Outlook for 2018

At this time of year we are usually inundated with projections for the year ahead, from predictions of imminent collapse to expectations of a record year.

We live in a world of uncertainty, where both extremes are possible, but neither is likely.

We are clearly in stage 3 (the final stage) of a bull market. Risk premiums are close to record lows. The yield spread between lowest investment-grade (Baa) bonds and equivalent risk-free Treasuries has crossed to below 2.0 percent, levels last seen prior to the 2008 global financial crisis. The VIX is also close to its record low, suggesting high levels of investor confidence.

Corporate Bond Spreads and VIX

Money supply continues to grow at close to 5.0 percent, reflecting an accommodative stance from the Fed. MZM, or Zero Maturity Money, is basically M1 plus travelers checks and money market funds.

Zero-Maturity Money

Inflationary forces remain subdued, with average hourly wage rates growing at below 2.5 percent per year. A rise above 3.0 percent, which would pressure the Fed to adopt a more restrictive monetary policy, does not appear imminent.

Average Hourly Wage Rates

Tax relief and higher commodity prices are likely to exert upward pressure on inflation in the year ahead. But the Fed’s stated intention of shrinking its balance sheet, with a reduction of $100 billion in the first 12 months, is likely to have an opposite, contractionary effect.

The Leading Index from the Philadelphia Fed gave a bit of a scare, dipping below 1.0 percent towards the end of last year. But data has since been revised and the index now reflects a far healthier outlook.

Philadelphia Fed Leading Index

A flattening yield curve has also been mooted as a potential threat, with a negative yield curve preceding every recession over the last 50 years.

Yield Differential 10-Year compared to 2-Year and 3-Month Treasuries

A yield differential, between 10-year and either 2-year or 3-month Treasuries, below zero would warn of a recession. When long-term yields fall below short-term yields financial markets stop working efficiently and bank lending tends to contract. Banks, who generally borrow at short-term rates and lend at long-term rates, find their margins are squeezed and become strongly risk-averse. Contracting lending slows the economy and normally leads to recession.

But we are some way from there. If we take the last cycle as an example, the yield curve started flattening in 2005 (when yield differentials fell below 1 percent) but a recession only occurred in 2008. The market could continue to thrive for several years before the impact of a negative yield curve is felt. To exit now would seem premature.

Not much wrong with the US economy

Profit margins in the US are contracting, with the second quarter showing a 6.0% decine in profit per unit of real gross value added (Nonfinancial). Contraction of greater than 10% would be cause for concern, but we need to dig a little deeper.

Declining US Profit Per Unit of Real Gross Value Added (Nonfinancial)

Earnings per share for the S&P 500 Index declined for the last two quarters and is projected to decline for the next two quarters as well (Q2 which is 98.6% complete and Q3 2015).

S&P 500 Earnings Per Share

The sharp fall in index earnings is primarily caused by losses in the Energy sector. Other sectors are reasonably healthy.

S&P 500 Energy Sector - Earnings Per Share

Another cause for concern is bellwether transport stock Fedex. Commencement of a primary down-trend normally warns that economic activity is contracting. Freight revenue for the fiscal fourth quarter increased by only 1%, while ground revenue increased by 19%. Slower earnings growth due to a lag in fuel surcharges and integration challenges with the acquisition of TNT may both be weighing on the stock.

Fedex

The Freight Transportation Services Index, however, has turned upwards.

Freight Transportation Services Index

And the LoDI Index continues to climb.

LoDI Index

The LoDI Index uses linear regression analysis to combine cargo volume data from rail, barge, air, and truck transit, along with various economic factors. The resulting indicator is designed to predict upcoming changes in the level of logistics and distribution activity in the US and is represented by a value between 1 and 100. An index at or above 50 represents a healthy level of activity in the industry.

Spending on durables remains promising, with light motor vehicle sales rising.

Light Motor Vehicle Sales

And construction spending (adjusted for core CPI) climbing steeply.

Construction Spending

The ISM Manufacturing PMI Composite Index remains above 50, indicating expansion, but is softer than it has been for a while.

ISM Manufacturing: PMI Composite Index

The Leading Index from the Philadelphia Fed, however, at a healthy 1.57%, continues to project a healthy economic outlook.

Philadelphia Fed Leading Index

Despite the falling Fedex stock price and softer PMI, there does not appear to be much wrong with the US economy. The positives outweigh the negatives. Analysts’ optimism about an fourth quarter upturn may be a little premature, but does not appear far off-track.

China’s leading indicators head south – macrobusiness.com.au

Take a look at the [Chinese] Leading Index’s sharp deterioration recently – there has been a clear and material deterioration in the leading index over the past couple of months. This suggests to us a substantial further fall in Chinese GDP. The last release of a week or so ago showed Chinese GDP growing at 9.1% against expectations of 9.1%. This leading index to us suggests that this growth rate will fall to 8% which is getting dangerously close to the “hard landing” territory.

via China’s leading indicators head south – macrobusiness.com.au | macrobusiness.com.au.