The US Economy: So Good It's Bad

This is why I try not to look at markets more than once a day. Just as I opine in the comments section, ringing the metaphorical “all clear” siren that there’s nothing but air between here from 17.5 to 13 in the VIX….it pops back up to 21.

….and equities roll over, sort of...spoos aren’t playing dead. At least not yet. Prior misgivings about the long-term health of the market notwithstanding, it is tough for me to see how this isn’t anything less than a beach ball held underwater.

Gamma driven mineshaft drops notwithstanding, we’ll just go ahead and call this a 50% retracement. Will equity indices drive higher? The burden of proof is on the bear camp again. Looks like a grind higher towards the 2800 level, maybe there valuation anxiety rises again and we get some chop.

I don’t like calling copper the world’s economic barameter, but I do think it strips out some of the noise in other asset classes. Earlier this month it fell roughly 5% from the low 3.20s to mid 3.00s. The beach ball has resurfaced….resume normal service. China.

The one market with a decent reversal today is USD:

I think EUR got a little over its skis above 1.25--but not expecting a change in trend here. I continue to prefer EMFX and EM local rates.

Now, while there isn't much to throw sand in the gears for risk assets in the short-term, I've been clarifying why I think the glory days for US equity returns are behind us.

I also mentioned in the comments that yesterday I sat in on a speech by Jim Paulsen, the ex-Wells Capital strategist that made a name for himself as the Minneapolis answer to Warren Buffett, regularly appearing on CNBC with folksy witticisms about the market.

I found his outlook pretty insightful--I’ve summarized his views below,  along with some graphs I hijacked from his deck, interspersed with my own commentary.   

First and foremost was the broadening of the economic recovery. I’d argue this really started back in 2015, when oil prices crashed but employment stayed strong-- and suddenly regular Americans had more money in their pockets. The data hasn’t been updated for 2017 but it is solidly higher with the trend intact.

Yet, contrary to all history, and the very fabric of this country--the US consumer hasn’t levered up!  There is plenty of runway for increases in areas like retail sales or home prices given the broad household balance sheet strength. Similarly, despite fears about massive issuance by US the corporate sector amid low rates and equity buybacks, Corporate debt relative to profits is far from overstretched levels.

Put another way...every dollar of the issuance avalanche (more or less) has been backed by an increase in profits. Is that a risk factor when profits eventually fall in a recession? Sure, but there’s little sign we’re there yet.

Earnings are also picking up. This is far from breaking news, but what I find fascinating is the trend.  There’s little doubt we’re now at full employment--one can make a strong argument that wages have found a new, higher trend level.

Which leads me to again look at US inflation breakevens. 5y breaks have risen to around 2%.... Yeah, I get it, it’s an oil trade. But it isn’t always. Looking farther back in history--not even ancient history--shows the 5y breaks/oil correlation doesn’t have to move in lockstep. If US producers indeed gun production amid higher prices in the next few months, breaks can move back towards the 1.80s but given the heavy volume in oil forward contracts that has come from US producers selling forward production, I think that’s not a big risk--or at least a two-sided one along with the potential for higher global demand to continue driving commodity prices higher.

Given the supply side of the economy at full capacity and the government throwing fiscal fuel on the fire...a lot of fiscal fuel...i think 5y breaks can move towards 2.30%. Remember this would still be well inside of the new trend of 2.5-2.8% for wage increases.

Here’s a reminder of what the US government is doing. Spending a ton of borrowed money is the only way to ring in a new era of bipartisanship.

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Indeed, on current evidence rates have to go higher--or at the very least, nominal rates need to continue to cheapen, even if the fed sticks to the low r* script.  

What about stocks? What I really liked about Paulsen’s presentation was his efforts to bring some objectivity to equity valuations.

In these two charts he breaks down annualized equity returns based on that month’s unemployment rate and by the ratio of price/earnings-to-U/E (a dubious number, sure, so take it with a grain of salt). Bottom line here is that it will take a lot...and I mean a lot...of game changers to drive and outperformance in equity returns from here.    

The Jeremy Grantham Fan Club, to which I count myself a member (although with the healthy cynicism of James Montier), will recognize the guts of the analysis here. Another way Paulsen looked at it was to look at six month annualized equity returns given certain buckets of the Citi economic surprise index. That index came into the year around 80 and while it has fallen back in recent weeks, the outlook after January’s equity melt-up isn’t good.

Unless the economy finds a miraculous way to outperform the high expectations already baked in, equity returns are going to be low, with downside risks. It’s the white goose walking merrily along, ignorant of the fact it is being stalked by a black swan and a gaggle of grey ones.*

Maybe one of the grey swans strikes--higher inflation, higher rates, lower equity valuations, or a simple slowdown in the economy-- but no shock. But as I've highlighted before, the market is ever more susceptible to the unexpected black swan.

Put another way, the economy is good….it’s bad. If bond yields are heading higher and US equities are fully valued, where should you put your money? Again like Grantham….and me!....the answer is emerging markets.

Commodity prices and the value of the dollar are generally good proxies for the performance of emerging markets assets.  Industrial commodities like aluminum and copper have been on a tear lately--and while EM equities have done very well since bottoming in 2016, their relative performance--especially beta-weighted--has been just ok.

I’ll save a few more charts on what I believe shows better equity valuations, growth capacity, and real rates in EM...you get the picture. Compra!

Shawn
TeamMacroMan2@gmail.com
@EMInflationista

*If you have the photoshop skills to turn that white goose gold, please get in touch with TMM management immediately.