With economic recovery having recently crossed the seven-year mark, investors may wonder if the tide will soon turn in another direction, and what triggers might cause such a shift. Certainly the past two years were more volatile than the previous five, given talk of interest rate increases, China market worries and Brexit, to name a few. Now, investors want to know: What’s the trajectory going forward?
PNC’s Chief Investment Strategist Bill Stone details the great landscape of the financial markets and economic conditions as we close out 2016 and look to the year ahead. His insight assesses where we sit in terms of the business cycle: the recurring pattern of expansion and contraction.
PNC expects U.S. economic growth for 2016 to be 1.5% year-over-year, accelerating to 2.3% in 2017. While the second-quarter GDP slipped to a disappointing 1.1%, we anticipate a rebound through the end of the year and faster growth in 2017. To land on an outlook for recovery, we consider the following:
The job and unemployment situation in the U.S. has surely improved since the dark days of the recession, and PNC considers the labor market to be in good shape moving into 2017. The current unemployment rate (4.9% and declining) suggests that the market might be hovering around its potential. This is despite fewer individuals participating in the workforce due to retirement, choosing to stay at home or attend school, and a high number of underemployed people (workers accepting jobs below skill level or settling for part-time work). 
The three-month moving average for monthly payroll growth ending in July 2016 (190,000 jobs) was slightly slower than 2014 and 2015 levels. Oftentimes, a job slowdown suggests the late stages of economic growth. However, July’s number was a strong 255,000. Total non-farm employment surpassed its pre-recession peak in 2014; this factor alone puts expansion at about two years old.
Labor market and payroll growth tend to be lagging economic indicators, meaning that the current status reflects three- to six-month-old trends. Along those lines, today’s job market has less value in forecasting the state of the business cycle.
Both a symptom of a strained economy and a contributor to recession, inflation quickens when a tight labor market or tight production (among other possible factors) pushes prices higher. This stresses both corporate and consumer wallets, leading to cutbacks in spending.
So far, inflation has been of little concern in this recovery. In fact, economists were more concerned about deflation. Many factors are helping to keep prices low, including minimal pressure from wage growth and oil’s steep and unexpected drop in 2015.
Growth in the Consumer Price Index (CPI) has been modest, and not likely to rise significantly anytime soon. In fact, CPI growth recently clocked in at 0.8% year-over-year. PNC economists forecast 1.2% growth in 2016 and 2.1% for 2017. Both are well in line with the 2% rate that the Federal Reserve’s Open Market Committee established as its long-term target. Excluding food and energy, core CPI was 2.2% year-over-year. Rising core personal consumption expenditures (the Fed-preferred measure of prices on consumer goods) are even milder, with a year-over-year increase of just 1.6%.
Following a recession, GDP growth usually accelerates as a result of pent-up consumer demand for goods. After the initial jump, growth tends to settle into a more sustainable level. In the last stage of expansion, it slows to the point of collapsing. The current U.S. recovery is a bit unusual in that we didn’t have that initial surge in growth. Quarter-over-quarter annualized real GDP growth has trended at about 2% since the recovery began.
While GDP growth has been far from robust and there have been slow quarters, there’s little evidence to suggest an absolute trend lower. As mentioned above, economic growth was slower than expected in the second quarter of this year (1.1%), and the slowest pace in three years. Consumer spending, on the other hand, was a huge positive: up at a 4.4% annual rate for the quarter after adjusting for inflation. PNC expects a rebound for GDP through year-end.
It is important to note that GDP data is typically not available as early as other economic data points; the initial estimate is not released until about a month after the quarter ends. This figure is highly anticipated and closely tracked, but often fails to accurately reflect economic performance. The estimate is revised at least twice in subsequent months, seriously altering perceptions of the economy.
This is one of the most tracked indicators of the goods-producing side of the economy, and is a timely alternative to GDP. Reporting requires just a few weeks. Unlike GDP, industrial production experienced a post-recession surge, maxing at 8.7% year-over-year growth in early 2010. After that, growth settled around 3%, consistent with historical trends. This suggests that industrial production has moved beyond the earlier stages of growth.
Housing: one of the great causes of the recession. It is especially necessary to keep an eye on this sector. Usually, housing is a source of stability during recessions and does not really experience a recovery. But, given the severity of the housing bust, some cyclicality can be expected. Housing has been slow to recover and is dependent upon location. Overall, PNC expects solid performance through year-end.
Interest rates are frequently used by analysts as signs of economic standing. Generally, falling rates correspond to recession and increasing rates mean expansion. The December 2015 rate increase was the first action taken since the zero interest rate policy began in 2008, and the Fed continues to emphasize that rate hikes will be gradual. This standard implies we are still in the earlier phases of recovery. Conversely, other monetary policies aimed at stimulating the economy during the feeblest stages of the recession have already ceased, suggesting that we’ve advanced into later stages of recovery. Current market expectations place a greater than 50% probability that the Fed will raise interest rates again before the close of 2016.
When investors expect a significant slowing of growth, the variance between shorter- and longer-term interest rates shrinks. When investors begin to suspect contraction, or a decline, future expectations of short-term rates fall more dramatically and the yield curve inverts. This inversion historically has had a very high success rate at predicting recessions 1-2 years in advance. Since 1953, there has not been a recession in the United States without the 10- to 30-year yield curve inverting no less than one year before the start of decline. Today’s yield curves are large, but not as large as those seen in 2011. This is no cause for concern, as the spread in 2011 was record-high, making “narrowing” almost certain as rates normalize.
Not surprisingly, markets tend to be volatile around periods of uncertainty; unease about economic conditions and forecasts drive volatility higher. Volatility is not a strong gauge of economic stance, but one to be scrutinized nonetheless. Earlier this year, the Brexit vote and the sharp eye toward the path of interest rates affected volatility. Oil prices also impacted market sentiment and trading.
Retail sales figures offer a good indicator of personal consumption expenditures – the measure of prices on consumer goods, which is a component of GDP. There is a direct correlation between strong retail sales and GDP.
Despite softness in July, consumer spending was leading the U.S. economy mid-year. The fundamentals for consumers are good: more jobs, accelerating wage growth as the labor market tightens, low interest rates, solid home and stock values. Consumer spending rose 4.4% at an annual rate in the second quarter after inflation, the clear standout in an otherwise disappointing GDP report. Consumer spending will likely slow, in our view, but should continue to lead U.S. economic growth through the rest of this year.
Inventory levels are widely seen as a solid forerunner of economic activity. The idea is that businesses add inventory in anticipation of strong future demand. In general, inventories have risen since 2010, but fluctuate wildly quarter-to-quarter. This year, inventories were a drag on second-quarter GDP.
Personal income is typically seen as a lagging pointer in the business cycle, trending hand-in-hand with other employment data. But this reporting is important. As economic conditions improve, income should increase, leading to strong spending. This is a sign of a healthy economy, and income growth has indeed returned to pre-recession levels.
Using data from 1900 to 2014, we analyzed whether stock market corrections (bear markets, in this case) can accurately predict recession. Our results show that stock price declines do not do a good job of predicting recessions.
Since 1900, bear markets have predicted 5 of 22 recessions. This is a less than 23% success rate. More often, bear markets have given false alarms. Furthermore, there is little evidence that a bear market has any lasting consequences for economic growth. GDP growth – in the quarter that the 20% threshold is crossed and in the following two quarters – does not show definitive movement in either direction across recessions.
A question we often get from clients is: How does the stock market perform in an election year? The follow-up question is: Does it matter to the financial markets who won?
One positive data point is that election years tend to be favorably correlated with market returns. Since 1928, the median return of the S&P 500 in an election year has been 9.0%, and has been positive 15 out of 21 times. All election years have experienced a rally of at least 10% at some point during the calendar year, with a median of 17.2%. Interestingly, the market seems to favor a mixed Congress, when majorities in the House and Senate are held by different political parties.
We expect low- to mid-single-digit earnings growth for 2016, barring a greater-than-expected acceleration in global GDP growth. The big drag on overall earnings growth this year has been the sharp drop in the energy sector, due to the decline in oil prices. A pickup in economic growth is supportive of earnings. In addition…
Economic expansions typically come to an end with external shock versus old age. At 7+ years, this recovery is taking longer than average. There have been more than a few recovery periods that have gone on much longer: 1970 at 106 months, 1991 at 92 months, and 2001 at 120 months, for example.
Due diligence warrants the discussion of where we are in terms of the business cycle, as indicated by the host of important economic and market data considered here. Still, the most important thing to note as the New Year approaches: There is generally an event that brings the cycle to an end, whether that be tighter monetary policy or an external factor like oil. It isn’t going to happen naturally.
Bill Stone is executive vice president and chief investment strategist for PNC Asset Management Group. He is responsible for leading the strategy teams for PNC Wealth Management®, PNC Institutional Asset Management® and Hawthorn, PNC Family Wealth® in monitoring the factors that influence the direction of domestic and international financial markets.
He is a member of PNC's Investment Policy committee and is responsible for defining the asset allocations and portfolio strategies used throughout PNC to advise individual and institutional investors. In addition, he is chairman of PNC’s Portfolio Construction committee where he directs the activities to design, monitor and support the various model portfolios utilized throughout the organization. In addition to traditional portfolios, these include PNC’s innovative liquid alternative and smart beta strategies. He is a voting member on PNC’s Investment Advisor Research committee, which oversees manager due diligence, and multiple other governance committees.
Stone joined PNC Wealth Management in 2000, serving most recently as chief investment officer and investment director of the Pittsburgh and Boston markets. In this role, he provided investment leadership in the creation and implementation of investment strategies. Stone's professional experience also includes several positions with Wall Street firms, most notably as financial analyst at Salomon Brothers and institutional sales with Smith Barney. He also served as chief investment officer at First Western Trust.
In addition, he is a popular public speaker and has presented at numerous U.S. and international conferences. He often appears on U.S. and international TV and radio as well as in print media to share his keen insights into the global financial markets. His expertise has been featured on ABC, Bloomberg, Bloomberg Asia, CNBC, CNBC Asia, Fox Business, and NHK World. He has been quoted extensively in the financial press, including The Wall Street Journal, Financial Times, Bloomberg News, Barron’s, USA Today, and The New York Times. He became a contributor to Forbes in 2014. He can be found on social media on twitter: @ewstone.
He previously served on the board of directors of the Economy League of Greater Philadelphia and is a member of the Union League of Philadelphia.
Stone is a cum laude and Honors Program graduate of the University of Dayton with a degree in Finance. He earned a master's degree in Business Administration from the University of Pittsburgh’s Katz Graduate School of Business. He earned the Chartered Financial Analyst® and Chartered Market Technician designations.
1. Decline in the labor force participation rate, Bureau of Labor Statistics and PNC. Participation fell from a prerecession peak of 66.4% to 62.8% in August 2016, the lowest level since the 1970s.
2. Bear market defined as a 20 percent market correction over a months-long period.
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