Slower Growth and Fewer Interest Rate Increases? Not Very Likely
Most of us are no longer surprised by a weak first quarter start to US GDP growth, yet some pundits and policy makers are using that weak start to argue for an easier stance for monetary policy. James Bullard, president of the St. Louis Fed, is once again calling for slower increases in rates, arguing that growth remains too slow and inflation too low. Bullard notes that the Fed’s plans to raise rates further this year may be “overly aggressive relative to actual incoming data on U.S. macroeconomic performance.” He also believes that because “U.S. inflation and inflation expectations have surprised to the downside in recent months,” the Fed should back off rate increases. On both counts, we beg to differ.
The first quarter GDP estimate is beset by measurement problems, as we and the BEA have noted before. Updated forecasts now indicate that second quarter GDP is likely to come in much stronger. Just Friday, the NY Fed raised its forecast from a 1.9% to 2.3% pace of annual growth in Q2, while the Atlanta Fed sees a robust 4.1% growth rate. On the inflation front, March’s dip in inflation will likely prove to be an aberration (wireless carriers’ unlimited data plans are partly to blame), while unemployment at 4.4% and rising wages are heaping more pressure on prices. More importantly for longer term investing, when we look deeper into both US and global growth drivers, we see signs of more persistent and broad-based output growth.
First quarter earnings reports came in much stronger than expected as companies in the S&P 500 are on track to deliver average year-over-year growth of 14%, well above expectations for 9% growth. More importantly, revenue growth for 64% of the companies reporting came in above expectations and above 5-year averages. This indicates that earnings are now also being driven by better sales, not just by cost saving or share buybacks, as was often the case earlier in the recovery. Firms are adding workers and starting to increase investments in capital equipment, which points to more sales growth to come.
Still, many remain concerned that productivity growth remains tepid, and at 0.2% growth in 2016, they may be right to worry. Productivity growth remains the main engine of GDP growth over the long term, especially for an economy which has slowing population growth and a limited supply of unemployed workers. Building new factories, adding more assembly lines, and increasing other office equipment (PCs, software, etc.) also expands output per worker, but the marginal benefits diminish unless technological improvements come along too.
Drilling down to specific industries, however, reveals more substantial pockets of productivity gains, and we may just now be seeing these starting to spread more broadly through the economy. The information technology sector continues to be a source of innovation and outperformed the S&P 500 by 710 basis points in Q1 (up 12.6% vs S&P 500 up 5.5%) as average earnings grew 17%. Companies in the communications sub-sector are among the main contributors. We are all familiar with the improvements we are enjoying in the capabilities of smartphones—free global video calls, live streaming of sporting events, megapixel photos, videos, and more. The iPhone 7, with 3.3 billion transistors in its compute engine, is more than 150 million times faster than the IBM mainframes behind the Apollo 11 mission. And lest we take too easy and distant a comparison of technology’s progress, note also that the iPhone’s capabilities exceed those even of IBM’s Deep Blue supercomputer, which beat chess champion Gary Kasparov in 1997. These improvements in technology for computing and communications have also made possible entirely new consumer products and services. A single Google search, for example, uses more processing power than all the computing power used on the ground and in space of all of the Apollo missions combined. The iPhone is not only an example of past progress, however, it is also a pointer towards future possibilities for growth and investment ideas.
Consider that smartphone users are pushing progress not only in chip power, but also in the communications infrastructure behind all these services. As consumers stream more video and tap the net for more searches, and as firms serving those customers rely more on computationally heavy data analytics, the pathways of the internet get increasingly crowded at the same time that users are demanding more speed. Companies that provide the specialized hardware needed to build a larger and faster network have been growing and look to have several more years of above-market growth to come.
Smartphone users are also demanding more features which require better motion, image, touch, and light sensors. Those sensor technologies—and the computing power which makes them work—are now finding their way into other industries, including automotive, industrial, health care, and all manner of consumer goods. In ways subtle and obvious, the technology changes now filtering into car design, factory automation, medical devices, and home appliances are enhancing value for users. Regardless of whether these improvements make it into measured GDP (quality changes being particularly tough to measure), they will shift competitive dynamics among firms – those that leap ahead with better products have the opportunity to grab more of the consumer wallet and take market share. Eventually, quality measures in official data will catch up and should finally show themselves in GDP growth.
In automotive, the Tesla sits at one extreme with well above $1,000 of semiconductor content, while the average car has just over $300 in chip content. But all vehicles are moving in the same direction and fully autonomous vehicles will require far more content; current forecasts point to 5-6% annual growth in chips for the automotive industry over the next several years even as semiconductor stocks continue to trade at 15.4 times earnings, below the S&P 500 current multiple of 17.4x. Not only are there investment opportunities in the chip providers, but the new technologies are also altering manufacturing costs for autos and are likely to upend the usage model for consumers; this will not only affect future profitability for auto OEMs, but also rental car firms, insurers, and car service companies.
We may not be seeing productivity growth equal to that of earlier eras—from steam engines to the integrated circuit—but these incremental changes are filtering now across more sectors and firms are responding. Measured growth may creep along, but sales are rising, job openings continue to outstrip hires, and wages—and so inflation pressures—are continuing to build. Investment strategies must both find those growth opportunities and be wary of the consequences of rising inflation and interest rates.
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