Bringing Mixed Signals Into Focus

Over the past three weeks, I’ve travelled from coast to coast for business meetings. Along the way, I’ve had many conversations with people about how they see the economy progressing in their own sphere of influence. What I hear tends to reinforce my own bimodal viewpoint on where the U.S. is going in the short term, and what risks could appear down the road.

We hear members and staff of the Federal Reserve System making public comments to the effect that it may well be time for a rate rise in September, or sometime soon, anyway. Most of these comments are based on the much-debated employment figures and the generally positive gross domestic product (GDP) figures that have been released. I do hope they are right. Or have we forgotten that “jawboning,” or talking up the market, is one of the roles listed for the Federal Reserve in most graduate finance books – maybe it’s just all talk.

But, as regular readers of the Daily Pfennig® newsletter know, I think that while “the market” does not always accurately predict the future, it does reflect what participants think. Price discovery – pretty much everywhere but restricted markets like China, anyway – occurs between willing buyers and sellers at an agreed upon price. The levels seen on screens and later published tell the story of how we collectively view the economic prospects at that moment. We commentators are just shaman laying out a tale told around the campfire for your enjoyment and, hopefully, providing you with context for your own decisions.

Believe The Market Or The Statistics?
While I am a huge fan of Pollyanna, right now, I’m more in the Debbie Downer camp. The plot of my story examines the uncertainty with weak economic growth embedded in direct market indicators all the way out to the horizon, and with some extreme risks positioned like highwaymen in strategic hideaways along the way. Here are some of the obvious indicators that I follow, with prices as of Aug. 16, 2015.

Ten-Year U.S. Treasury Note: 2.20%.1
This key indicator incorporates the expectations of inflation over the next 10 years, and with that, a measure of expected economic growth. Pure bondholders have a choice at any point in time of purchasing a 10-year note, or buying shorter issues and rolling the proceeds over during the same term. In addition, a premium is required by long-term holders to compensate for uncertainty over the 10-year period. This has been estimated by some at about 1.60%,2 leaving only 0.60% to pay for inflation and avoiding any alternative investments.

Market Verdict – no growth, and no inflation for 10 years.

Oil: $42.50/barrel.
Call it a supply overload from Saudi Arabia and others, a competitive challenge to fracking, or a reduction in demand due to slow economic growth. None of these really change the viewpoint that if global business were robust, the price would be much higher. Some would note that the strengthening in the U.S. dollar over the past 3 years has caused this fall in global prices, but this doesn’t foot with the fully 50% fall from the highest levels over the same period. And, of course, oil is priced in USD.

Market Verdict – low demand/slow growth.

Copper: $2.33/pound.
Like oil, but less political, copper is used in just about everything that is made when there is economic growth. Off 40% from its three-year high and trending lower, copper is perhaps one of the best barometers of current global market activity.1

Market Verdict – low demand/slow growth.

I could go on, but you get the point. I acknowledge that there are some good things going on – corporate profits appear high, and other indicators are moving steadily to the plus side. But, I just can’t shake my feeling that the market tells a more accurate story than statistics.

Follow Where The Money Is Going
Another way to gauge attitudes is to understand where companies are placing their bets. Strong investment in research, product development, or even marketing can indicate that managers are confident that their plans will succeed.

Today’s corporate manager doesn’t typically decide on a whim to invest. They do studies. They calculate prospective profit margins. They assess the competition. They look at production improvements. They lay probabilities out against all these factors. They propose to their own manager, then the next layer up. And then take it to committee.

At committee, the question, “How sure are you of your projections?” will surely be asked almost to the point of caricature. With more certainty, the project will likely go ahead; with less certainty, it will be back to the drawing board.

We can look at this level of confidence in the aggregate by examining what companies have done for the past decade or so. In fact, William Lazonick at The Harvard Business Review has done just that. David Stockman and Bill Bonner each referenced this paper recently, so I took a look.3 I can’t say I agree with some of his conclusions or solutions, but from a forecasting perspective, I found the statistics fascinating.

If those managers we discussed above were confident in their projections and companies felt that additional investments would boost their market capitalization, then the commitments would be made. It turns out that for “the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012…those companies used 54% of their earnings – a total of $2.4 trillion – to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.”3 Not much confidence there.

So, take it from market prices, corporate confidence, or reading the tea leaves, there’s a story line that convincingly says that growth will be slow, prospects uncertain, and inflation nearly zero for 10 years. Does this sound like Japan over the past 20 years? I certainly hope not, but I am beginning to give in to the feeling.

Onward and upward.

Until the next Daily Pfennig® edition…

Frank Trotter
EVP & Chairman
EverBank Global Markets Group