Economic Growth Trumps Frustration
The election shock resulted in a boost for stock prices as potential economic benefits of Trump’s economic agenda were objectively analyzed. Through last Friday, stocks, measured by the S&P 500, rose 6.3% since the election, while the NASDAQ is up 7.3% and the broader-based Russell 2000 had a 14.2% increase. Interest rates measured by the 10-year Treasury rose from 1.80% prior to the election to reach 2.60% in December, but fell back to 2.35% as of the close on Friday. The Volatility Index (VIX), often defined as an indicator of fear, was 11.23% as of close last week, not far from the 5-year low of 10.28% in early-July 2014. Many of the market strategists who had forecast a major sell off if the Democrats lost the election have returned with a decidedly negative outlook. Bearish technicals are beginning to emerge and will gain credibility on any market weakness. Brexit has reappeared as Europe’s latest problem as Italy’s banks rotate into the background.
Over the past year our Reports have focused on the longer-term trends in the economy. Primary has been a gradual improvement in the overall economic well-being of the consumer. This has spurred auto sales to historic levels and served as underpinning for the uptrend in the housing market. Unfortunately the corporate side of the ledger has been plagued by low productivity and a higher dollar. Oversupply of oil and other industrial raw materials resulted in recession levels for revenues and profits for their respective sectors. Despite continued negative forecasts, the economy kept its 2% real growth and stocks corrected by trading in a long-term narrow range. Our optimism is based on the belief that the mislabeled “Trump Rally” largely is a response to economic gains. Overall real growth has improved, employment remains strong, Fed policy is on track, inflation and wages are rising, and a vibrant consumer is spending. The prospects of enhanced growth from aggressive fiscal policies are welcome, but the consumer is the lynchpin to sustainable economic growth and in turn, a rising stock market.
A Healthy Consumer
A short-sighted market ignores the potential that the current economic foundation holds for growth. While waiting on Washington, better demographics and technology continue to drive the economy. For the consumer, spending is a combination of ability and willingness. Ability is determined by change in disposable personal income and willingness is chiefly affected by confidence. Today consumer spending on necessities as a percent of disposable income is at levels not seen since the early-1980’s. Any boost from tax cuts will go directly into spendable income. Consumer Confidence, measured by both the Conference Board and the University of Michigan, is near record levels for Expectation Indices, while not directly correlated to spending, the improving financial state of consumers gives weight to spending expectations.
Another gauge of a healthy consumer is credit quality. At tops of the business cycle, consumer spending is restricted by debt and increasing delinquencies. The ratio of household debt to disposable income was at 1.35 in 2008, today it has fallen nearly 30 percentage points and is now at levels not seen since 2002. The debt service coverage ratio (percentage of before tax earnings spent on paying off loans, including
auto, student and revolving credit) is about 10%, a record low going back to 1980 when the series began. Although there are early indications of increases in auto delinquencies to sub-prime consumers (below 660 credit rating), overall credit delinquencies (90-day plus) are down from 9% in 2010 to below 4% in 2016. Mortgages represent about 75% of household debt with 90% at a record low 3.8% average fixed rate. Even with a rising interest rate with less than 10% of consumer loans exposed to rate increases, consumers are protected from higher payments.
Data from the Census Bureau shows that for the first time 2007 real median income for middle-income households increased 5.2% in 2015, the latest data available. Housing formations have been increasing at a 1 million units annual rate over the past two years and this rate is expected to continue. These data are part of the tailwind in housing that we have discussed in previous reports. With home inventories low, rental rates rising, and erratic new home starts, the housing market should benefit from rising wages and negative equity (10%). Additionally, foreclosures are moving out of the 7-year restriction creating an additional source of potential demand which will continue over the next several years. In summary, the financial health of consumers continues to improve and even given the frustrations of Congress, tax reform and deregulation will augment consumer spending.
Washington moves slowly and with repeal and replace of ObamaCare as the stated first order of business, problems will arise with a replacement plan and accompanying timeline. Repeal is easy, replacement will be difficult and frustration, especially by the Administration, will be magnified in the media. Offsetting the long procedural delays for a new healthcare bill could come from reversing Obama’s executive orders. From an investor perspective, the choice of tax reform is far more beneficial than assuming ownership of contentious TrumpCare. However, tax reform too will require legislation and Trump already has issue with the House revenue offset, “Border Adjustment” (Compass 1/03/17). The question facing markets will the delays create frustration turning to impatience and result in a sell off in equities.
Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors see limited visibility for economic improvement from new policies. However, any correction should be considered a long-term buying opportunity. It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies. To mitigate the potential of higher-than-expected inflation and multiple compression, portfolio’s should include value companies exhibiting sustainable earnings growth and dividends.