Economic Outlook – Winter 2019 Edition
The 4th quarter of 2018 reintroduced investors to the volatility that can suddenly hit the stock market. The S&P 500 reached all-time highs in September before dropping 13.5% over the next three months. Since the stock market is more predictive than reactive many observers were wondering if this sharp draw-down could be a clue that the long running economic recovery is finally coming to an end. A few of the economic indicators released in the last couple months have weakened as well, lending additional credence to the theory that we are getting closer to recession.
On the flip side, there are also a lot of positive data points which suggest the economy is still running strong. Job and wage growth are strong and consumer confidence remains high. So we have conflicting signals on how long this economic expansion can last. To add to the confusion, there are some major question marks, in the form of trade negotiations and monetary policy, which could tilt the balance towards either continued growth or recession.
Here is a summary of
Potential Trouble Ahead
Yield Curve
The Fed sets the benchmark for short-term interest rates, and the market then sets interest rates from there accordingly. In a normal, growing economy the rate of interest is higher for 10 years than 3 months. This makes sense because if you were the lender, you would have more confidence that someone can pay you back over the course of 3 months versus 10 years. You would charge a premium to assume the additional risk of waiting longer to get paid back. This is just like how you can get a better rate on a 15-year mortgage versus a 30-year.
When the Fed increases short-term rates higher than the market is willing to pay on longer term rates, it can be a sign that the economy has some trouble. The technical term for this phenomenon is an inverted yield curve. If you look at the chart above you can see the yield curve at three recent points in time. A lot of market commentators believe that we are on the cusp of the yield curve inverting, and therefore, heading for recession.
The latest Fed decision, in January, has alleviated some of those worries. The Fed made it clear they will be “patient” with any additional increases in interest rates. So the pressure of the short-term rates going higher may be lessened; however, we could still see an inverting curve if the longer-term rates go lower.
ISM numbers
The ISM (Institute for Supply Management) Manufacturing Purchasing Managers Index (PMI) and Non-Manufacturing Index (NMI) are very simple data points to understand. The good folks at ISM place calls to different manufacturers (or non-manufacturers) and ask questions regarding their business activity. A score of higher than 50 indicates the company expects more activity than the month prior, and below 50 indicates less.
In the chart above you can see that both indicators are well above 50. The bad news is that both numbers came in below where the market expected. This could be a sign that the economy is weaker than expected and these numbers will dip below 50 sometime in the near future. We do not necessarily feel that is the case but will be monitoring both of these numbers closely.
Housing
New housing starts have not recovered anywhere near pre-recession levels. In fact, as you can see from the chart above, it has barely gotten back to the levels from 1992! While the slow recovery in housing has not been a mystery, what is of concern now is the fact that it appears those numbers could be leveling out and start falling.
There are plenty of explanations as to why housing has been such a non-factor in this 10-year recovery and expansion. The first is demographic, as 20 years ago marked the peak earning years of the baby-boom generation. Now those baby-boomers who bought houses back in the boom are retiring and down-sizing and the millennial generation has been slow to pick up the slack.
The long-lasting impact of the financial crisis is another factor. When home prices collapsed it left a lot of homeowners in mortgages that were underwater, thereby inhibiting their ability to move and purchase a new home. Over the prior 20 years, if you were building a new house, you were using the equity in your current home to cover some of the costs. Today, 10 years after the Great Recession, there is still not much excess equity in homes.
Housing has a tremendous multiplier effect on the economy. That means that a new home built tends to lead to additional economic activity (you fill a new home with furniture and appliances, the contractors get paid pretty well and go spend money on new trucks, etc…) If housing activity is indeed rolling over, the multiplying effect could work to the downside as well.
Signs of Health
Wage growth
After being flat (or at least range-bound) for many years, we are finally starting to see wage growth accelerate. Early in the economic expansion, even though lots of jobs were being added every month, and the unemployment rate was dropping, there was still a lot of slack in the labor force as employers did not feel a need to raise wages. We may finally be seeing that dynamic change.
Paychecks are rising as more competition for talent arises in the workforce. There are a lot of stories of companies having a hard time getting qualified people to fill positions and having to offer more generous compensation. And when wages grow (3.2% annualized) faster than inflation (1.95% annualized) that means workers are seeing an increase in their purchasing power. When more people are making more money and able to afford more stuff, it is usually a good sign for the economy.
Consumer Debt
Not only is the consumer making more money, but they are not nearly as strapped with debt as they were before the crisis. In fact, the percentage of disposable income that goes to paying debt is at a 40 year low! That is good news for future economic growth because it means that consumers are not over extending themselves
New Orders – Durable Goods
Despite the ongoing narrative that companies are not reinvesting the windfall they received from the tax cuts and instead just buying back stock, we are seeing growth in capital spending. Durable goods are the heavy fixed investments that companies make to improve their businesses. A lot of surveys are conducted to gauge the optimism of businesses across the country (and the globe for that matter) but the proof of how companies feel about the future is in how they spend their money. If companies are investing in plant, property, and equipment, then there is some optimism that the future will be good.
Conclusion
Everyone is waiting for the next recession to hit. There is evidence that the economic expansion is beginning to stall, but there is also reason to believe that we have a lot of room left to run. We are gauging the information as it comes in and currently feel that we should have some time for continued growth. That being said, the odds of recession have definitely gone up, even if it is still less than 50%.
Right now we are positioning our client portfolios fairly close to their long-term targets. Therefore, we will continue to rebalance portfolios as markets move – buy at the dips and sell after rallies. We will let you know as our views evolve in this area.
Please contact one of our Trust professionals if you have any questions.
Keith J. Akre, CFA, CFP® – Trust Officer
Opinions expressed are solely my own and do not express the views or opinions of Stillman Bank. Investments available through Stillman Trust & Asset Management (1) are not FDIC insured (2) are not deposits, obligations, or guaranteed by the bank and (3) are subject to investment risk including possible loss of principal.