Solid Q4 GDP Report Portends Good 2018 Economy

Do Yields Matter Now?

The stock market fell modestly on Monday as the S&P 500 was down 0.67%. Because the market has had such a spectacular year, this is the worst day so far. The 99 day streak without a 0.6% decline, which was the longest streak ever, ended. Some are blaming the increase in the 10 year bond yield for the decline in stocks. The 10 year bond yield hit above 2.7% for the first time since April 2014. This means for the first time in years, the bond market believes nominal GDP growth will be strong. This worries those who believe in the TINA thesis because yields will provide competition for stocks. It worries me because yields are rising with inflation expectations. I think the 10 year will be a problem for the stock market when it gets above 3% which would be close to the highest point since 2011. While the size of the market decline wasn’t sharp, the NYSE breadth (the amount of stocks up versus the amount down) was horrible. It was the weakest since August 2017.

Momentum Still Excessive

A day where the overall index falls less than 1% isn’t enough for me to think the market isn’t overbought anymore. As you can see from the chart below, the S&P 500’s distance from the 200 day moving average has rarely been higher. Stocks were only more overbought in the 1920s and the 1980s. This overbought ratio is why so many traders were worried about Monday’s performance even though it wasn’t that bad. The traders who haven’t experienced a 5% correction, because that hasn’t happened in over 400 days, are nervous and the investors who know the market is ripe for a correction are licking their chops.

Headline GDP Miss, But Good Underlying Growth

The GDP report showed the economy grew 2.6% in Q4 which was below the expectation for 3.0%. This was much worse than the 3.2% growth seen in the prior quarter. However, the report was very good if you ignore the headline and get into the details of it. The personal consumption was up 3.8% which signals consumer spending was very strong during the holiday season like I expected. The final sales to private domestic purchasers was up 4.6% quarter over quarter which was the fastest growth rate since Q3 2014. It’s not a surprise the consumer was strong; the labor market was strong and sentiment was high. Non-residential fixed investment was up 6.8% which shows firms are investing more in capex. I’m worried that the capacity to utilization rate will hit a ceiling this year.

The big negative that caused the miss was the trade deficit. It’s interesting to see such a high trade deficit when President Trump prided himself on fixing the deficit issue. The deficit with China in particular increased even though Trump singled out this bilateral trade deficit as a problem. My theory has always been that we shouldn’t worry about Trump’s harsh rhetoric on trade. However, those who disagree with me think this trade deficit will provoke tougher tariffs and more protectionism. We’ll get a good idea where Trump stands on this issue at the State of the Union. He might mention the trade deficit specifically or ignore it. If he ignores it, that’s a good sign for trade. I think the trade deficit isn’t a problem because it usually increases during cyclically strong periods. That’s the reverse of the budget deficit which gets weak when the economy is weak.

The chart below breaks down each factor that led to the GDP growth of 2.6%. Personal consumption expenditures helped GDP by 2.58%. Fixed investment added 0.84% to GDP. Inventory destocking hurt GDP by 0.67%. This issue is the main reason why I think this GDP report was better than the headline. Without it, the GDP growth would have beaten expectations. The trade deficit hurt GDP growth by 1.14%. The 1.96% hit from imports was the worst impact to GDP growth since Q3 2010. Inflation saw an acceleration which supports the notion that the Fed will hike rates 3-4 times in 2018. It was up 2.5% in Q4 which was 0.8% higher than Q3. Core inflation was 1.9% in Q4 which was up from 1.6% in Q3.

Late Cycle Indicators Are Engaged

The savings rate in Q4 fell from 3.3% to 2.6%. It was 2.4% in December. This is either a very good sign or a bad sign, depending on how you look at it. On the plus side, it means consumers are optimistic enough to spend their disposable income instead of save it. The earnings growth in 2018 will flow almost directly to consumer spending growth. On the other hand, the savings rate is near the lowest level ever which is a sign the economy is near the end of the cycle. The lowest savings rate ever was 1.9% in June 2005 which was a year before the peak in the housing market.

Another way to look at the savings rate is to compare it to the net worth to disposable income ratio. Essentially, the increase in the stock market is causing people to save less money because their 401K valuation has increased so much. For example, say you make $80,000 per year and start the year with $300,000 in retirement savings. If your retirement account went up 20% in 2017, you made $60,000. If your take home pay is $60,000 and you save 3% of that, you save $1,800. As you can see, the increase in a retirement account could be more important than saving a small percentage of income.

In addition to saving less, consumers are also borrowing more. The consumer is leveraging up because we’re at the end of the business cycle. The big spike in consumer credit that you see in the chart below will probably start to reverse itself in 2019 when the labor market isn’t as strong as it is now. The record high credit card debt will be a pain to unwind in the next recession.

Spread the love

Comments are closed.