The Macro Matters
Highlights from the June 23, 2017 Lake County Partners Big Event
Presentor: Sumit Desai, CFA, Director of Research
Focus: Eight key economic factors that business owners and investors may want to consider when making long-term investment decisions, and in determining how these factors might impact Lake County businesses.
- U. S. Gross Domestic Product (GDP) — Since 1929, we have experienced relatively smooth GDP growth, despite wars, depressions, recessions, and social and political challenges. U.S. GDP has grown at an average annual rate of 3.3% since 1929, adjusted for inflation, but that growth rate has dropped to 1.3% over the past ten years, even though this post-crisis expansion represents the second longest period of gains for U.S. financial markets since the Great Depression. This recent subpar GDP growth masks some strong long-term trends that have reshaped our economy over the past 10 years:
- The broad manufacturing sector, which makes up almost a quarter of our economy, has essentially been flat (with some exceptions like auto and construction). High-tech manufacturing has seen growth.
- Service and information-based industries continue to grow at an impressive rate and now make up a much bigger portion of our economy
- Significant disruption is occurring across sectors — and is expected to continue to do so — changing consumer expectations and traditional business models.
- S&P 500 Operating Profit Margins — The scalability of these new-economy disruptors is resulting in higher profits than the companies they compete against. The average operating margin for the S&P 500 has increased from around 5.5% in 1994 to over 10.5% as of last quarter. That means that profits per dollar of revenue earned has almost doubled over the past 20 years.
- Corporate Profit as a Percentage of GDP — Profits as a percent of the overall economy are also increasing. This has some tremendous implications at the corporate level and from a political and social perspective. This overall improvement in profitability isn’t confined to the new-economy, however, due to cutbacks in capital expenditures and increasing productivityand efficiency..
- Commodity Prices — Big expense line-items like raw materials have benefited from declining oil prices in recent years.
- Unemployment Rates — Employee costs are usually a company’s largest expense. We’ve also seen an interesting evolution of the employment environment in the past 10 years. The historical average monthly unemployment rate since 1948 is 5.8%, which means at a 4.3% unemployment level reported as of May 2017, we’re well past that historical average. Employment trends have been improving steadily following the 2008 financial crisis, to the extent that we’re seeing a possible inflection point. Corporations are now talking about labor shortages and challenges finding qualified talent to fill open jobs. It’s worth asking the question of whether wages need to keep rising if employment trends continue.
- U.S Dollar — At the same time as we saw commodity prices plunge, we saw the US. Dollar strengthen relative to most other currencies, especially the Euro. The currency environment has been relatively stable since the big shift in 2015, but those that do business overseas should keep an eye on potential volatility. Certainly, the uncertain geopolitical environment can also impact currencies.
- Inflation — The Federal Reserve targets a 2% inflation rate and we’ve been trending below that for most of the past 5 years. Market expectations for inflation shot up immediately after the 2016 presidential election but have since trended back to pre-election levels. This appears to indicate that financial markets are largely expecting minimal inflation.
- Interest rates — We are in a period of historically low rates. This “lower-for-longer” rate environment manifests itself in many ways. Baby-boomers near retirement are struggling to find ways to generate income, forcing investors to take on more risk to meet their retirement needs. The low rate environment has also incentivized public corporations to take on more debt to fund share buybacks and dividends, which has boosted the stock market. The low rate environment is noteworthy for its historic levels, but it’s also important to monitor the differences between short and long-term rates.
- Long-term rates are near all-time lows, reflecting to some extent the market’s expectations for low inflation. However while long-term rates remain low, short-term rates are following a different path.
- The Fed funds rate is a very short-term rate that determines the interest that banks pay to borrow money overnight. It’s controlled by the Federal Reserve and has a major impact on economic activity. The Fed lowered this key rate during the 2008 financial crisis as an attempt to spur growth and kept the Fed Funds rate near 0% for several years until finally deciding to raise rates in December 2015. Including that time, the Fed has now raised rates 4 times, 0.25% each turn.
- The unique dynamic of short-term rates rising while long-term rates decline is referred to as yield curve inversion. A fully inverted yield curve, where long-term rates are actually lower than short term rates, is widely viewed as a precursor to a recession. This situation bears watching as short-term rates rise but longer-term rates continue to decline.
- In our opinion, the future direction of interest rates will play a larger role in the future direction of our economy than any of the other indicators above.
- Many economic indicators are at extreme levels.
- Stay ahead of competitive disruption.
- Understand the big picture for employment. Proactively recruit talent.
- Protect yourself from rising rates.
Long-term success will depend on innovation and service you provide your customers, and the competitive advantages you build along the way.