The following paragraph is a refresher on our macro analysis framework from a prior post:
We divide the economy into four components: consumer, corporate, real estate, and government. We evaluate each component along several factors including, but not limited to, liquidity, leverage, and sentiment. Each factor is evaluated on both an absolute and trend basis to determine the fundamental outlook for each component. This helps to determine our overall macro view, which states our risk tolerance and direction. The outlook at the individual component level helps determine in which areas we want to take more or less risk.
Below is a summary of our recent macro discussion:
As we have mentioned in prior posts, the current overall global economic data is weak, and the trend is still negative. Several of the leading indicators we look at, including the JPMorgan Global Manufacturing PMI, the New Orders Components, and the OECD Composite of Leading Indicators, suggest that there is more weakness to come.
The U.S. continues to report better economic data than other developed markets, but the weakness that started to appear in global data 18 months ago is having a larger impact on U.S. data.
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Our overall macro view remains that global growth is continuing to decline, and the leading indicators suggest a bottom in economic data has not been reached. Global and U.S. GDP expectations are trending lower compared to 2018 and early estimates for 2019. It is not clear that the U.S. will definitively enter a recession in 2019, as some of the coincident and lagging indicators, such as employment and GDP growth, are still positive. We expect the Fed to continue to cut rates in 2019 and move its outlook closer to what market indicators of future interest rates are forecasting.
There are some ongoing discussions about how effective lowering interest rates will be given how low interest rates are on a historical basis. There may be a shift in focus to more fiscal stimulus efforts, which is something the European Central Bank mentioned at its most recent press conference.
In terms of the four components, we continue to view the consumer and commercial real estate sectors as supporting the most favorable characteristics compared to the corporate and government sector. The corporate sector has deteriorated throughout the year as profit growth has slowed and expectations for future economic growth has slowed. The consumer still looks healthy overall, as the labor market remains strong, and consumer balance sheets are in better condition than the prior cycle. We are starting to see some indications that the weakness in the economic environment may be impacting some parts of the labor market, which could be causing some weakness in certain consumer credit markets.
Overall, payroll growth is still positive, but the growth rate is slowing, especially in the manufacturing sector. Average hourly earnings are still increasing, but the growth rate has turned down, as well as the work week. A similar picture is developing across the entire Goods Producing industry.
Some leading indicators of the broader labor market are starting to decline. In the most recent Job Openings and Labor Turnover Report, the number of job openings continued to decline. Aggregate payrolls, which measures hours worked multiplied by average hourly wages, is still relatively high, but has been declining.
Consumer balance sheets continue to look healthy, as the residential mortgage market continues to experience exceptionally low delinquency rates. There are other areas that show signs of weakness, like credit card and student loans. These areas are not large enough to have the same type of impact as housing in the last cycle but could a be sign that the consumer is experiencing some balance sheet weakness that may lead to lower spending.
The fundamentals of the commercial real estate market continue to be healthy and there are few signs of balance sheet issues in terms of the amount of debt, maturity profile, interest costs, or coverage ratios.
There has been a reduction in volume in 2019 compared to 2018. Much of the decline has taken place at the entity level or large buyout level. There are some announced transactions that have not taken place, that may increase this number by the end of the year. A slowdown is starting to occur in individual asset sales, mainly in the office sector.
Price appreciation remains positive but has been slowing down. This appears to be normal as the cycle ages and prices have reached record highs. Return dispersion remains elevated and the retail sector continues to struggle while industrial continues to lead. We believe this differentiation is a healthy sign that investors are appropriately assessing the potential risk-return across the real estate market with some evidence that well-located retail locations have been successfully repurposed. Development activity continues to remain balanced and there are few signs of oversupply. REIT net operating income (NOI) has slowed, most recently due to weakness in non-same store sales NOI.
Leverage in the corporate sector reached a record high in Q2 2019, as measured by non-financial business debt to GDP. High corporate leverage at a time of slowing economic and profit growth continues to be a major concern.
The recent corporate profits slowdown has caused leverage ratios to increase and interest coverage ratios to decline. They remain at levels that do not suggest immediate risks, but they are trending in the wrong direction. If the economy continues to track along the negative trajectory that we noted above, this will likely have a negative impact on corporate profits and cashflows. Declining profits combined with high levels of leverage will put the corporate sector in a vulnerable state. This is starting to materialize in the percentage of companies that are beating revenue and earnings expectations, as well as guidance for earnings growth for the remainder of 2019. Sustained weakness in the corporate sector could lead to an increase in unemployment, negatively impacting consumers, and eventually impacting the commercial real estate market through higher vacancy rates.
Measures of business confidence have come off their recent highs. However, outside of CEO confidence, they remain at levels suggesting positive, yet slower, economic growth. This could be a temporary setback based on lack of direction around trade policy or a reflection of weaker global growth. Either way, business confidence has historically had a high correlation with capital investment which has a high correlation with profits and employment. We intend to continue to monitor developments in the corporate space, as they tend to lead the other components.
In a prior post, we mentioned the difference between current fiscal and monetary conditions today compared to 2007 (when the FOMC was last cutting interest rates). Monetary policies are more accommodative today and will likely have less of an impact during the next recovery. While the U.S. Federal Government budget deficit continues to increase and is now over 4.5% of GDP, we expect the focus of stimulus efforts to shift from monetary to fiscal policy during the next recovery.
In summary, at this time, we continue to maintain our reduced level of market risk and we will likely look to further lower the risk profile of our portfolios should economic data continue to weaken from current levels.
Rank Dawson, CFA
Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.