While we still believe there is less uncertainty in the markets now, uncertainty in the first half of the year has nonetheless remained considerably higher than what we envisioned at the start of the year. From our perspective, the deeper-than-expected dip in U.S. home prices that occurred until February of this year, combined with ongoing European sovereign fiscal anxiety and the earthquake and tsunami in Japan, kept investors from fully embracing risk assets. Through it all, our four key economic variables on average are currently fairly neutral but still at pro-growth levels, which we interpret as largely consistent with a 2.0% to 2.5% GDP growth environment.
VRS Research now provides a mid-year update of our key indicators and offers our expectations for the second half of the year.
Interpretations: VRS Research’s Revisited Checklist For Gauging The Macro Investing Environment
1. VRS Research on Jan. 4, 2011: “Average nonfarm payroll growth needs to remain greater than 50,000 per month, at minimum, and should gradually build momentum in the direction of 100,000+ new jobs created per month.”
Nonfarm payrolls grew by an average of 147,800 new jobs per month over the first five months of this year. Although the three-month average gain in payrolls actually reached 215,330 in April, the disappointing 25,000 rise in May and the extremely disappointing 18,000 increase in June pulled the three-month average down to just 86,000 currently.
There is no way to put a positive spin on the last two months’ employment reports. The best we can say is that the underlying rate of monthly job creation remains closer to 100,000 than the 200,000 we had believed (or at least hoped for) just a couple of months ago. At this point, a continuation of the 100,000 average job growth trend would certainly not be bad news for investors and the economy, but at the moment, fears of a significantly weaker rate of job creation now appear to be outweighing waning hopes for a stronger underlying trend in employment growth. The next couple of jobs reports should solidify the true pace of employment growth, which we still believe is closer to 100,000 than to zero.
2. VRS Research on Jan. 4, 2011: “The core Personal Consumption Expenditures (PCE) deflator, which is a measure of inflation based on changes in personal consumption, must remain less than 2% year-on-year (and really should move back above 1% in the first half of the year).”
In our January commentary, we said that with core inflation remaining well below 1%, the Federal Reserve was not primarily concerned with inflation, but this is clearly no longer the case. Since first moving above the 1% year-over-year threshold in April, the core PCE deflator then quickly rose to 1.3% in May. Core inflation is now rising, which--as long as the rate of core inflation remains below the Fed’s upper 2% comfort zone--could actually be good news since it suggests that the U.S. economy is no longer deflating. We once again reiterate our belief that the core PCE deflator must remain below 2% year over year so that the Federal Reserve is not required to suddenly slam on the brakes by implementing an overly restrictive monetary policy, which is not consistent with the degree of spare capacity, or slack, currently associated with the economy.
3. VRS Research on Jan. 4, 2011: “The Institute for Supply Management's (ISM) manufacturing and service-sector Purchasing Managers' Indices (PMIs) must remain greater than 50, indicating that the U.S. economic expansion remains on track.”
Until recently, the view that the ISM's PMI must remain above the neutral 50 level was, frankly, a slam-dunk, but this changed in dramatic fashion in April and May. The ISM manufacturing PMI declined to 53.5 in May from 60.4 in April after the service sector PMI had declined in equally dramatic fashion to 52.7 in April from 64.1 in March. As of June, the manufacturing index had rebounded to 55.3 while the service PMI came in at 53.6, which, between the two, averages out to 54.5, which is comfortably above the neutral 50 level, for now.
In the opinion of VRS Research, two independent factors appear to be weighing on the PMI indices at the moment. First, the PMIs over the past 20 years historically have not sustained many periods with readings in excess of 60, which appears to be the extreme upper bound for this series of economic indicators. From this perspective, it appears that it was just a matter of time before the indices pulled back to more moderate mid-50 readings. Second, we quickly linked potential supply-chain-related shocks from the March earthquakes and tsunami in Japan to the steep decline in the ISM manufacturing PMI. As we stated at the start of June, the U.S. economy must retain sufficient positive momentum to quickly shake off the supply-chain-related impact of Japan’s disaster, and for the moment, the PMI indices continue to suggest a moderate and hopefully sustainable GDP growth trajectory for the U.S economy.
4. VRS Research on Jan. 4, 2011: 'Average existing single family home prices cannot slip below $200,000, preferably holding well above the $205,900 cyclical low point from January 2009.'
Home prices are yet another economic indicator that suggests overall economic growth remains quite moderate and that the U.S. economy is still facing a long road to full recovery. Average existing single-family home prices, which had been steadily declining until February, actually registered a slight new cyclical low of $203,000 in February before rebounding back to $214,900 as of May.
We continue to believe that in the existing economic cycle, the recoveries in both U.S. employment growth and housing will lag the overall economy. However, we now expect to see evidence of this lagged response/recovery during the second half of this year.
Concluding Thoughts
We specifically selected these four key economic variables because we believed at the start of 2010, as we believe today, that they help drive market valuations and psychology. Half way through 2011, we now think that those variables continue to paint a picture of a marginally sub-Goldilocks (not-too-hot, not-too-cold) economy. Economic growth and employment growth in particular remain at sub-par historical levels, which is potentially problematic since it suggests that U.S. GDP growth may be just slightly above some unknown stall-speed. An underperforming U.S. economy may also be abnormally vulnerable to external shocks, the likes of which were witnessed in Japan in March. Core inflation also now needs to be watched closely, not only for potential monetary policy implications, but because consumers now require additional wages to keep pace with rising consumer prices.
How these key indicators play out over the second half of 2011 will help determine if the S&P 500 can earn the $99.38 currently expected by the market, according to the Capital IQ consensus, for calendar year 2011. This is the same statement we made back in January when the market was only expecting 2011 earnings of $95.56 per share from S&P 500 corporations. At the moment, the PMI indices, along with the average rate of nonfarm payroll creation, suggests to us that the U.S. economy retains positive, albeit moderate, growth momentum. Accordingly, home prices remain range bound, subject to largely seasonal realty market trends, while core inflation needs to be monitored closely for signs that the economy is shifting away from a sub-Goldilocks condition to something more closely resembling a stagflation scenario."
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