Why weak economic growth limits upside for consumption and stocks
Consumption weakens in sync with real GDP growth
The below graph reflects the long-term decline in real GDP growth. As noted in the third article in this series, consumption growth rates have been declining, and consumption as a percent of GDP is now lower than it was a few years ago. With the Baby Boomer generation starting to retire from the workforce, it could be that the post-1980 era of consumerism is decelerating. As the Baby Boomer generation moves to a fixed income for consumption purposes, it could be that this large portion of the U.S. population and workforce will be forced to consume less than it used to when employed. Perhaps the tendency of Baby Boomers to tighten the belt on spending as they enter retirement has been just enough to slow the growth in consumption rates in the USA and will remain a drag on overall real GDP growth. This article considers the ongoing weakness in overall economic data and the implications for equity markets.
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For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Consumption and GDP
As we noted in the third part of this series, consumption as a percentage of GDP had reached roughly 69.5% of GDP by 2011, though it has fallen to closer to 68% of GDP today. This shortfall in consumption as a percent of GDP has been replaced by government spending, investment, and net import of goods. The import data and trade deficit have stayed fairly constant at around 3.0% of GDP the past three years. Government spending as a percent of GDP has declined from 8.0% to around 3.5% in the past three years. Gross private investment has grown from roughly 15.6% of GDP in 2010 to 16.9% of GDP in 2013.
Great news: Investment gains are now offsetting consumption declines
So the decline in consumption as a percent of GDP has been offset by growth in investment. This is an encouraging trend, though the current level of investment is still considered very weak relative to prior periods of post-crisis recovery. Much more private investment will likely be required to sustain consumption and avoid the return of growing government deficits.
To see how consumption growth rates have behaved relative to overall GDP growth rates since 1964, please see the next article in this series.
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).