There are great expectations by most that the US will continue to deliver growth that is well above the rest of the developed world. The most recent economic data has been lackluster and has not indicated that the recent uptick in US growth is sustainable in the face of growing deflationary pressures and an across the board slowdown in global growth.
In addition, my proprietary US indices are indicating that the great expectations for the US could quickly become a great disappointment.
Last week did not offer any signs of a tailwind for US growth to start 2015. To start, the World Bank cut their 2015 global growth forecast to 3% from 3.4%. The Eurozone’s growth was cut from 1.8% to 1.1%, Japan was cut from 1.3% to 1.2% and Chinese growth was cut from 7.2% to 7.1%.
That said, US growth was raised 20 basis points from 3.0% to 3.2% and the World Bank says they expect the Fed to hold off on interest rate hikes longer than anticipated due to falling prices, stagnant US wages and lower global growth.
Following the downgrades, there were several US specific data points of note: December CPI, retail sales and industrial production.
December’s CPI declined more than expected on the worst drop since December 2008. The decline was primarily due to a 9% slide in gasoline prices as compared to November.
If you remove the Food and Energy component of CPI, I’m not sure you why you would do this unless people stop eating and driving, then CPI rose 1.6% year over year. The question is whether or not the Fed will see this as transitory or the beginning of a prolonged period of lower energy prices and as a result, a prolonged period of fighting deflation.
This one report could single-handedly derail the Fed’s plan to raise rates by mid-year. As falling commodity prices filter through the system, it will take nine months to a year, before we start to see inflation in the US, and around the globe for that matter, begin to stabilize and pick back up.
Last week also saw the reporting of the advanced retail sales for December, which fell 0.9% month over month. The last time retail sales had a bigger monthly drop was June 2012.
We can’t blame the decline on lower gas prices, even if you eliminate gas prices, retail sales still fell 0.3% on great expectations of a 0.5% gain. The weak sales report converts to a 3.2% annual increase, which is the slowest year over year growth rate in 10 months.
This sales report could be a warning sign for the US economy, but a closer look indicates that December's decline is probably just noise. The retail numbers would cast a much darker shadow for the US if there were clear warning signs elsewhere in the economy. But the combination of a positive trend in the monthly labor data and the de facto tax cut for consumers by way of falling energy costs should keep growth stabilized for the time being. But stabilized is not the same thing as accelerating.
The final critical data point from last week was December industrial production, which declined 0.1% after November's 1.3% increase. It should be noted that November’s report was the biggest gain in 5 years, so some mean reversion was to be expected.
Although it’s clear that industrial activity slowed sharply in December, it’s important to recognize that the year-over-year gain is only slightly off its recent peak. What matters most occurs at the margin. In short, the latest IP report still points to an economy that’s set to grow at a reasonable rate.
While recent economic data doesn’t paint a picture of the US economy falling apart, it also doesn’t paint the picture of an economy immune to deflationary pressures abroad or one that aligns with the Fed’s prerequisite for hiking interest rates. We’ve looked at recent economic data and the World Bank’s forecasts, now lets look at what market are saying, in real-time.
What the Markets Are Saying
Regular readers of TWR, know that I maintain numerous proprietary indicators that inform me of what is occurring in the global markets and generally allow me to front-run a change in investor sentiment.
Two such indicators, the US High Growth Index and the US Slow Growth Index, allow me to understand, in real-time, whether financial markets are pricing in slowing US growth or US growth that should begin to accelerate higher. So let’s take a look at the performance of these two indices and the broader US equity market, via the benchmark S&P 500.
As the names would imply, the US High Growth Index is a benchmark of assets that historically outperform of US based assets during periods of accelerating US growth.
The US Slow Growth Index, is a benchmark of assets that historically outperform as US economic growth is slowing. So far this year, through the close of business on Friday, January 16, 2019, here are the performances of the indices plus the S&P 500:
US High Growth Index: -3.0%
S&P 500 Index: -1.9%
US Slow Growth Index: +6.5%
So, 2 weeks into 2015, the 2014 trend continues. For the full year of 2014 here is the performance of the same indices:
US High Growth Index: +9.1%
S&P 500 Index: +13.5%
US Slow Growth Index: +17.2%
In 2014 and so far this year, the financial markets are telling us in real time that investors and speculators are expecting that US growth will slow sequentially, quarter over quarter. Listen to the markets.
9500 basis points of outperformance over their High Growth counterparts and 8400 basis points of outperformance over the broader US equity market in 2 weeks SPEAKS VOLUMES. I trust what the markets say much more than I trust economists’ forecasts and talking heads on CNBC.
As a hedge fund manager, I’m obsessed with risk-adjusted returns and am constantly looking to keep my net exposure tight and hedge both long and short positions with offsetting positions.
I want to make money on good ideas and not market beta. So, I look at last year’s performance of these three indices and I love the fact that you could have been long the US Slow Growth Index and short the US High Growth Index and earned a risk free rate of return north of 8%.
Likewise, so far in 2015, if you used the same playbook, you’d be up almost 10% in 2 weeks, risk free.
If you are investing in US assets, you should be wary, but for now it’s premature to assume the worst. That could change, of course, depending on what we see in upcoming reports and what the markets are signaling to us. But based on what we know now, the odds still look favorable for expecting that the US recovery will survive the latest round of turbulence.
And specifically, as long as the US remains the beacon of growth in a slowing global economy, assets will continue to flow here. But there is alpha to be earned in being LONG assets that perform well in a slowing US environment and either SHORT or NEUTRAL in high growth US assets.
Economic data in the week ahead is largely limited to housing starts, housing permits and existing home sales. President Obama delivers his sixth State of the Union address. The Federal Reserve meeting is still a week away, but expectations for a mid-year lift-off have certainly been called into question.