2020 Vision: Long Live the Expansion

Transcription

1 September 2, 2014 US Equity Strategy and US Economics 2020 Vision: Long Live the Expansion The US expansion is more than five years old, but business cycles don't die of old age. Herein we discuss why this could be the longest US expansion ever, and how to gauge when it could end. We believe a prolonged period of deleveraging in the US, coupled with an uneven global recovery, are just two of the reasons why this could prove to be the longest US expansion ever. Supporting our theory are: The world economy is not in sync. Major regional economies are at different points along the growth cycle. In general, DM is leading while EM is lagging. Volatility in the US continues to trend lower, which can extend the life of expansions. Deleveraging in the US is ongoing, albeit largely complete, and balance sheet priorities have shifted. Interest payments on debt burdens are ultra-low, and household debt dynamics suggest there exists a sizable cushion protecting consumers in a rising interest rate environment. Capital spending and inventories do not look stretched. Corporate management hubris and other corporate metrics of overheating remain muted. Several broad economic indicators in the US have only just reached normal expansionary levels and are far from looking unsustainable. MORGAN STANLEY & CO. LLC Adam S. Parker, Ph.D Adam.Parker@morganstanley.com Ellen Zentner Ellen.Zentner@morganstanley.com Taken together, evidence suggests the US cycle peak is far from imminent. And as we highlight below, our Cross Asset Strategy team's assessment of cycle timing also pegs the US in the very early stages of expansion. The US Equity Strategy team believes that equities should benefit from a scenario where the probability of a cycle peak remains low for some time. As the prolonged expansion becomes more visible, we'd expect a materially higher US stock market. Our best guess is that an S&P500 peak of near 3000 is possible should the US expansion prove to have five or more years left to it, based on 6% per annum EPS growth through that time frame and a 17x price-to-earnings ratio. The US Equity Strategy team remains bullish on US equities and will continue to monitor the metrics we discuss below for signs of peak-ish behavior. As always, the US Economics team will parse leading indicators of the business cycle as they evolve, and pay particularly close attention to movements in MSRISK Morgan Stanley's recession risk model. Note: Ellen Zentner is an economist and is not opining on equity securities. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. 1

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3 The Global Economy - Out of Sync The US expansion has lasted more than five years, prompting an oft asked question - how long could it last? If investors' concern is founded on age alone, then rest assured there simply is no age component involved when modeling the length of a business cycle. Instead, business cycles tend to die of overheating (excessive hubris and debt), oftentimes accompanied by a bubble-popping response of monetary policy (when real short rates have moved significantly above the natural rate in response to inflation rising). Other events have also precipitated downturns in the US. For example, abrupt and sharp increases in oil prices played a key role in the recessions of , , , 2001, and We highlighted in previous research the oil price impact on US GDP and why the US, while not immune, has become less sensitive to these price changes (see The Impact of Higher Oil Prices, June 20, 2014). To be sure, there have been myriad causes of US recessions, and no business cycle has precisely matched the last. The Financial Crisis that hit in autumn 2008 sent global financial markets reeling and sparked a prolonged period of deleveraging that began in the United States, then spread throughout the world's developed economies. Faced with a Herculean task of turning around broken markets, central banks stepped in with unprecedented monetary policy accommodation, precipitating a prolonged period of ultra-low interest rates. Six years beyond the financial crisis, the global economy continues to feel its effects and growth is uneven. While deleveraging in the US is largely complete, Europe is not nearly as far along. Economic activity in certain sectors of the UK is looking frothy, but Japan's near-term outlook is clouded by uncertain fiscal outcomes. Growth in Brazil is troubling while growth in India and China appears to be bottoming and Mexico is turning upward. All this is to say that positioning along the global growth cycle is uneven, and such an unsynchronized global recovery may have the effect of prolonging the current economic expansion. With regional economies at different stages of the business cycle, the risk of global overheating is likely lower than it would be were all the G10 economies expanding strongly in concert. In developed markets, monetary policy accommodation remains an important prop for growth, and as central banks increasingly, albeit grudgingly, acknowledge lasting damage to potential GDP, the promise of low rates for longer has solidified. Those low rates, coupled with deleveraging in the wake of the financial crisis, has allowed households and corporations, particularly in the US, to rebalance. Indeed, debt burdens and delinquency rates continue to move downward, not upward. The most recent three expansions have been among the longest in US history. Post-WWII expansions have lasted an average of five years, while the three most recent have lasted an average of eight years. As we discuss below, the longest expansion lasted ten years. An environment of low volatility can help extend the life of an expansion, and volatility in GDP growth has fallen over time (Exhibit 1). 1 Exhibit 1 maps volatility in GDP as the 4-quarter rolling standard deviation in the 2-quarter smoothed annual rate of growth. To be sure a complicated calculation, but it clearly shows that longer expansions have occurred alongside diminishing volatility of GDP. 3

4 Exhibit 1: Less Volatility in Trailing GDP May Portend Longer Expansions Source: Bureau of Economic Analysis, Morgan Stanley Research. Note: Gray shading denotes periods of recession as determined by the National Bureau Economic Research. While the concept of a business cycle applies globally, herein we focus primarily on the US, where we highlight household and corporate balance sheet dynamics, investment and the inventory cycle, as well as the credit cycle to provide evidence of why we think the US business cycle is very early in the stage of expansion, and why this could prove to be the longest economic expansion ever. Defining the Business Cycle In the US, the National Bureau of Economic Research (NBER) is the official arbiter of business cycle dating. The duration of a cycle is determined by gauging the peak-to-peak or trough-to-trough in economic activity. Since the 1850's, the US economy has experienced 33 cycles, 11 of those in the post-wwii period. Since WWII, business cycles have lasted an average 69 months, with expansions averaging 58 months (or just under 5 years) and contractions lasting an average 11 months (or just under a year). The longest expansion lasted 120 months (or 10 years from March 1991 to March 2001). Exhibit 2 provides a historical look at real GDP growth in the US with periods of recession shaded in gray. 4

5 Exhibit 2: Post-WWII Expansions Have Lasted an Average 58 Months Source: Bureau of Economic Analysis, Morgan Stanley Research. Note: Gray shading denotes periods of recession as determined by the NBER. Recession Through the Eyes of the NBER When determining a peak in the business cycle (i.e., when the expansion has ended and the US economy is entering recession), the NBER looks at a range of indicators, placing the greatest emphasis on higher-frequency monthly indicators as opposed to simply using GDP growth as a gauge. A long-held misconception is the twoquarter rule of thumb, where declining real GDP growth for two consecutive quarters indicates the start of a recession. But the two-quarter rule would have only indicated 14 quarters of recession in the postwar period, whereas the NBER has identified 41. To date the end of expansion, the NBER looks for a significant decline in activity across a number of indicators that includes industrial production, real retail sales, real personal income (excluding the effects of government transfers), and most importantly, jobs. These indicators are shown in Exhibit 3 below, and importantly, all continue to expand at moderate paces. 5

6 Exhibit 3: Key Indicators of the US Economy Continue to Expand Source: Federal Reserve, Bureau of Labor Statistics, Bureau of Economic Analysis, Census Bureau, Morgan Stanley Research Slower, But Longer With the US economy having entered recovery in July 2009, the current recovery has lasted a little over five years thus far - prompting the question, how long could this expansion last? To be sure, five years is a bit longer than the postwar average, but about half the length of the longest expansion. The shadow of the financial crisis lingers over the US economy, expressed primarily through deleveraging of private debt. Indeed, an historical exploration of financial crises among developed countries indicates that the credit-to-gdp ratio balloons in the 10 years leading up to financial crises, and that the retrenchment tends to last as long as the surge in credit. [ 1 ] ) Further, in the decade following the financial crisis, deleveraging of private debt damps credit and employment growth (and lasts for about 7 years), resulting in GDP growth that is about one percentage point lower over that time. [ 2 ] We view this period of deleveraging as a repair phase of the business cycle, and its unusual length this time owes to the aftershocks that follow in the wake of financial crises. We believe that the US economy has largely completed the repair phase and is entering the very early stages of expansion. Indeed, our Cross-Asset Strategy team headed by Andrew Sheets recently introduced a US Cycle Indicator (Exhibit 4) 4 that also indicates the US is in the early stages of expansion. Morgan Stanley's US Cycle Indicator is derived from data on employment, credit conditions, corporate aggressiveness and the yield curve. The indicator level is based on the deviation of these metrics from their long-run trend (see Cross-Asset Dispatches: Introducing Our Framework, August 5, 2014). 6

7 Exhibit 4: Our Cross Asset Team's US Cycle Indicator Indicates the US Is in the Early Stage of Expansion Source: Bloomberg, NBER for recession shading, Morgan Stanley Research Note: Percentile deviation from trend Perhaps the strongest opinion of where the US economy is positioned along the business cycle is expressed by America's households. The US economy entered recovery in July 2009, but for nearly five years since that time, US households continually asked themselves, what recovery? To view the recovery through the lens of America s households, we look at the behavior of the Conference Board s monthly consumer confidence index over the business cycle (Exhibit 5). 5 After plummeting to a new historical low of 25.3 in February 2009 (prior to the financial crisis the low had been 43.2 in December 1974) confidence finally surpassed 80 in March A level around 80 has been the average measure of confidence during past recoveries, implying that it took US households nearly 5 years for the recovery to feel like a recovery - 5 long years of repair. In August, consumer confidence increased further to a reading of 92.4, approaching the level of 100 that is considered the normal average during expansions. 7

8 Exhibit 5: Consumer Confidence Is Only Just Moving Back to Historically Normal Levels US Equity Strategy and US Economics September 2, 2014 Source: Conference Board, Morgan Stanley Research. Note: Gray shading denotes period of recession as determined by the NBER Consumer confidence is just one example of an economic indicator that has only recently moved back into its normal range in expansions. Weekly initial jobless claims is another such indicator, and at around 300,000 it has now reached a level indicative of a normal labor market expansion. As the US economy continues along its transition from a phase of repair to expansion, more economic indicators should fall in line with historical norms. Deleveraging and Debt Dynamics US households have aggressively delevered, with debt as a share of disposable income declining sharply from an historical high of 135% on the cusp of recession to where it has stabilized over the past several quarters around 108%. Exhibit 6 below expresses this relationship as a ratio and underscores the unprecedented shedding of debt. Indeed, outside of mortgage debt, the household deleveraging cycle is nearly complete. 8

9 Exhibit 6: Ratio of Debt-to-Disposable Income Has Fallen Back Near Pre-Bubble Levels US Equity Strategy and US Economics September 2, 2014 Source: Federal Reserve, Morgan Stanley Research Declining debt alongside ultra-low interest rates has led to a financial obligation ratio that's not been seen since the early 1980s - an indication that household leverage has reached a sustainable balance (Exhibit 7). 7 The financial obligation ratio measures regular out-of-pocket monthly obligations, such as rental or mortgage payments, credit cards payments, etc., as a share of disposable income. Exhibit 7: Households Are Devoting a Smaller Share of After-Tax Income to Monthly Obligations - Further Evidence a Cycle Peak Remains Far Off Source: Federal Reserve Board, Morgan Stanley Research. Note: The financial obligations ratio (FO R) includes auto lease payments, consumer debt payments, rental payments on tenant-occupied property, payments on mortgage debt, homeow ners insurance and property tax payments. The easing of financial burden is also expressed in still-declining delinquency rates. In 2Q14, the overall 90+ day 9

10 delinquency rate fell to 4.5%, the lowest level since early 2008 (Exhibit 8). 8 Falling delinquency rates certainly do not describe an environment in which households are re-leveraging. Moreover, the historically low financial obligations ratio also implies households have plenty of room to add to debt levels before they become unsustainable. These household credit conditions and lower delinquency rates increase our confidence that the cycle peak is not near. Exhibit 8: The Percent of Balance 90+ Days Delinquent Is at Multi-Year Lows Source: Federal Reserve Bank of New York, Morgan Stanley Research Household Balance Sheet in a Rising Interest Rate Environment As the lingering effects of the financial crisis move further into the rear-view mirror, the Fed will need to begin normalizing policy. When interest rates rise, how will the household balance sheet fare? Roughly 75% of the household balance sheet is parked in mortgages (Exhibit 9), 9 and about 90% of outstanding mortgages are being held at a fixed rate. 10

11 Exhibit 9: Roughly 75% of the Household Balance Sheet Is in Mortgages... US Equity Strategy and US Economics September 2, 2014 Source: Federal Reserve, Morgan Stanley Research A legacy of financial crises long periods of low interest rates is expressed in the gradual transformation of the average yield on long-term fixed-income securities. Exhibit 10 charts the effective yield on all outstanding mortgages alongside the 30-year fixed-rate mortgage rate. The effective yield has fallen to a historical low of 3.9% meaning that the bulk of the average household's balance sheet is locked in at an extremely low fixed rate. Exhibit 10:...And the Effective Yield on All Outstanding Mortgages Has Fallen to a Historical Low Source: Bureau of Economic Analysis, Morgan Stanley Research While rising interest rates will, as intended, slow the creation of credit, households' outstanding debt today is 11

12 largely protected in a rising interest rate environment. This cushion should help US households remain more nimble should financial conditions tighten, dampening volatility in consumer spending and thereby prolonging the expansion. Capital Spending Dynamics US Equity Strategy and US Economics September 2, 2014 The US Equity Strategy team's bullishness regarding the equity market is based on the thesis that the top of the cycle, or the end of the expansion, will be defined by hubris and debt. By hubris, we mean some form of management spending gone awry. Hence, we monitor important metrics such as capital expenditures and inventories. Should these remain at conservative levels it would likely mean the end of the expansion is not imminent. Relative to sales, capital spending in the US has trended lower since the 1980s (Exhibit 11), in part because of new business models with high revenue like GOOGL or AMZN, which have relatively lower structural capital requirements, and also in part due to greater focus on margins by Corporate America. The ratio has risen from all-time lows, but we think notable further increases are unlikely. After excluding energy and utilities, capital spending-to-sales is even more muted. Exhibit 11: Capex-to-Sales Could be Peaking Source: ClariFi, Thomson Reuters, Morgan Stanley Research To be fair, capital-intensive businesses like autos and industrials (Exhibit 12) have shown an uptick since the economic trough in 2009, but are still below both long-term averages and the peaks seen in prior cycles. 12

13 Exhibit 12: Automobiles and Industrials Capex-to-Sales Has Come Down Over Time US Equity Strategy and US Economics September 2, 2014 Source: Thomson Reuters, Morgan Stanley Research The US Economics team has taken an in-depth look at business investment in the US and concluded that only a modest cyclical pickup in overall capital expenditures can be expected (see Capex Outlook: Modest Is as Good as It Gets, July 23, 2014). From a global perspective, capex-to-sales has held relatively steady in recent years and is not expected to increase significantly (Exhibit 13). From the US stock market perspective, we think it noteworthy that muted capital spending likely is a positive and that relatively speaking, capital intensity is expected to pick up more outside of the US. 13

14 Exhibit 13: Global Capex-to-Sales Is Below its Pre-Crisis Peak Source: Thomson Reuters, Morgan Stanley Research Inventories Inventories are a highly cyclical component of GDP, and volatile swings in inventories tend to magnify the amplitude of swings in the business cycle. Though economic literature has been inconclusive in this regard, it is possible that the inventory cycle is more muted today in the US, owing to such factors as the evolution of technology in inventory control management and a rising share of companies that hold little physical inventory. In the US, inventory-to-sales has risen from its crisis lows but remains contained (Exhibit 14). 14

15 Exhibit 14: Inventory-to-Sales Is Contained in the US Source: ClariFi, Thomson Reuters, Morgan Stanley Research A diminishing inventory-to-sales ratio may also reflect the fact that the percentage of companies with no inventory has increased over the past 30+ years (Exhibit 15). Exhibit 15: The Percentage of Companies That Carry No Inventory Has Risen Drastically Since the Early 1980s Source: ClariFi, Thomson Reuters, Morgan Stanley Research Globally, the inventory-to-sales ratio has risen modestly since the financial crisis and is now creeping toward multi-year highs (Exhibit 16). A key signpost of excess to monitor will be global inventory-to-sales over the coming quarters. 15

16 Exhibit 16: Global Inventories Have Risen Modestly Since the Crisis Source: Thomson Reuters, Morgan Stanley Research The lack of a substantial build-up of inventory-to-sales, coupled with technological advances in real-time control of inventory (helping companies remain nimble relative to unplanned changes in aggregate demand), and the growing share of companies that hold no inventory, should dampen the cyclicality of the inventory cycle. Corporate Debt Dynamics Debt maturities have been pushed out until 2017 or later (Exhibit 17), as management teams have taken advantage of the low cost of capital and ample capital availability. This is an important point as difficulty with debt financing is often at the center of events that cause the end of expansions. The extended nature of corporate financial obligations today is a key element in why we believe this expansion could be long-lasting. 16

17 Exhibit 17: Many Debt Maturities Have Been Pushed Out and Don't Come Due Until 2017 and Beyond Source: Thomson Reuters, Morgan Stanley Research While the total amount of debt due by US corporations is high, rolling over that debt is further out on the horizon, and rolling over the debt may not prove difficult. Today, interest coverage is elevated as cash-rich companies have been able to refinance at very low interest costs, moving from 4x to nearly 8x in the past five years (Exhibit 18). This means the odds of many companies having difficulty making their debt payments in the coming years is sharply lower than it has been in some time. Furthermore, the US Economics team believes that when the Fed does begin to raise interest rates, the terminal nominal federal funds rate will be 3.5%, and it will take several years to get there. This suggests that even in a rising interest rate environment, companies will still face an historically low cost of financing. 17

18 Exhibit 18: Interest Coverage Ratios Are High Source: Thomson Reuters, Morgan Stanley Research The Credit Cycle As Exhibit 19 shows, the high-yield bull market in the 1990s was uncommonly long, but as the current cycle continues (it has already surpassed the last cycle in duration), a 1990s repeat becomes more probable (see US Credit Strategy: Where Are We in the Credit Cycle?, July 18, 2014). The credit timeline usually plays out in the following way: 1) spreads trough at some point in the expansion phase, 2) the economy and earnings roll over, leading to a spike in leverage, drop in debt coverage, and spike in spreads, 3) the new issue market shuts down for lower-quality credit, and lastly, 4) defaults spike as companies can t refinance, can t make interest payments, or can't restructure due to unsustainable leverage, covenant violations, and other headwinds. The lag between 1) and 4) can be years (it was 4.5 years in the late 90s). While we aren't analyzing a statistically significant number of cycles here, it does appear that we could be many years away from a credit downturn. 18

19 Exhibit 19: Is This Credit Cycle a Repeat of the 1990s in Length? Source: The Yield Book, Morgan Stanley Research Easier to Use History as a Guide One interesting, but arguably more anecdotal reason that could make this cycle last longer is that it is far easier to analyze data than any time in human history. The amount of data stored means lots of smart people can analyze trends and anticipate factors associated with historical downturns. In Exhibit 20, we map new data capacity sold in a given quarter since Enterprise data storage capacity has grown dramatically since the early 2000s. While it's not a metric to monitor for cycle peaks, it is possible that history is less likely to repeat itself as often as it did in the past, given how much data and analytics are possible today. 19

20 Exhibit 20: Global Enterprise Data Storage Has Grown Rapidly... Source: IDC, Morgan Stanley Research Processing power has also risen sharply (Exhibit 21). Exhibit 21:...As Has Processing Power Source: Company Data, Morgan Stanley Research We do think that technology has likely enabled some changes in human behavior - and the ability to analyze and process data en masse might in and of itself help to lower volatility and extend economic expansions. Demographic Shifts 20

21 A quick note on demographics is in order because the headwinds from an aging population will not last forever. The share of the US population aged over 65 has been an increasing drag on economic activity. This substantial headwind was already a factor in slowing the economy's potential before the financial crisis, but has grown steadily since (see Potential GDP and Its Implications, March 10, 2014). As the years progress, however, the increasing share of the aging population slows, while the share of the prime working-aged population increases (Exhibit 22). This shift does not begin in earnest until about 2020, but with every passing year after that, the headwind from the aging population lessens. Exhibit 22: Shifting Demographic Trends Slowly Turn from a Headwind to a Tailwind Around 2020 Source: Census Bureau, Morgan Stanley Research MSRISK The US Economics team recently introduced the Morgan Stanley Recession Risk Model, or MSRISK (see Introducing the Morgan Stanley Recession Risk Model, July 15, 2014). Moments of tension in the economy should be captured by rising volatility in MSRISK and tends to provide a 6-month lead-time to downturns in the business cycle, while the level of the indicator should definitively call the cycle peak. In August, both level and volatility of MSRISK continued to indicate a very low risk of recession (Exhibit 23). 21

22 Exhibit 23: Very Low Risk of Recession Currently Indicated by MSRISK Source: Morgan Stanley Research. Note: The level of MSRISK must pass the 95% confidence threshold to signal recession has begun. Volatility in the MSRISK must pass 300% to provide the 6-month lead-time for the start of recession. Bottom Line Business cycles don't die of old age, they die of overheating. Debt dynamics, particularly in the US, paint the picture of a more prudent household sector and well-managed corporate sector, both of which remain far from the heights of leverage typically associated with risks to business cycle expansions. Moreover, volatility in the economy has trended lower over time, owing in part to technological advances that have helped companies remain nimble when sudden changes in aggregate demand occur, and in part to a rising share of companies that carry no inventory. The current expansion is more than five years old, and with little evidence of global synchronicity, there are no signs as yet that the global economy is overheating. The current US expansion has already lasted longer than the average expansion in the post-wwii period, but the factors we monitor and have discussed here lead us to conclude that it isn't unreasonable to expect that this expansion could be the longest on record. In a scenario where the cycle does extend for several more years, earnings could grow modestly as well. The US Equity Strategy team notes that EPS growth of 6% per year from would drive S&P500 earnings to near $170. A 17x multiple would translate into a peak level for the S&P500 near 3000 under this scenario. Of course, no one can predict unforeseen shocks to the economy - be it fiscal or monetary policy missteps domestically, geopolitical events abroad, or even major natural disasters. But our title, 2020 Vision, is our tongue-in-cheek way to desribe the idea that the current US expansion could prove to be the longest ever and perhaps last until There are a number of ways the current expansion could get derailed. Europe and China are already slowing and near recession in some parts. Japan is highly dependent on the success of policy. US reforms on key issues like the budget, taxes and entitlements, and immigration seem a long way off and are likely to cause much angst in the coming years. And after a prolonged period of unprecedented monetary policy accommodation, we are on the cusp of removal of that accommodation - also in an unprecedented way. So by no means can we say that six or seven more years of expansion are an obvious outcome. But, all else being equal, the metrics we analyzed in this note are unlikely to be the root cause if this expansion were to be cut short. 22

23 Additional Research US Economics: Capex Outlook: Modest Is as Good as It Gets (July 23, 2014) Cross-Asset Dispatches: Introducing Our Framework (August 5, 2014) US Credit Strategy: Where Are We in the Credit Cycle? (July 18, 2014) US Equity Strategy: What Do You Buy if You're Bullish? (August 11, 2014) US Quant Research: Momentum: Hurry Up and Wait (August 25, 2014) 23

24 Endnotes 1 (Reinhart, Carmen and Vincent, After the Fall, FRBKC Jackson Hole Symposium, August Slower also implies the US business cycle could be more vulnerable to smaller shocks because growth is not more robust. Think of it as a swimmer treading water, head bobbing precariously above the surface. It doesn't take much for the swimmer to dip under and pop back up. A recent example of this is the deeply negative quarter of growth in 1Q14 prompted by several factors, the largest of which was an unusually severe winter. As we discuss below, one quarter of negative growth does not meet the criteria needed to determine that a cycle peak has occurred. 24

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