“ To know what you know and what you do not know, that is true knowledge.”
— Confucius
As of this past Friday’s close, the S&P 500 surpassed the 2,600 level, setting once again, a new high. NASDAQ also closed at a record. Climbing the Wall of Worry has enabled almost all US broad-based indices to be at or near all-time highs. Despite an improving economy and 10% earnings growth, bears, since 2011, have consistently searched for reasons for a bear market selloff. Most recent is the flattening yield curve. Highly respected by institutions, Ned Davis Research warns investors about “jumping to conclusions and making premature portfolio change s because of the slope of the yield curve.” The analysis examines the six instances when the spread between the 10-year Treasury yield and the 6-month T-Bill flattened to less than 100 basis points and a recession followed. It took an average of seven months of yield curve flattening to inversion and the S&P 500 rose in all but one instance.
From inversion to the start of recession took an average o f 14 months (range 8-23 months). Best performing sectors during the flattening were Energy and Technology with defensive stocks best perform e r when curve inverted. Spiking oil prices have been the primary cause of the inversion and it is doubtful that it will happen during this current cycle. Based on the findings of Ned Davis Research, there seems no rush for the exit (the spread as of last Friday was 90 basis points). We will most likely see the spread narrow over the coming months as the Fed raises rates. Low inflation and low yields are also a contributor to the flatter curve, currently the German 10-year Bund is at 0.34%. Needless to s ay we will continue to monitor the spread, but for now there is no indication of imminent inversion.
China Economics 101
Markets around the world continue to rise in response to global growth. China, which only two short years ago was forecast by many to bring t he US stock market to its knees, continues to grow above all major countries as the value of their exports increase s and the transition to a consumer economy responds to government policy. The worst fears of the debt/deflation cycle s are over, and with it go the chances of financial shock predicted to shake the world’s stock markets. Even US foreign policy seems to be more cordial, but far from embracing. The MSCI Share Price Index shows China up 55.6%, and Hong Kong rising a respectable 32.2% year-to-date. The EM Index for Asia is up 35.0% and all countries are positive. If a weakened China was forecast to dramatically alter the global markets, it seems logical that the emerging strength would form a strong foundation for growth, particularly in the Asia/ Pacific region.
China’s progress has been much faster than anticipated, even among those optimistic just a few short years ago. The macro environment of stable growth, manageable inflation, and improving debt management characterizes the current economy despite tight monetary and fiscal policy over the past year. The improvement is the result of a counter-cyclical growth policy. By weakening nominal GDP, accompanied by rising debt, external demand eventually recovers, and capacity utilization improves giving pricing power to corporations. As a result thus in 2017, the ratio of incremental debt to incremental GDP is at 3.2%, down from its high of 5.5% in 2015. The slowdown in credit growth reversed non-commodity deflation in October 2016 and prices have been rising about 2.5% since the beginning of 2017, giving a boost to nominal GDP. Export growth has recovered to 7.4% year-to-date over 2016 and well-above the 3.8% decline in 2015. The lower debt-to-GDP ratio is inversely correlated to low import growth.
The transition to personal consumption continued throughout the 2014-2016 policy adjustment and continues to outpace the broader economy. Real consumption growth surpassed the investment growth in 2016 and now accounts for a record 54% of GDP. This rise is attributable to higher incomes due to the strength of corporate re venues and nominal GDP growth. Higher income growth allows consumers to move beyond the bare necessities and shift to discretionary spending facilitated by a broad sophisticated e-commerce infrastructure. Spending on consumer staples is a declining share of spending as durable goods, such as home furnishings and autos, has risen. Preference for foreign brands has grown as well, with over 60% of S ports wear sales in the largest cities having foreign labels. Also, the growth in services, including travel and gaming, no longer are only for the wealthy.
The shift to private consumption, particularly in the rural areas, has been underwritten by an expanding e-commerce platform. Online retail sales have been growing about 25% annually. Retail penetration, or the share of online as a percent of total sales, was at 19.5% during 3Q2017, up from 16% in 2016. For the US, the Commerce Department estimates retail penetration at 9.1% in 3Q2017 , which we believe is too low . The extent of e-commerce spending was dramatically illustrated recently on “ Singles Day ” when Alibaba and JD.com reported sales of $ 25.4 billion and $ 17.8 billion, respectively. This far outdistances US Black Friday and Cyber Monday combined. China is currently in the early stages of a countrywide build out (100 Gb transmission) for the provinces.
Investment Policy
Our investment policy remains optimistic. Fed policy is on a course of no surprises in the early stages o f rising rates and in the absence of trade wars, potential lower taxes and reduced regulation, government policy is a positive for economic growth for the first time in nearly a decade. A selloff of not more than 5% is possible, but our view does not assume a meaningful decline resulting in a market correction of 10% or more. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderate rate increases, and strong consumer and business confidence. W e expect the economy to remain above 2% annual growth in 2H 2 017 as slowly improving wages, housing, and Internet retail continue to reflect a healthy consumer willing to spend. I t is highly unlikely given the increasing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, a successful implementation of the Fed’s balance sheet reduction, will result in increased earnings and multiple expansion giving further upside for select domestic Large-Cap Technology, Industrial, and Healthcare sectors, and selected Financial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.
Authors: David Minor & Rebecca Goyette
Editor: William Hutchens
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