July was a good month for most investment markets and added to good investment returns for 2016. U.S. stocks were up by about 3.5% in July while other markets such as small company stocks (+6% for the month) and emerging markets (+5% for the month) had even stronger returns. At the end of July, many investment markets were at all-time highs.
As markets were reaching all-time highs, U.S. Gross Domestic Product (GDP) was released. GDP is the most closely watched measure of U.S. economic growth. In a word, GDP results were disappointing. I’ll go further and say they were very disappointing. GDP growth continued a trend of the U.S. economy experiencing the most tepid economic recovery since at least World War II. So, why the disconnect? How can stocks be reaching highs while the economic growth limps along? This is the paradox we will address.
Low interest rates are providing the fuel for the stock market and risk assets. As of the end of July, the ten-year Treasury note is yielding 1.5%, close to all-time lows. Indeed, domestic investors in Treasury notes are locking in negative real (i.e., inflation-adjusted) returns. In contrast, the dividend yield on the S&P 500 index of stocks is 2.1%, and 2/3 of the stocks in the index pay a dividend that is higher than the yield on a ten-year Treasury note. As long as interest rates stay low, stock valuations, particularly for strong dividend-paying stocks, should be supported (albeit with at least some volatility).
Recent GDP releases paint a more nuanced picture. First, the positive: consumer spending, which makes up 2/3 of economic growth, is strong – up 4.2% on an annualized basis in the second quarter. This is not surprising to us. At the beginning of the year when many prognosticators were predicting a U.S. recession, we opined that a tight labor market was leading to real wage growth and that lower energy prices were creating an energy “dividend” for consumers that could boost household consumption. This appears to be the scenario that is playing out.
The very negative aspect about GDP is the utter lack of business investment, which is acting as a big drag on the economy. Often cited reasons for this lack of business investment are that businesses are not confident enough to invest in new projects and are drowning in a morass of increased regulatory costs and burdens. I think there is definitely something to these arguments. Anecdotally, I hear from business leaders who are still “scarred” by the financial crisis and aftermath. The increased regulatory burden is also real for many businesses. I know that there were 220 new rules issued by regulators from 2010-2015 that JoycePayne Partners is subject to. I believe that another reason for the lack of business investment that is not mentioned as much as regulatory burdens is the ever-spiraling costs for businesses to provide health care benefits. For businesses that provide health care insurance to their employees, percentage cost increases have been in the double digits each year. This is an unsustainable escalation and will increasingly make U.S. businesses less competitive, especially with global competitors.
There are some mitigating factors to the bad GDP report on business investments. First, businesses drew down inventories to get leaner at a more rapid pace than expected. A return to “normal” inventory levels could add to GDP growth. Second, the investment pullback in the energy and natural resource industries due to the significant declines in commodities and natural resource prices has seemingly leveled off.
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Commentary by: Michael Joyce, CFA, CFP