Are We Close To An Economic Tipping Point Now?

Market and Economic Update –  Fortnight Ended 26th July 2019

Peter Flannery CFP AFA

 

 

“If you have one economist on your team,
it’s likely that you have one more than you’ll need.” 

Warren Buffett

50 years on…

The Markets

The above charts show the Standard & Poor’s Index on the left and the Dow Jones Index on the right. Both charts measure the movement in each of their indexes over the last 12 months.

 

Take a look at the above chart – that is what a record close looks like.  That is right, the American share market, as measured by the Standard & Poor’s index, closed at a record high on Friday, the 26th of July 2019, at 3,025.86.  The S&P500 Index is made up of 500 of the largest companies that trade on the New York Stock Exchange and the NASDAQ.  These companies are selected to be part of the index based on their size and liquidity and are based on how easily the shares can be traded without impacting on the trading price. 

The Dow Jones Industrial Average (DJIA) is based on only 30 companies.  This index was created after Charles Dow, who created it in 1896, and his business partner, Edward Jones, got together, to create one of the oldest and most widely used stock market indexes in the world.  It is based mainly on the weighted average of the 30 largest companies on the New York Stock Exchange and the NASDAQ. 

The NASDAQ and the S&P500 both closed at record all time intraday highs last Friday, as Alphabet (Google) saw its share price jump after beating earnings expectations.  At the same time, the news emerged that the US economy grew at a better than expected pace in the second quarter of 2019.  Alphabet shares rose 9.6% to $1,245.22 after the company posted stronger than expected second quarter earnings, driven by gains from YouTube ads and its growing cloud business. 

So, does record numbers on these indexes mean we should be excited or scared?  The short of it is we should be neither.  That is because we invest in the underlying business and do not play the share market. Price movements up and down merely provide cheap entertainment from time to time and offer better buy prices when the markets become broadly unhappy.  Lower buy prices mean better buying value.

Economic Update

The above chart shows growth in the American economy, highlighting the second quarter of 2019 (the green bar at 2.1% on the right side of the chart).

 

The American economy remains solid and continues to grow.  So much for the American economy falling off the cliff, as suggested by many internet jockeys over the last several years.  More recently, we have been taunted by that now famous chart, showing the yield inversion curve, and why that signals the tipping point for the American economy and the global economy.  I am not saying it will not happen at some point, but so far, we have simply seen ongoing growth. 

We have also, over the last year or two, been inundated with article after article, chart after chart, showing how huge levels of debt are across the globe.  I cannot predict the future; however, I struggle to see why a nominal increase in debt spells the tipping point for the global economy into an abyss from which it can never emerge.  The fact is, whilst sometimes, negative banter from the media can become a self-fulfilling prophesy, as we have seen, inverted yield curves and global debt levels are certainly worth watching and may well lead into difficult times at some point in the future, but not right now.  Indeed, when we focus on the American economy, there are some negatives but there are also some positives. 

 

USA Manufacturing PMI

The above chart measures US manufacturing (as measured by the Purchasing Managers Index – PMI).

 

The IHS Markit US Manufacturing PMI fell to 50.0 in July 2019.  This is the lowest since September 2009 and below market expectations of 51.0.  As you know, a reading above 50 signals growth and a reading below 50 signals contraction.  The American economy looks to be right on the cusp, from that perspective.  Recent surveys suggest that a downturn in motor vehicle manufacturing, along with global economic uncertainty, are two factors potentially driving the loss of momentum in the manufacturing sector in July.  Other data suggests that export sales were particularly subdued with new orders from outside the US falling at the fastest pace since April 2016.  At the same time, domestic demand continued to rise, providing an offset. 

Meanwhile, all eyes are focused on Jerome Powell, the US Federal Reserve Governor, and his interest rate announcement coming up this week.  There was talk of a 0.50% interest rate cut, although the underlying data suggests this would be a bit much and more likely there may be a 0.25% cut.  We will soon find out.  Either way, the question is whether this is based on economic data or pressure from Donald Trump!  Of course, Donald Trump would like to see lower interest rates and a subsequent boost to economic growth (so that Donald Trump “can look great again”).  Either way, the American economy continues to roll on, with unspectacular but solid growth, driven more recently by the spending power of the American consumer.

 

US Wages Growth

This chart measures wages growth in America.

We have talked about the unspectacular but reasonably solid growth in the US economy, driven in part by the American consumer.  What is notable is the moderate uptick in wages growth.  The real question here is whether or not The Phillips Curve is starting to come into play.  The Phillips Curve, you may recall, suggests that low unemployment eventually drives wages up.  It is too early to say, however there is certainly evidence here of wages growth as the chart above is starting to demonstrate.  Wages growth could well translate into a more confident consumer, which in turn could increase consumption, which is by far the single biggest driver of American economic growth.

 

Global Snapshot of Economic Growth, Interest Rates, Employment and Debt Levels

The above chart provides a snapshot of some of the larger countries and their economic health (or otherwise). As you can see, it is not all red (doom and gloom).

The global economy remains a mixed bag.  As we can see from the chart above, economic growth continues; however, unemployment (the jobless rate), budget deficits and debt to GDP is not looking so flash.  Still, this is not the end of the world as we know it.  Indeed, if we think back to the period prior to 2007/2008 (the global financial crisis), this was a period of what some referred to exuberant markets, which eventually proved to be correct.  Then came the global financial crisis and what has followed since around 2010 (nearly 10 years) is a kind of economic malaise if you like. 

On the one hand, we have not had booming economic growth.  On the other hand, we have not had global economic failure of epic proportions.  Of course, the cynics argue that the day of reckoning is nigh!  Mind you, we have heard that for many years.  I have heard that for over 34 years in my time as a financial adviser, analyst and investor.  One thing we know for sure and is worth watching is the level of interest rates in developed economies, which are either around zero or not far away. 

The bottom line is that, to me, this signals what I have called “deflationary funk”.  Despite this, people continue to go about their everyday lives in a world of relative economic stability and investors continue to see their investments grow.  Of course, markets cannot and do not rise forever in a straight line.  Corrections are a natural function of markets.  Asset prices, whether it be residential property, direct shares or other assets, are supported to some extent by debt and low interest rates.  That is partly why the world is watching closely, as central banks around the world release their interest rate intentions. 

New Zealand

The above chart measures some key economic data across the New Zealand economy.

The New Zealand economy remains in “steady as we go” mode.  As I have been suggesting for some time, the global economy is stable and so too is the New Zealand economy.  As mentioned elsewhere, all eyes are on central bankers around the world, as interest rates continue to decline.  There has even been talk of the idea that the New Zealand Reserve Bank should start to consider some form of quantitative easing (printing money).  The same has also been mentioned for Australia.  After all, both New Zealand and Australia are small players in a much larger global economic village and tend to be price takers, rather than price makers.  It will be interesting to see whether or not this type of action from either the New Zealand or the Australian Reserve Bank actually comes to fruition.

The above chart measures who is buying property across New Zealand.

Meanwhile, elsewhere in the economy, first home buyers are increasing their share of market buying activity across New Zealand.  Low interest rates are definitely helping. Also, it appears that around Auckland, first home buyers (I imagine this is the case elsewhere too) are foregoing ideal locations and buying around the fringes because those properties are likely more affordable.  Although it is not widespread as yet, generally around the Auckland area, property prices have remained stable or declined somewhat, which means that savers can actually make some headway against their ultimate purchase price, as their savings accumulate and grow, whilst the ultimate purchase price of their property declines. 

That is an ideal scenario for any purchaser of property but in particular first home buyers, as they struggle to get on that first rung of the ladder.  Of course, it has been very difficult for them over the last 10 years, as ever declining interest rates / ever rising property prices against slow wages growth have made owning that first home more difficult.  There is no need for us to get carried away though because, whilst ownership of property may have declined by some measures, nonetheless those first home buyers, who apply themselves with discipline to hard core savings, will ultimately obtain their first home at some point.  It is possible too, that whilst it is going to be a mixed bag, I believe, property prices have stopped rising across the board and we are now starting to see affordability if not improving at least stabilising, albeit at expensive levels for those first home buyers. 

The market, of course, decides the price of assets (not the fundamentals) and therefore, it is possible that ever declining interest rates may help support first home buyers and other property participants in the short to medium term. 

On the other hand, increasing regulation for property investors is clearly putting some off, as is tighter lending conditions, particularly for those borrowers who were already at the margins with regards to their equity position and serviceability. 

Like me, you have probably heard anecdotal evidence of banks drilling down into the detail of borrower’s budgets, looking for details around such things as Netflix subscriptions and other expenses that may tip the balance of borrowing unfavourably against them.  Changing times for property participants ahead?

 

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