Too Much of a Good Thing?

May 2018

Things are going swimmingly! Especially in the U.S. We’ll forgive you if you didn’t know that, given all the rhetoric about the dangers of free trade and how jobs need to be brought back to America. But it’s true! Look, there’s even a chart to back up this claim: the U.S. unemployment rate is near its lowest level since the 1960s.

Obviously, as more people find employment, fewer people become unemployed. To fill job vacancies in a tighter labour market, employers must offer higher wages. As the next chart shows, this has been observed to some degree. That said, wage growth still lags its pre-recession levels, and has not grown at the same pace as the employment rate.

Unlike the Bank of Canada (which only targets inflation) the U.S. Federal Reserve has a dual mandate. In addition to maintaining price stability, the Fed also strives to foster economic conditions that achieve maximum sustainable employment. In other words, it wants to keep the unemployment rate low. With respect to low unemployment, the first chart shows that the Fed’s mission has been accomplished. As the second chart alludes to, however, inflation has not responded as quickly.

The Fed’s dual mandate is a tough objective to achieve. For instance, if the Fed kept driving unemployment lower and lower, consumers (collectively) should be richer and buy more goods. This should drive up demand for those goods. That should encourage manufacturers to produce more goods, which should drive up demand for labour. All of this should drive up both wages and prices as manufacturers work harder to ramp up production to meet the increasing demand.

But because inflation has been muted since the recession, the Fed has kept interest rates near all-time lows. The following chart shows that only recently has the Fed started to raise rates (red line). The chart also shows that this delay in raising rates has resulted in a growing discrepancy between movements in unemployment (blue line, shown inverted) and interest rates. Does this mean the Fed has been ignoring part of its mandate by keeping rates too low for too long?


Source: Bloomberg, Cowan Asset Management

The next chart shows another, unintended consequence that loose monetary policy may have had. On the x-axis the federal funds rate (the interest rate that the Fed controls) is shown. On the y-axis the price-to-earnings ratio of the S&P 500 is shown. There is a striking inverse correlation. We have previously discussed the relationship between interest rates and equity valuations, and this chart summarizes that discussion: as rates decline, valuations tend to increase. Furthermore, at almost 25x earnings, the current valuation of the S&P 500 is very high by historical standards.


Source: Bloomberg

The following chart shows how this elevated equity valuation has helped contribute to asset price inflation that has disconnected from GDP growth. Historically, the two have grown at a similar rate. The major exceptions are during periods of investor euphoria, such as the dot-com bubble or housing bubble. More recently, asset price growth has once again outpaced GDP growth. And this has coincided with unprecedented levels of monetary stimulus from central banks like the Federal Reserve.

As asset prices increase, people get richer. The metric household net worth as a percentage of income is shown on the x-axis of the following chart. By this measure, U.S. households have never been richer. But when people feel rich, they tend to spend more and save less, as shown in this chart. This is great for GDP growth (consumer spending is the single-largest driver) but it is not good preparation for the inevitable rainy day.

Don’t be mistaken, rainy days are inevitable. This next chart shows the same metric from the x-axis on the previous chart (household net worth as a percentage of income) varying over time (blue line). It also shows the same metric from the y-axis in the previous chart (personal saving rate) varying over time (red line). Note how the two lines moved relative to one another in the green highlighted areas: not to get too technical, but when one zigs the other zags. Before each of the last two recessions, net worth skyrocketed while savings rates fell. But the gap between the two lines before those recessions pales in comparison to what is now being observed.


Source: U.S. Bureau of Economic Analysis, Board of Governors of the Federal Reserve System (US)

The Fed isn’t the only one to potentially blame for inflating possible bubbles. The U.S. federal government has also had a hand in things. While central banks are responsible for monetary policy via interest rate changes, governments are responsible for fiscal policy via budget spending. In a recession, monetary stimulus is applied via lower interest rates and fiscal stimulus is applied via deficit spending. But during boom times, not only should monetary stimulus be removed to prevent economic overheating, so should government deficit spending.

The U.S. government has not been reining-in budget deficits recently. As the next chart shows, budget spending as a percent of GDP (red line) has historically moved in sync with the unemployment rate (blue line, shown inverted). However, even though unemployment has been falling drastically in recent years, the U.S. government has maintained budget deficits. Whether they are doing this for political reasons (voters do like having money spent on them) or because they are worried about economic growth is unclear. Actually, who are we kidding? They’re almost certainly doing it for political reasons.

As the saying goes, “trees don’t grow to the sky”. Central banks and governments cannot stimulate economic growth indefinitely without eventually triggering painful corrections. As it applies to today’s equity markets, investors have not come face-to-face with a correction… yet. We are worried about what will happen to the markets once the Fed does eventually bring rates back up to more normal levels. History has shown that interest rate normalization can be painful for investors to endure.

It’s not a foregone conclusion that we’re on the verge of seeing any bubbles burst. Nonetheless, there are clues that there are more risks than rewards lurking in today’s markets. That’s why we continue to position your investments conservatively, refusing to get caught-up in the fear of missing out on the next rally.