The Macro Matters
Highlights from Sumit Desai’s presentation | The Big Event 2018
Sumit Desai, CFA, Director of Research for Mesirow Wealth Advisors, provides insights into key economic factors 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 positive 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 1.5% over the past ten years. Part of that is due to the 2008 financial crisis, but we’ve also been in a period of sluggish growth for the past few years. The good news is that we’re starting to see signs that growth may improve. The recent tax cuts are impacting profits, and companies are reinvesting those profits into new projects and share buybacks, which should have positive impacts.
The Largest U.S. Companies Are Changing — Innovation is spurring growth. Internet and new-economy companies now dominate their industries and make up some of the largest companies in the world. In 2008, the top ten companies in the S&P 500 included major industrial corporations like Exxon Mobil, General Electric, Chevron and IBM. Today, the corporate landscape looks much different. Many of the top companies from 2008 are no longer in the top ten, replaced by companies like Google, Amazon, and Facebook; Apple is now the largest company by market capitalization in the S&P 500.
S&P 500 Operating Profit Margins— The average operating margin for companies in the S&P 500 has effectively doubled over the past 20 years. Why? New-economy companies are typically “asset-light,” and thus enjoy extremely high operating margins; for example, Facebook enjoys operating margins approaching 50%, compared to just under 8% for Exxon Mobil.
Will this trend towards higher profitability continue? Basic laws of economics would suggest that high profits attract competition, eventually lowering aggregate profitability back to some sort of normalized level. It is also possible that, given the shift to the new economy, profits may have structurally reset at a higher level due to the unique business models and competitive positioning of the firms that dominate our economy today.
Commodity Prices — Fluctuating oil prices impact energy companies as well as firms that use oil as an input to produce other goods. Over the past four years, we’ve watched oil prices drop from over $100 a barrel to as low as $25 in early 2016, and then rebound back to over $70 a barrel recently. It will be interesting to see how this impacts input costs.
Unemployment Rates — We’ve 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 that at the 3.9% unemployment level (reported as of May 2018), we’re well below 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.
Consumer Price Index (CPI) | Inflation — The Federal Reserve targets a 2% inflation rate and we’ve been trending below that for most of the past few years. Recently, we’re seeing a shift in this dynamic. In April 2018, the consumer price index (CPI) grew at a 2.5% annualized rate, in part due to oil and labor costs. We can expect further inflation if we see continued economic growth.
Interest Rates — We continue to be in a period of historically low interest rates; however, rates are beginning to rise across all bond maturities, although not at the same velocity:
- The Fed Funds rate is a very short-term rate that determines the interest banks pay to borrow money overnight. It’s controlled by the Federal Reserve and has a major impact on economic activity. The Fed has raised its key Federal Funds rate six times since late 2015, with a 1.69% rate as of April 2018.
- Short-term rates are mirroring the Fed Funds rate, rising to 2.24 as of April 2018.
- Longer-term rates ― like 10 and 30 year Treasuries ― have increased, but not at nearly the same pace as short-term rates.
Corporate and Government Debt — Corporations have taken advantage of historically low rates and issued record levels of debt. As these firms refinance their debt at higher rates, we may see an impact on the bottom line. In the past, we have seen that high relative levels of corporate debt have corresponded with recessions in the past.
We also see in the horizon the need for the government to issue more debt to fund projected budget deficits. Issuing more debt at higher interest rates will obviously be more costly if rates rise.
Market Outlook — A rising rate environment will have some implications for both stocks and bonds, which can ultimately impact your retirement and savings accounts. Rising rates means lower bond prices, and we’ve seen that play out so far this year. As rates have risen this year, we’ve seen considerably more volatility in equity markets, and many bond funds have seen negative returns so far year-to-date.
From an economic standpoint however, for bond holders, rising rates can create attractive opportunities to reinvest capital at significantly higher returns. For equities, higher rates might have a negative impact in terms of companies having to pay more for their debt, but it could suggest strong underlying growth as it is unlikely that the Fed would continue hiking unless the economy can support it. That means that innovative companies with strong balance sheets should continue to have room to grow despite the macro environment.
- Economic growth in the U.S. remains strong, boosted by recent tax cuts and growth through innovation.
- Input costs ― like employee wages and oil prices ― are on the rise and could pressure margins.
- Interest rates are also on the rise and may impact corporate balance sheets, government funding, and investment portfolios.
- Maintain a long-term perspective while keeping a pulse of short-term trends to protect against negative outcomes