Why Slow US Growth Isn’t Impacting Stocks - Yet

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Ronan Keenan writes: There is a reason why asset management firms don’t employ legions of economists to do their investing. Providing accurate economic forecasts is very useful, but financial markets generally don’t reflect the state of the world. 

US stock markets have rallied strongly over the last two years, while economic growth has been weak. Appetite for stocks has been driven by central bank action, not forecasts of skyrocketing consumer demand. The Federal Reserve has held its interest rates close to zero for the last five years while implementing vast amounts of quantitative easing - printing money to buy government bonds.

These purchases effectively lower bond yields, resulting in lower financing costs for companies while simultaneously encouraging investors to buy assets such as stocks since the return on fixed income is so low.

Moreover, when economic news does noticeably move markets, it is typically due to “surprises” in data releases rather than the absolute level of growth. So if the economy is weak, but a GDP figure is unexpectedly strong, markets will often rally and appetite for riskier assets increases. A longer-term rally can ensue when an economy appears to be on a turning point; transitioning from recession to a period of growth.

In recent years US markets have also been boosted by upbeat corporate earnings that have continually surpassed estimates. While this is clearly beneficial for stock market performance, it does not necessarily reflect well on the economy.

The focus on quarterly results has led to aggressive cost-cutting, aiding corporate profits. Earnings per share have also been augmented by a large number of stock buybacks, in which repurchases by companies lead to fewer shares. This can be beneficial for shareholders, but is not an indication of improvement in a company's performance.

Worryingly, earnings have been rising but revenue has remained little-changed. Hence, earnings have grown while actual demand for a company’s product has not. Moreover, there has been no increase in private sector capital expenditure in 2013; something that will be necessary to fuel economic growth when the Fed reduces its monetary stimulus. 

Strong momentum and near-zero central bank rates may see the stock market rally continue into 2014, but without an active consumer the longer-term picture is not so optimistic. While the US unemployment rate has declined to 7%, much of the job creation has been in low income roles, and the rate is enhanced by a fall in labor force participation to its lowest level since 1978. Notably, real median wages (adjusted for inflation) have fallen just over 3% since the start of 2009. 

There was a better-than-expected retail sales number for November and consumer confidence improved, but Morgan Stanley forecasts that this year will see the weakest holiday spending since 2008. In addition, projected gift spending per person will decline for first time since 2009. The possibility that a reduction in the Fed’s bond-buying  program may lead to rising yields is not a good sign for the housing market. This year’s jump in long-term yields, spurred by the Fed’s first mention of “tapering” in May, has resulted in a slowdown in US housing activity as higher borrowing costs make homes less attractive. For example, in May a $1,000 mortgage payment could attain a house worth $225,000, while the same payment now buys a $195,000 house. 

However, an important milestone was reached this week following the release of Q3 data showing the first rise in outstanding mortgage debt since the beginning of 2008. Over the last five years, the US has been in a deleveraging phase in which the private sector focuses on minimizing debt, thus sacrificing spending. But the recent rise in mortgage debt indicates that US households are making some progress in their deleveraging efforts and are demanding more credit. This is good news, but the growth in credit demand is from extremely low levels. 

Some additional optimism has been fuelled by a rise in US household net worth in Q3 to $77.3 trillion, an increase in approximately $2 trillion from the previous quarter. Proponents of the “wealth effect” theory assume that an increase in households’ net worth will lead to a rise in consumer spending. However, the source of last quarter’s increased wealth should temper cheer.

Rising stock markets were attributable for $917 billion of the wealth increase, while $428 billion came from higher house prices. Essentially, most of the increased in wealth is going to the population that invests heavily in stocks - the wealthy. They will likely use this new wealth to re-invest in stocks, helping to fuel the bull market momentum. Since rising house prices accounts for a much smaller percentage in added household wealth, most Americans will not feel much wealthier and consumer spending will unlikely see a sizable increase.

The outlook for US economic growth remains positive for 2014, but not strong. Most forecasts fall below 3%, yet the absolute level of growth won’t impact the stock market. Instead, momentum, central bank action, earnings and data surprises will likely dictate movements. For the rally to sustain beyond next year there will need to be more consumer spending, otherwise companies will have to increase their own expenditure as they run out of methods to artificially boosting earnings.

This article also appears on Ronan Keenan’s MacroWatcher blog

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