Views From the Floor

In this week’s edition - Bullishness is wearing off in the US consumer; and is a US recession nigh?

Bullishness Is Wearing Off in US Consumer

Two M&A deals were recently announced in the US consumer sector: a luxury deal that was priced at 22x EBITDA, and a restaurant deal at 16x EBITDA. These deals have been touted as expensive and haven’t acted as catalysts for peers (which can be the case with M&A), which shows to us that bullishness in the US consumer sector – at least from a valuation perspective – appears to be wearing off.

Indeed, the SPDR S&P Retail ETF – which tracks a broad-based, equal-weighted index of stocks in the US retail industry – has been trending down since it hit a high of $52.50 on August 23, 2018.

Figure 1. SPDR S&P Retail ETF Trends Down Since Hitting a High in August

As of 26.09.2018

Is a US Recession Nigh?

It’s the topic du jour at the moment: where are we in the US economic cycle? Indeed, it’s a topic that’s being discussed across Man Group. While we are not doubting that we’re late-cycle, we think it’s too early to call the end of the cycle. There are three reasons for this in our view.

First, we looked at cyclically adjusted budget balances as a percent of potential GDP. Historically, an increase in the budget deficit typically contributes to GDP growth. The projected budget deficit for the US is 5.6% in 2018 and 6.7% in 2019, from 3.1% in 2017, which implies that there is still potential room for GDP growth in the US.

Secondly, we looked at commercial and industrial loans in the US. Figure 3 shows lenders are easing lending criteria rather than tightening standards (illustrated by the lines going below 0), which contributes to growth.

Third, there are some positive signs on inflation: The US 10-year is breaking out and wage growth has ticked up in the US, standing at 2.9% on an annualized basis at the end of August.

Figure 2. Cyclically Adjusted Budget Balances, as % of Potential GDP

Source: OECD; as of 27.09.2018

Figure 3. Lending Criteria Are Being Eased

Source: The Fed Senior Loan Officer Opinion Survey on Bank Lending Practices; as of 01.07.2018

Stocks, Bonds and Correlations

One reason term premium may be lower than in the past is “the changed correlation between stock and bond returns, likely associated with changes in the expected inflation outcomes,” Fed Governor Lael Brainard said in a speech to the Detroit Economic Club on September 12, 20181. These comments echo what we wrote about in ‘Fire, then ice’.

Brainard cited a Fed working paper from 20162 which said “conventional asset pricing theory suggests that the sign of risk premiums depends on the sign of the covariance of the returns of those assets with the typical investors' consumption or wealth. For example, stocks require a high positive risk premium because equity prices tend to fall during recessions, precisely when consumption also falls. Assets with payoffs tied to inflation are often modelled in this way too."

The authors of the Fed working paper showed that the correlation between inflation expectations and forward consumption has trended up since it was deeply negative in the 1980s, but has recently switched.

What does this mean for equity portfolios? As mentioned in ‘Fire, then ice’, as inflation accelerates, we believe that the stock-bond correlation will eventually flip from negative to positive. It’s just another potential reason to look towards a value-tilted portfolio should inflation start to accelerate.

Figure 4. Estimated Correlations Between 10-Year Forward Consumption and Long-Run Inflation

Source: The Federal Reserve; as of 04.04.2016

With contribution from: Pierre-Henri Flamand (Man GLG, CIO), Fritz Gallagher (Man GLG, Analyst), Teun Draaisma (Man Solutions, Portfolio Manager) and Ben Funnell (Man Solutions, Portfolio Manager).

1 https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm

2 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/has-the-inflation-risk-premium-fallen-is-it-now-negative-20160404.html