Research Note - October 2016

Threats to the Status Quo

October 04, 2016 | Market Commentary

Slow growth and volatility have been the status quo throughout most of the current expansion. Our indicators suggest these features are likely to remain in place for now, but it is still important to consider what could threaten this outlook. Expectations for low growth can prove incorrect not only to the downside, but also to the upside. This month’s Research Note explores some factors we are actively monitoring that could affect the status quo:

Downside Risks

  • The U.S. Federal Reserve is too slow to raise rates
  • Corporate profits roll over
  • The economic expansion dies of old age

Upside Catalysts

  • U.S. consumer drives stronger domestic growth
  • Emerging market economic growth accelerates

U.S. real GDP growth has hovered around 2% since 2012, similar to the three-year annualized growth rate during the recession of the early 1990s as well as the period following the 2001 recession. One of the hallmarks of periods of muted growth is elevated volatility. Since 1990, when GDP growth has been below 2.5% on a three-year annualized basis, high volatility days (represented by CBOE Market Volatility Index (VIX) levels above 30) have been nearly twice as likely as when growth has run above this level (even when excluding the 2007-2009 global financial crisis from the analysis). This makes sense, as the threshold to move into contraction territory is closer when GDP growth is lower. Therefore, disappointing economic data is more likely to spook the market in low growth environments than in more robust expansions.

The market today also must wrestle with valuation levels that suggest long-term returns will probably be muted going forward. The likelihood of volatility also is elevated due to this lack of a valuation catalyst in the market. The headline next 12-month price-to-earnings (NTM P/E) ratio of the S&P 500 is notably lower than during the technology bubble, and not materially different from its 20-year average. However, it is notable that the NTM P/E of the median stock in the S&P 500 is near the high end of its range over this same window.

Elevated valuations combined with low growth further increases the likelihood of additional volatility. Our research suggests that as long as economic indicators remain supportive of equities, elevated volatility can be a friend to investors as they work to achieve their objectives in a low return world. We believe a flexible and active approach is critical for achieving positive investment outcomes in such an environment.

This “volatility equals opportunity” formula has been the status quo for several years and remains our base case today. However, as noted above, we believe it is worthwhile to explore factors that could shift the status quo.

Downside Risks

Risk #1: The Fed gets behind the curve

Inflation expectations are so low today that even a modest upside surprise in inflation could stoke concerns that the Fed is behind the curve with respect to raising policy interest rates. In such a scenario, it is likely that rates would move higher across the yield curve. Besides the obvious risk that higher rates pose to bond investors, higher rates also pose risks to equity investors. One of the popular bullish stock market arguments in recent years is that stocks are cheap versus bonds. Higher yields could change this calculation and force a valuation de-rating of stocks.

The federal funds rate today is just one rate hike removed from the all-time low level that it sat at for the past several years. Over this time, there has been a gradual improvement in the labor market (as well as the broader economy) such that today there are concerns that there is little to no slack left in the labor market. Historically, tight labor markets have been associated with periods of inflationary pressures as companies compete for workers with higher wages, which in turn leads to higher prices. The unemployment rate has fallen significantly, consistent with the view that there is limited slack in the labor market. At similar levels of unemployment in the past, the Fed had already been at least a few hikes into the interest rate tightening cycle. Enough tightness in the labor market combined with wage growth could fuel stronger inflationary pressures, and once those pressures take hold they can be hard to put a lid on without derailing the economy.

The decline in the unemployment rate suggests that the Fed may indeed be behind the curve relative to other cycles; however, there are other factors that counter this notion. Wage growth, while stronger in recent quarters, remains soft by historical standards. Meanwhile, actual inflation data remains relatively contained, with the core Consumer Price Index (CPI) hovering around 2% and headline CPI below that.

We will continue to closely monitor for signs of building inflationary pressures using tools like the labor market chart-book, but at present believe the risks posed by this scenario are not sufficient to deviate from our base case of embracing volatility.

Risk #2: The business cycle has turned

Judging from the modest pace of GDP growth during the current expansion, it would be reasonable to expect relatively tepid earnings growth as well. However, aggressive cost cutting combined with low interest rates and restrained capital expenditures has helped propel margins and earnings to record levels. Further, earnings per share (EPS) gains for many companies have been aided by record amounts of stock buybacks that have been funded, in many cases, by additional debt. Today, however, margins have rolled over at the same time as debt levels have continued to climb. This comes at a time when the economy is later in the business cycle and most of the low-hanging fruit of margin improvements and refinancing have already been picked by most firms. The chart below looks at the net debt to total assets of the median company in the Russell 1000, aiming to take the temperature of companies as a whole. As the business cycle moves further along, stock market returns become more difficult to come by, which heightens the need to monitor for extremes in corporate behavior.

Despite concerns that we are later in the business cycle, the good news is cycles can persist for long periods of time, absent extremes. One of the big differences between today and the late 1990s is the interest rate backdrop right now is considerably more favorable, and interest coverage metrics are still reasonably healthy. Turning to margins, it is not uncommon for margins to contract starting in the middle innings of a business cycle. It is periods of earnings recessions with severe draw downs in profitability that pose the greatest risk for the market, not the rollover in margins itself. Margins alone are not an indicator of the end of a bull market in equities. However, these factors do support an increased focus on selectivity in the current environment. As more companies are seeing leverage ratios increase and margins roll over, companies that counter these trends are rewarded over time.

Risk #3: Expansion dies of old age not unsustainable extremes

U.S. economic recessions historically have been the result of unsustainable extremes that bring about the end of the prior expansion. Consequentially, the majority of the economic indicators we track to gauge the risk of a recession are focused on identifying extremes. Today, these indicators show few, if any, signs of unsustainable excesses in the domestic economy. This mild backdrop has been in place for years, and has enabled this expansion to rank as one of the longest periods of growth in the United States since the 1950s. Despite a lack of major warning signs, we are seeing some weakness in key economic indicators. The Institute for Supply Management’s manufacturing purchasing managers’ index dropped below 50, and U.S. industrial production turned negative. Historically, these events have often, though not always, been followed closely by a recession. This suggests to us an elevated risk that in a low growth world, the economic expansion could die of old age instead of unsustainable conditions.

The current expansion may be considered old by historical standards, but the magnitude of growth off the trough of this cycle is not unique. The chart below plots the cumulative growth in GDP over each expansion on the X-axis versus the duration of the expansion on the Y-axis. This chart makes clear the degree to which growth has been modest relative to the historical relationship between the duration of expansion and growth. Furthermore, although the chart only looks at GDP growth from the trough in the economic cycle, real GDP growth contracted more in the last recession than most prior recessions. The first 4% of real GDP growth from the trough was only to regain prior peak levels, and that did not happen until mid-2011. One of the key roles of recessions is to wring out the excesses from the prior cycle. The more excesses, the longer and more painful the process is. While it is possible the economy just rolls over, this scenario likely provides for a very mild recession given the economy would not be correcting from unsustainable extremes.

Upside Catalysts

Risks to the downside tend to dominate our assessment of threats to our base-case expectation for a slow growth world where market volatility should be seen as an opportunity. We believe this is appropriate given that the current economic and market cycle are well off the trough, where the upside opportunity is most compelling. Nevertheless, the possibility remains that the economy and market surprise to the upside and result in a missed opportunity to achieve strong returns to support investor objectives. The U.S. consumer and global growth, particularly in emerging markets, are two specific potential upside catalysts that we are monitoring.

Upside Catalyst #1: U.S. consumer drives stronger domestic growth

One catalyst to the upside of our base case is a stronger consumer, a potential surprise we discussed a few months ago. Average hourly earnings have strengthened over the past year, which puts more money in consumers’ pockets. Consumers are the largest contributors to GDP, and they could provide very strong tailwinds to economic growth if they experience healthier wage growth as well as begin to form more households (there is pent-up demand in terms of household formations). Increased consumer spending power could increase the top-line growth of companies, which could help them sustain earnings growth and also make them more willing to invest in future growth through increased capital expenditures and additional hiring.

Upside Catalyst #2: Stronger global growth

The United States has been arguably the healthiest major economy since the end of the global financial crisis. There has been very lackluster demand from outside of the United States, hurting the exports and sales of multi-national companies. Healthier global growth could help the domestic trade balance, strengthen industrial production and GDP growth, and boost the top-line growth of companies. Stronger revenue growth would help to alleviate some of the margin pressure facing companies, and would likely encourage companies to continue hiring workers and investing in their businesses. While Europe and Japan still look like they are struggling to get their footing, there are countries among the emerging markets that are showing signs of life.

Emerging markets are now a very meaningful piece of global growth, and the potential rebound in the growth of these markets would be significant. Our outlook for emerging markets is improving, as many countries are making some headway on their structural issues. This improvement comes at the same time as profitability is stabilizing in some emerging markets, valuations for most emerging markets are not notably stretched compared to developed markets, and emerging market demographic profiles are much healthier than most of the developed world. More specifically, there has been stabilization in EPS estimate revisions in Brazil and better EPS growth expectations during a period where the impeachment of President Dilma Rousseff has been formalized, a new government has pursued reform efforts, inflation has eased somewhat, and economic indicators have signaled a bottom, with the potential to emerge from recession in 2017. Brazil is moving in the right direction, though it is likely that the ensuing recovery will be more U-shaped than V-shaped. Roadblocks to fiscal reform and the need to rein in welfare spending remain large concerns that we are monitoring.

India is another country that is moving in the right direction. The country is making progress toward the approval of a goods and services tax, which should be a large positive as it would make taxes more unified between the regional and national governments and might lower the tax burden for many companies. In Indonesia, tax amnesty declarations and repatriations are moving well ahead of the expectations of the central bank. This should increase the tax ratio and be a positive for confidence, infrastructure spending, and the banking sector.

China remains an area of concern, as the nation’s environmental risk profile is deteriorating and our base case continues to be for growth to decelerate. Government efforts to prop up the slowing economy have led to further debt accumulation in the economy. The property sector appears to be frothy, potentially because the Chinese government is using it as a tool for stimulus and wealth creation. On the more positive side, China’s private economy has begun to show signs of potential stabilization.

Overall, we continue to believe it is important to be selective within emerging markets, as some countries are more expensive than others and some are making better progress on reforms than others. There have been false starts in recent times in many emerging markets that failed to materialize into sustained recoveries. Although it is unlikely that there will be a massive fixed investment boom in emerging markets like what China provided in the 2000s, stronger growth from here would bode well for global growth prospects at the margin.

Investment Takeaway: No unforced errors

Tennis players are familiar with the idea of “no unforced errors,” and that translates into a worthy goal for how to navigate today’s investment backdrop. Slow growth does not sound exciting, but it requires us to walk a tightrope between risks of low-to-negative economic growth and a return to the old normal growth rate. We believe that an active and flexible investment approach that takes advantage of other investors’ overreactions can increase the odds of achieving investor objectives in this slow growth, low return environment. It is imperative for investors to avoid reacting to short-term noise and instead focus on whether near-term data alters the long-term outlook, while also monitoring for signs of a long-term regime shift.

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The S&P 500 Total Return (S&P 500) Index is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. Index returns provided by Bloomberg. S&P Dow Jones Indices LLC, a subsidiary of the McGraw Hill Financial, Inc., is the publisher of various index based data products and services and has licensed certain of its products and services for use by Manning & Napier. All such content Copyright © 2016 by S&P Dow Jones Indices LLC and/or its affiliates. All rights reserved. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or the data included therein. The S&P 500 Constituents are calculated by the daily returns for the individual constituents of the S&P 500 Total Return Index.

The Russell 1000® Index is an unmanaged index that consists of 1,000 large-capitalization U.S. stocks. The Index returns are based on a market capitalization-weighted average of relative price changes of the component stocks plus dividends whose reinvestments are compounded daily. The Index returns do not reflect any fees or expenses. Index returns provided by Bloomberg. The Russell 1000 Constituents are calculated by the daily returns for the individual constituents of the Russell 1000 Total Return Index.


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