- Risks are cumulating and getting bigger.
- U.S. GDP growth is slower than expected, earnings and oil prices continue to decline.
- Japan is unable to grow while BREXIT risks are still unfolding.
It is difficult to find good news lately. The last really good news was the June jobs report when 287,000 jobs were added. Since then, most of the news seems dismal, however, it has yet to have a negative impact on financial markets. It’s as though investors are just hoping for something good to happen in the future. As hopes are an immaterial human feeling, they should not be the base for investment decisions.
In this article we are going to analyze what’s pushing the S&P 500 to new highs. Are we in a state of euphoria about stocks or are the valuations and price increases rational?
The U.S. economy was expected to grow 2.5% in Q2 2016, but it only grew 1.2% (seasonally adjusted). U.S. economic growth for 2016 is currently at 1% which is the weakest start of a year since 2011. Saving the economy from a recession is consumer spending which increased by 4.2%.
Low interest rates create cheap money which fuels two trends, growth in both consumer spending and the S&P 500. Consumer loans have increased at a faster pace than consumer spending which makes it clear that spending growth is fueled by debt.
Figure 1: Consumer loans at all commercial banks (blue) and consumer spending (green). Source: FRED.
Anyone who has studied economics will tell you that the economy works in credit cycles, when money is cheap and prospects good, people take on credit and spend it. But one can only take on so much credit, and all banks want their money back sooner or later. When sentiment shifts, a credit contraction arises and consumer spending falls. As this is inevitable, the only justification for the current hope of increased GDP growth can be explained with the most dangerous words for investors: “this time is different.”
Figure 2: Credit cycle. Source: Loomis Sayles.
As we are in the expansion part of the credit cycle, a recession is going to hit us as soon as we reach the downturn part of the credit cycle because consumer loans are the only thing still boosting growth.
Figure 3: Contributions to Q2 economic growth. Source: Wall Street Journal.
If it wasn’t for consumer spending fueled by cheap loans, the U.S. economy would most likely already be in a recession.
The S&P 500
With economic growth largely missing expectations you would assume the S&P 500 would tank, but that’s not what happened Friday when the economic data was released. On the contrary, the S&P 500 reached a new intraday high at 2177 points. The main reason for the new S&P 500 high is hope of future economic growth, the same economic growth that didn’t realize itself in this quarter.
Another reason stocks have continued to rise has been the Q3 2016 expected corporate earnings growth, but that also vanished like the above described economic growth. As most companies have issued negative guidance we cannot expect higher earnings in Q3 2016.
Figure 4: Q3 2016 earnings guidance for the S&P 500. Source: FACTSET.
It would appear the FED is also somewhat in denial about the true state of the U.S. economy and S&P 500 earnings, and is holding on to the hope of increasing interest rates as soon as the economy shows signs of strength, be we’ve been hearing the same story for a while now.
Last week the FED left the door open for interest rate increases as the economy seemed to be improving, but this was before Friday’s GDP debacle. With growth being lower than expected, the FED will probably continue with its status quo policy. As we now know that the only thing pushing the economy higher is consumer spending fueled by consumer debt, any interest rate increases would be detrimental for the economy and push it into the downturn part of the cycle because higher interest rates would increase the cost of debt.
Data on jobs, consumer spending and inflation will be available before the FED’s next meeting in September so we will closely watch that in order to see if the FED will eventually move, highly unlikely after the latest GDP debacle.
The BREXIT had only a short-term effect on markets as investors soon focused on other things and hoped that it would not have any long term effects. But any BREXIT effects won’t be seen in economic data for a few years as it will take the UK at least two years to exit the EU, if not four.
Figure 5: Soon forgotten BREXIT. Source: Google.
News from Japan was also not that good. As economic targets have not been reached, the Bank of Japan decided to double the annual amount it uses to buy exchange traded funds, from ¥3 trillion to ¥6 trillion ($57 billion). This is only a modest increase to Japan’s easing policy, measured in hundreds of trillions, and brings us to the conclusion that Japan is out of monetary policy ammo. Even with constant increases in monetary easing, Japan has experienced a 0.5% deflation in June and slower consumer spending. This should be a warning sign for the U.S. as it is clear that easing has its limits.
All the above indicates that we are currently in the denial phase of a stock market cycle. We have had a bull market for 7 years now and no one wants to look at the above data as it indicates a turn in the credit cycle, lower business spending and earnings, a strong dollar and global uncertainties with the UK, Japan and China. We will analyze the situation in China soon as it requires a special article.
Figure 6: Stock market cycle. Source: The Gold and Oil Guy.
Not to mention oil prices coming close to $40 dollars per barrel, which will push energy earnings down, again.
All of the cumulating risks we’ve discussed send a strong message. Investors have to start thinking about risks and rewards. In the late stage of a bull market, many are overweight stocks, which means they can expect a beating if any of the above mentioned risks trigger a bear market. The options are to increase one’s cash in order to have liquidity when a market decline comes, or to own more uncorrelated asset classes. I’ve written more on this in our recent article on Ray Dalio’s strategy.
For stocks, simply ask yourself, how much are you willing to risk for a 4% long term expected yield?