longer a goal of the U.S. What it shows about Trump is consistent with the behavior of Jacksonians; besmirching honor guarantees a response.[1] It’s clear that Trump took the attacks personally. Assad engages in war atrocities often but usually with conventional weapons. Thus, indiscriminate bombing of civilians is tolerated but the use of chemical weapons isn’t. And, the fact that the images of gassed children were broadcast worldwide appears to be a major factor behind the response. So, the lesson to the world isn’t that attacks on civilians won’t be tolerated; it’s that high-profile attacks using banned weapons will not be allowed. We don’t see a change in U.S. policy in Syria. We seriously doubt we will see a large U.S. ground troop presence in the country anytime soon or an escalation of U.S. military activity in the region. For nations under threat, such as North Korea, this missile strike is a warning of sorts and may raise tensions even further. At the same time, Pyongyang should also note that it’s the public dishonor that gets one into trouble; acting badly in secret is probably ok.
The Mar-a-Lago meetings: Thus far, not too much has come out of the talks between Chairman Xi and President Trump. The Syrian attack will act as a distraction. North Korea, trade and the level of U.S. influence in the Far East are all issues but we doubt they will be solved in this meeting. Xi needs a smooth runway into CPC meetings in October that will allow him to pick his own team for his second term. Thus, low-key meetings are his goal.
The Senate goes nuclear: The Democrats are prepared to filibuster Neil Gorsuch and so the GOP will change the rules and allow Supreme Court justices to be appointed by a simple majority vote. Although legislation is still subject to filibuster, it’s just a matter of time in our opinion until this changes as well. The Senate has traditionally acted as a governor on policy, preventing it from moving too far or too fast in either direction. Once we go to simple majorities, there isn’t much use for having the Senate around. It probably should become like the House of Lords in the U.K.
Why is this happening? The nation has become deeply divided on partisan lines and thus sees anything the other side wants as prima fascia evil. Both will claim “the other side started it” and both are credible. At root, however, is that we get the government we send to Washington and when the country becomes partisan and divided, we want the other side vanquished. Since the divisions are more or less equal, it’s hard to get a large enough majority to force one’s will on the other.
(Source: Voteviewblog.com, Rosenthal and Poole)
This chart shows the degree of partisanship in the House and Senate; the higher the number, the more partisan the body. The House is the most divided it’s been since the data series began in 1879; the Senate is approaching the highs it set in the late 1890s. We suspect partisanship was probably higher around the Civil War but that shouldn’t offer us comfort. This level of partisanship makes it difficult to govern and probably impossible to maintain the superpower role. It’s worth noting that the trend for bipartisanship began to accelerate after WWI when the U.S. was beginning to realize that it was going to have to take a more global role. We remained remarkably bipartisan through the Cold War, although the degree of agreement began to unwind as the Cold War ended. We don’t know how this will play out for sure but there are a couple of observations that can be made. First, if the Senate eventually ends the filibuster rule, policy shifts will become more pronounced and violent with new parties in power. Political risk for financial markets will escalate. Second, we are probably in an era of major coalition changes within the established parties. Third, America’s superpower status will almost certainly be unsustainable with this degree of domestic political division.
[Posted: 9:30 AM EDT] Most of the time, Fed minutes are snoozers. On the other hand, there is often real action within the FOMC. The full meeting transcripts are published with a five-year lag and they show verbal sniping and open disagreement. By contrast, the minutes are sanitized with code words like “some members” or “many members” to give hints at the degree of support or opposition. Most of the time, the minutes are nothing more than a longer version of the statement.
However, that was not the case yesterday. The FOMC made its clearest signal yet that it intends to shrink the balance sheet. The general expectation was that the Fed would allow the balance sheet to slowly unwind by not buying bonds when paper matures. However, that doesn’t seem to be what the FOMC is saying; instead, it appears to be looking to actively reduce the size of the balance sheet.
This is a big topic that will require deeper analysis. To be completely clear, no one knows for sure exactly how the balance sheet expansion affected the economy and the markets. We can look at market effects, but we can’t tell for sure why those factors worked the way they did. We can make a very good case that QE was good for stocks.
The chart above shows the S&P 500 regressed against the Fed’s balance sheet. From 2009 until the middle of last year, the model did a good job of projecting the path of equities. Since the Trump election, equities have moved sharply higher. Our position was that the actual effect of QE was to boost equity market sentiment.
The chart above shows the Shiller CAPE and the balance sheet. Periods of QE are shown in gray. Note that the P/E tended to rise when the balance sheet expanded. Obviously, the most recent lift isn’t being caused by policy but by the election.
Perhaps the most underappreciated element of QE was the impact on long-duration interest rates. One of the reasons for implementing QE was to lower long-term interest rates. However, the evidence suggests the impact was just the opposite of what policymakers expected.
This chart shows the yearly change in the size of the balance sheet along with the yield on the 10-year Treasury. Note that, especially with QE2 and QE3, yields tended to rise during periods of balance sheet expansion. Although the common expectation is that yields will rise once the reversal begins, in fact, we would be more inclined to expect bond prices to rise. Why did bond yields rise during QE when the Fed was buying longer dated paper? Most likely, investors feared the goal of policy was reflation; rising inflation is always negative for bond prices and those fears overwhelmed the impact of reduced supply.
However, we are cautious about drawing too many conclusions from these patterns. We have no experience with cutting the size of a balance sheet this large. On the one hand, it shouldn’t make much difference. The rise in the balance sheet did nothing more than bloat the banking system with reserves that, for the most part, have not been lent. Reducing excess bank reserves shouldn’t be a big deal. On the other hand, QE and the balance sheet were symbols of Fed policy support. The psychological impact could be quite negative. We will have more to say on this going forward, but our initial read is that balance sheet reduction could be bearish for equities and bullish for bonds. Then again, the impact may not be large and could be overwhelmed by other issues, such as tax changes, geopolitical events, etc.
In other news, the China/U.S. summit begins later today. We would not expect much to happen here as the Chinese leader needs a “no drama” meeting. The Czech Republic ended its peg with the EUR; since mid-2015 the Czech central bank has pegged the koruna/euro rate at 27.0313. It has rallied about 0.5% on news that the Czech government will allow its currency to strengthen.
Stephen Bannon, special advisor to the president, was pulled off the National Security Council yesterday in a clear win for the establishment. Our read is that the key power broker is Jared Kushner and there have been rumors that Bannon and Kushner’s relationship has cooled in recent months. Some reports suggest Bannon was prepared to resign but the Mercers pressed him to stay. Gary Cohn, the White House economic advisor, apparently asked some senators about Glass-Steagall in a private meeting. According to Bloomberg,[1] Cohn expressed support for bringing the separation of investment and commercial banking back to the financial system. This is a bit of a shock coming from Cohn but it may be a trial balloon to see if Congress would support such a measure. Bannon’s fall from grace is a blow to the populists, while Glass-Steagall would be a win for this group.
Overall, in our establishment/populism “meter” the former is gaining strength. If the establishment gains power, financial markets will favor this outcome. However, populism isn’t going away and moving in this direction leaves President Trump vulnerable to a challenge from a leftish populist in 2020…if and only if the Democrat Party sees the opening.
U.S. crude oil inventories rose 1.6 mb compared to market expectations of a 1.5 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart below shows, inventories remain elevated.
As the seasonal chart below shows, inventories usually increase for the next three weeks before rising refinery operations for the summer driving season lower stockpiles. This week’s smaller than seasonal rise puts us further below normal. Although inventories remain high, this seasonal level is consistent with early July, meaning that we may be on the way to an easing of the inventory overhang.
(Source: DOE, CIM)
Based on inventories alone, oil prices are overvalued with the fair value price of $26.81. Meanwhile, the EUR/WTI model generates a fair value of $40.66. Together (which is a more sound methodology), fair value is $35.36, meaning that current prices are well above fair value. The data indicate that the bullish case for oil mostly rests on a weaker dollar. If the dollar continues to soften, coupled with the usual seasonal decline in oil inventories, our models will raise the fair value level. That isn’t necessarily bullish for oil prices but it does remove a potentially bearish factor. Simply put, current oil prices have already factored in a drop in inventories and likely a weaker dollar.
[Posted: 9:30 AM EDT] Yesterday, Richmond FRB President Lacker announced he was stepping down immediately after admitting he was involved in a leak of confidential information to an analyst with Medley Advisors, a well-connected Washington think tank. In October 2012, Medley published details of Fed deliberations that were non-public. In a conversation with that analyst, Lacker refused to comment on the information, which may have given the impression that he was confirming the report. We doubt that Lacker was the source of the leak; the public information we have suggests he was not but, perhaps inadvertently, confirmed it for Medley. Still, his abrupt resignation and acceptance of responsibility usually occurs as part of a deal to spare Lacker from further investigation. We suspect the leaker has still not been found.[1]
In the short run, his departure isn’t a big deal. First of all, he was leaving in October anyway. Second, he wasn’t a voter this year. The FOMC is losing one of its hawks; we rated Lacker as a one-star hawk, our most hawkish designation. Usually, regional FRBs replace presidents with similar characteristics. After all, it’s the bank board that appoints these presidents and there is some degree of continuity on these boards. However, given the whiff of scandal that surrounds Lacker, the Richmond FRB may decide to go a different direction which may lead to a more centrist replacement.
It looks as if Syrian President Assad’s forces used chemical weapons in an area controlled by rebel forces. We note that this attack closely follows comments from the administration’s ambassador to the U.N. suggesting that regime change is not the goal of the Trump government. Although that is the de facto policy of this administration, some things are better left unsaid. Confirming Assad’s position might have given him confidence that he could get away with using chemical weapons. However, in all fairness, U.S. Syrian policy has been a mess for some time. President Obama’s red line in Syria that was crossed and subsequently ignored was poorly managed. Allowing the Russians to participate in Syria was a mistake as well.
We think the best way to examine U.S. Middle East policy is to consider it as part of the postwar order. The U.S., in addition to containing communism, froze conflict zones in Europe and Asia by taking over the defense of Western Europe and Japan. This gave confidence to other parties in the region who would have normally been traditional enemies that they had nothing to fear. So, demilitarizing Germany (and, effectively, the rest of Europe) told Russia and the other European nations that the U.S. was the keeper of the peace and traditional regional rivalries were no longer a threat. In the Far East, by taking over Japan’s defense, China knew it was protected from Japanese attack. In the Middle East, the U.S. enforced the flawed existing borders, which meant living with the brutal autocrats in the region who were the only ones capable of maintaining order in states that were not created for natural stability but for the benefit of colonial powers. In the Middle East, we can safely say that American postwar policy is no longer in existence. By supporting the Arab Spring, the U.S. has unleashed tribalist and nationalist factors that will likely shape the region for the next three decades. Richard Haass has suggested that conditions in the Middle East closely resemble Europe in the 17th century during the bloody Thirty Years War. At this point, the Middle East is in turmoil and we don’t expect it to improve anytime soon. For markets, so far, the conflicts haven’t affected oil production and so the impact hasn’t been significant. However, continued conflict will raise the likelihood that, at some point, oil flows will be disrupted.
As Chairman Xi and President Trump gather together in Florida, the Young Marshal in Pyongyang launched an intermediate range ICBM. The response from the White House was, “the clock has now run out and all options are on the table.” It is unclear what exactly this means, but it does suggest that some options might include military activity. It doesn’t appear that the financial markets are expecting such action; if they did, we would expect equity values to be declining sharply, with Treasury prices and the dollar rising as well. We don’t expect military action by the U.S. either but our confidence in this position isn’t strong due to the nature of the Trump administration. We continue to monitor conditions closely.
By all accounts, the French debate wasn’t good for Le Pen; her opponents attacked her position on the Eurozone and her responses were deemed weak. European political systems tend to isolate populists as the establishment parties, who usually oppose each other, unite to prevent a populist victory. We expect a similar outcome in France. However, it will all come down to turnout. It doesn’t appear to us that the other candidates foster strong feelings among supporters; at the same time, Le Pen supporters seem to be committed. If voter participation is low, Le Pen has a better chance of winning than current polls suggest. However, even a low turnout may not be enough to grant her a victory.
[Posted: 9:30 AM EDT] It’s another quiet and mostly sluggish day in global markets. The French are holding a presidential debate today at 8:40 pm local time (2:40 EDT) that will be closely watched. Current polling hasn’t changed; Le Pen and Macron will likely win the first round and the latter should win easily in the runoff. However, given the mixed performance of polling in recent elections, there will be some degree of concern until the runoff is held on May 7. The first round will occur on April 23.
The NAPM remains robust, holding above 57. We are also seeing globally strong manufacturing data, suggesting an improving global economy. One of our alternative models for fed funds uses the NAPM manufacturing data.
The model compares the yearly difference in fed funds to the ISM manufacturing index; the index leads fed funds by six months. Given the time adjustment, this model would project one more rate hike by the end of Q3. Assuming the economy holds recent gains, the model’s forecast would be consistent with three hikes for the year. It also suggests that the FOMC isn’t “behind the curve” as the Phillip’s Curve-based models indicate, such as the Taylor and Mankiw Rules.
We continue to closely monitor the situation in North Korea, especially with Chairman Xi visiting the president in Florida. NBC carried a long interview[1] with Thae Yong Ho, the former Democratic People’s Republic of Korea (DPKR) deputy ambassador to the U.K. Ho warned that the “world should be ready” for some sort of missile attack from the Hermit Kingdom. Adm. Stavridis (Ret), former NATO commander, suggested the current situation is unusually dangerous. First, Kim Jong Un’s grip on the DPKR appears unstable, which accounts for his brutal purge. Second, there is political instability in South Korea due to the impeachment of its president. Third, the Trump administration appears to be aggressive in its tactics with North Korea. Ho suggested that the “young marshal” is capable of anything and his removal from office is the only way to ensure peace. It is rather obvious that the markets are not discounting any degree of flare-up on the Korean peninsula; if they were, the JPY would be significantly weaker because Japan would be a likely target. We view Korea as a “gray swan”; it is a known/unknown, but the degree and timing are uncertain.
On March 25th, European Union (EU) leaders from 27 nations gathered in Rome to celebrate the 60th anniversary of the founding of the organization. Although the EU currently consists of 28 members, the U.K. was absent due to its recent decision to leave the EU.
On that day in 1957, France, West Germany, Italy, Belgium, Luxembourg and the Netherlands signed the Treaty of Rome, creating the European Economic Community (EEC), which eventually became the EU. Over time, new members joined the group. This map shows the current members.[1]
(Source: EU)
It should be noted that this wasn’t the first attempt at a supranational European body. France proposed the European Defense Community to be comprised of the six original EU members. However, the French failed to ratify the treaty. In 1951, West Germany and France built the European Coal and Steel Community which included the other four founding nations of the later EU and it became a forerunner of the EU. In 1957, the same six nations agreed to cooperate on nuclear power. Still, the EEC is considered the original source of what evolved into the EU.
The primary goal of the EU was to prevent another world war from being fought on European soil. That goal, at least so far, has been successful. The key to meeting this goal was to solve the “German problem.” That issue continues to evolve.
In Part I of this report, we will discuss the German problem and how NATO and the EU were developed in response to resolving that problem. In Part II, we will examine the post-Cold War expansion of the EU, including a discussion of the creation of the euro and the Eurozone. With this background, we will analyze the impact of the 2008 Financial Crisis and the difficulties the EU has faced in dealing with the problems it caused. There will be an analysis of immigration and European security as well. We will look at several proposals being floated in the wake of Brexit about reforming the EU and, as always, conclude with potential market effects.
[1] For the next two years, the U.K. will remain a member. PM May did submit an Article 50 letter on March 29 which begins the two-year process of exiting the EU. It is possible that this deadline could be extended depending on negotiations. Britain is the first nation to exit the EU.
[Posted: 9:30 AM EDT] BREAKING: There was a bombing on a St. Petersburg subway that has killed at least 10 and injured 50. This is still a developing story. Thus far, no group has claimed responsibility. With the recent widespread protests (according to reports, nearly 100 cities have seen some degree of organized protests), we will be watching to see if Putin tries to accuse the protestors of this attack.
The big event this week is Chairman Xi’s visit to the U.S. He will be with the president in Florida. In a wide-ranging interview over the weekend with the FT, Trump made it clear that the trade deficit with China will be a key topic of conversation.
The bilateral trade deficit was $78.3 bn in Q4; last year, it was $309.8 bn. For comparison’s sake, the deficit last year with the EU was $92.3 bn. It isn’t clear what these negotiations will bring. If we were consulting with Chairman Xi, we would recommend he make expansive promises to engage in direct foreign investment in the U.S. to build plants and equipment. The promise of manufacturing jobs would probably be enough to forestall punitive tariffs. We also expect Xi to be supportive of the president’s family business ties to China.
There has been a spate of articles over the weekend on the growing role of Jared Kushner in the White House. The son-in-law has been given a broad portfolio, including streamlining government, handling relations with China and Mexico and solving the Middle East. A Politico article[1] suggests that Kushner may be cooling on Bannon, who had made a point to befriend Kushner early in the election process, likely perceiving his influence.
According to this and other reports, Kushner is increasingly siding with the establishment, becoming more closely aligned with Gary Cohn. Another Politico article[2] indicates that the White House is planning its own tax reform measure, having decided that relying on Ryan and Congress reduces the president’s control over the process. Reports suggest that the controversial border adjustment tax (BAT) won’t be part of this measure. Details are clearly scarce but killing the BAT will leave a large fiscal hole. Our read is that the president doesn’t really care about deficits and will likely lean on the OMB (which will create a different narrative than the CBO) to dynamically score the tax proposal by goosing growth. Lifting the deficit will be controversial; the most likely outcome is that it will be bearish for long-duration fixed income.
Finally, on the geopolitical front, there were two items of note. In the FT interview, President Trump indicated that the U.S. is willing to “go it alone” on North Korea. It isn’t clear if that means just sanctions or if military action is being considered. None of the military sites we monitor are suggesting a U.S. military mobilization against North Korea. We suspect this is a negotiating ploy to woo China into punishing the Kim regime.
Second, in comments that seemed to come out of the 16th century, a former Conservative leader, Lord Michael Howard, suggested that PM May would be willing to “go to war” against Spain in Gibraltar. Spain lost control of Gibraltar at the 1713 Treaty of Utrecht; voters on “the Rock” are strongly British, voting 18,000-187 on shared sovereignty with Spain. Spain has indicated it would veto any favorable measures for the U.K. during Brexit unless Britain gives up Gibraltar; given that all 27 nations must agree on Brexit, this veto threat is real. Although it is hard to imagine a hot war developing over this issue, as we have noted numerous times, the EU/NATO project was all about preventing war in Europe. The tenor of this spat shows those issues remain despite over 70 years of peace.
Historically, recessions tend to come from three sources—overly tight monetary policy, geopolitical events and inventory overhangs. The latter has mostly become irrelevant due to improved inventory management, leaving overly tight monetary policy and geopolitical events as the typical causes of downturns. As our regular readers know, we monitor both quite closely.
One of the problems with monetary policy is determining “tightness.” Although we have a plethora of models that attempt to calculate the “neutral rate” for fed funds, in reality, the correct neutral rate changes over time due to economic conditions. Again, we usually focus on inflation and the most visible data, such as the employment report and GDP, to gauge the health of the economy. However, we also monitor more obscure numbers which may offer insights into the economy that are not being picked up by the bigger and more common reports.
One of these lesser watched metrics tracks vehicle miles driven. The Federal Highway Administration measures how many miles are being driven by all vehicles, including commercial vehicles and passenger cars and trucks. We have found that miles driven are sensitive to economic activity and oil prices.
These charts show the same data on different time scales. The left chart shows the rolling 12-month data on vehicle miles driven since the early 1970s. The gray bars indicate periods when the monthly total is not a new peak. Once a new peak is reached, the gray bar ends. Although there have been short-term declines from the peak, there were three significant events seen in 1973-75, 1979-82 and 2007-2014. All three of these events occurred during deep recessions that coincided with high oil prices. The chart on the right shows the data since 2000. Note that we finally reached a new peak in early 2015, just over seven years after the previous high in late 2007.
As the chart on the right shows, in 2014, miles driven began to accelerate, suggesting the economy was improving. However, since Q2 2016, the growth rate in miles driven has started to stall. Although it is still making new highs, the slowdown does raise concerns.
This chart shows the annual change in the 12-month rolling total for vehicle miles driven. Until 2012, negative readings coincided with recessions but only severe ones that also suffered from high oil prices. However, even the 1990-91 downturn, which was part of the oil spike caused by the Iraqi invasion of Kuwait, did not bring a negative reading to this number.
There is a structural trend in the data as well. Note that the level of driving seems to grow at a slower pace during each expansion. The expansion after the 1973-75 recession was 3.8%; the expansion after the 1980-82 recession was 4.1%. However, the subsequent growth rate after the 1990-91 recession was 2.5% and after the 2001 recession was 1.3%. In this expansion, the average growth rate in miles driven is a mere 0.8%. Why are fewer miles being driven? We suspect a number of factors are at work. To some extent, the law of large numbers is having an effect. There are simply constraints to driving that are probably leading to slower growth, namely, road infrastructure and the amount of the population that can afford to own a car. The aging baby boom population is being replaced by Americans who seem to drive less.[1] The advent of social media may reduce the need to drive; baby boomers used to “cruise” to meet friends. The internet allows gatherings to occur without leaving home.
Still, the jump in the data from 2014 into early 2016 and the subsequent slowdown do concern us. This drop could be an early warning that consumers are retrenching; the lack of wage growth may be weighing on household spending. We note that consumption trends are showing slowing growth.
This chart shows the three-year moving average of the contribution to GDP coming from household consumption. The sharp decline in the last recession shows how damaging the last recession was to the household sector. Although the recovery has been robust, the level of growth remains well below previous cycles. In addition, for the past three quarters, the trend contribution level has been stuck at 2%. If this reading fails to accelerate, it would suggest growth will remain slow.
Thus, the miles driven number does suggest some softening in the economy. The slowdown isn’t serious enough to signal an imminent recession, but it should give policymakers pause on moving aggressively on interest rates. If monetary policy remains accommodative, the bullish environment for equities should remain in place.
[Posted: 9:30 AM EDT] Global equity markets had a weak tone overnight but much of that is probably related to quarter-end adjusting. We did see good Chinese data (see below) and sentiment surveys remain robust. For example, the National Association of Manufacturers’ outlook survey hit a new all-time high for the 20-year history of the index. We suspect some of this reflects hopes of trade relief from the Trump administration. The key is whether or not this boost in sentiment, seen in both business and consumer surveys, will translate into real growth. History suggests that we should see a boost to the economy over the next two to three quarters. However, there isn’t much evidence in the actual output data of a robust expansion.
On the trade issue, the administration is starting the push to address the trade deficit. Commerce Secretary Ross and the U.S. trade representative (Robert Lighthizer, who hasn’t been confirmed yet) are expected to conduct a comprehensive study on how foreign nations are taking advantage of the U.S. They are expected to report back to the president in 90 days on their findings. At the same time, Peter Navarro, the head of the newly created National Trade Council, is arguing that there is too much “dumping” occurring that the U.S. isn’t penalizing. Dumping occurs when a nation sells goods and services into the U.S. below the cost of production.
Given the struggles this administration has faced in terms of execution, it remains to be seen if much will come of all this. However, unlike health care and tax reform, there is much the president can do on trade without Congress. And, there are few champions of free trade left in Congress. Thus, we would expect little pushback from the legislature on protectionist measures. The reserve currency issue seems to have eluded this administration. Simply put, the reserve currency nation needs to run a trade deficit or it reduces the global money supply and cuts growth. The global ramifications of trade impediments will be negative for growth.
It should be remembered that the quickest way to reduce imports is to weaken consumption.
This chart shows the three-year average contribution to GDP from consumption and imports (imports shown on an inverted scale). The two series are tightly correlated. In general, the causality runs consumption to imports, which means that reducing imports doesn’t necessarily bring down consumption but consumption changes imports. Thus, the attempt to simultaneously boost growth and lower imports probably fails.
Of course, the other way to reduce the trade deficit would be to lift exports. Exports are always dependent on foreign growth but are also sensitive to the dollar. The Trump administration will likely figure out at some point that a weaker currency is key to narrowing the trade deficit.
Once this realization sets in, we would expect the FOMC to become the target of scorn as it raises rates. If the administration wants a narrower trade deficit, it needs a weaker dollar, which would be helped by easier monetary policy. The Fed raising the policy rate doesn’t support that goal.
We note the president warned, via tweet, that meetings next week with General Secretary Xi will be contentious. The steps the administration is taking with trade probably reflect this warning.
In South Africa, President Zuma has fired his well-respected finance minister, Pravin Gordhan, in a bid to solidify control. As we have noted, this move hasn’t been taken well by the financial markets. Gordhan was seen as a steady leader, one who modified the free-spending habits of Zuma. With Gordhan out of the way, markets fear an inflationary fiscal and regulatory expansion.
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