October 15, 2019

Consumer and Labor Market Strength – But Is That Enough?

 “Hold the door.” Hodor, Game of Thrones


The litany of headwinds facing the U.S. economy includes the trade wars, Brexit, global growth slowdown, manufacturing slowdown even in the U.S., soft business spending, and now election uncertainty. This long list is wearing on investor psyche, but in terms of forward-looking market dynamics it is actually good that the economy and markets have been grappling with these issues for quite some time now. Defending the economic castle are a robust labor market and healthy consumer spending. There is widespread concern in the market that the gates will crack. In this month’s Outlook, we detail why the U.S. economy remains in a reasonably good position to absorb these blows, but also what important markers – if they develop – would indicate otherwise.


First, it is important to note that the labor market in the U.S. is not just strong, it is historically strong. Almost two years ago, with much media fanfare, the number of job openings surpassed the number of unemployed, and since then this relationship has stayed in shortage territory (Exhibit #1) and the unemployment rate has fallen to record lows. Add to this landscape wage gains that remain well above inflation, falling household debt service, and a comfortable savings rate (Exhibit #2), and it’s fair to conclude that consumer strength is not just healthy but downright formidable. The housing market is also stable and well-supported (Exhibit #3). If interest rates stay near current levels then mortgage refinancing will provide a boost to the economy for quite some time.




If we dial back to 1999, however, the labor market also appeared strong, but as the dot-com bubble burst that strength quickly unraveled. This comparison provides a nice segue as to why the U.S. economy is well positioned to absorb blows – the lack of major imbalances or misallocation of resources. Prior to both of the previous recessions, such imbalances resulted in an underlying economic fragility that we do not believe is present today. While business spending is currently subdued, forward-looking survey measures do not indicate a dramatic fall-off in expected spending (Exhibit #4). That “bend but not break” outlook is in part due to end consumer demand holding up well, but also due to the fact that business spending over the past several years has been quite modest. There is little indication of an excess to be “unwound” as was the case 20 years ago.



Potential early warning signs

How all of the various headwinds will play out is still uncertain, and there are multiple developments that could lead to a reassessment of the expected path for the economy and markets. A sharp fall-off in business spending expectations would be concerning, as would a strong trend upward in initial unemployment claims or collapsing consumer confidence. Companies are likely to face some pressure on profit margins, but we don’t believe this will occur to a degree that shifts the labor market outlook. Similarly, a brisk tightening of lending standards by banks, should it occur, would also likely ripple through the economy. Banks’ balance sheets are healthy and profits are under pressure from a flat yield curve so we believe banks are unlikely to move quickly to rein in lending without clear signs that the slowdown is accelerating. We also expect the U.S. economy to remain relatively insulated from the global economic slowdown, and we believe that the majority of the trade wars damage is now baked in to economic forecasts. Nonetheless, it is possible that multiple uncertainties could all play out in a negative way and surpass what is currently priced in and expected. As our base case, however, labor market and consumer strength – despite being outnumbered by headwinds – looks able to hold economic growth steady and support the markets.

But what about price?

Our BMO composite Valuation Metric for U.S. equities remains in a neutral range (Exhibit #5). The relative weights on different components that make up the Valuation Metric are determined by statistical relationships with future market returns and also the correlation with other components. While currently low interest rates do have a favorable impact on this metric, the majority of the weighting is on components that are not directly tied to interest rates. In our view, U.S. equities are not “cheap,” but we do not expect a correction driven primarily by valuation concerns. Over the long term, valuation is an important driver for equity returns, so this longer perspective also points to fair compensation for taking equity market risk.





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