Q4 Brought a Substantial Drop in Household Net Worth, Is Spending Next: With the huge stock market sell of that occurred in the fourth quarter of 2018 (and mostly in December), recent readings of household net worth in the United States have come back significantly lower from the previous year. This is not in the least surprising, and neither would a subsequent drop in consumer spending for the first or even second quarter of 2019 since it is commonly held that there is some connection between net worth and propensity for consumption (i.e. the more rich I feel, the more likely I am to buy something). However, the U.S. consumer by most other measures appears to be doing very well. Recent initial jobless claims have been at multi-year lows, Bloomberg’s Consumer Comfort Index is at its highest levels since the early 2000s, and unemployment remains very low. All of these factors coupled with the strong performance of asset prices, nearly across the board, since the beginning of this year leaves some doubt that we may experience much, if any, significant slowdown in spending.
Our Takeaways: We think that while a slowdown in spending is certainly possible, if it does occur it will 1) likely not be as dramatic as the drop in household net worth data would suggest, and 2) likely not be related to a decline in net worth as it would be other, more significant, factors. The first theory for why these two conditions are likely to be true is that the United States currently has a dramatic dichotomy in households that compose the aforementioned net worth statistics. A large portion of household net worth is concentrated in a few number of households, and as you begin to work your way down the scale (say from $1,000,000 to $250,000) in total household net worth, the percentage of that value being derived from things such as stocks and bonds goes down and the percentage of that value coming from the household’s primary residence goes up. Many households have little to none of this value coming from anything besides the equity in their primary residence, which, at least recently, has not been subjected to the kind of correction that we are seeing in the net worth data. However, just because a household has a net worth that is four times higher than another does not mean that their consumption is going to be four times higher, so this translates into the long tail of households with lower (or negative) net worth still making up a sizable portion of the total consumer spending pie. Therefore, the idea that just because in aggregate household net worth declined (primarily due to a decline in the stock market) does not necessarily mean that in this case we are likely to see the same thing, because many consumers did not personally feel the effects of this decline. The second theory focuses more in the duration of the change. Since the drop in net worth was quick, and with the rebound in asset prices (primarily stocks) throughout the year, most consumers will not have had time to be conditioned by the change.
Check In on the Brexit Roller Coaster: March was an eventful month for the U.K. with updates coming all the way up until the publication of this letter (and surely after). To a certain extent, this was to be expected since the end of March was the original Brexit deadline for a deal to be struck, but as you will see, even that is no longer the case. After what looked like some positive activity within Parliament in January to support Prime Minister Theresa May’s efforts to put a deal with the EU together, things took a turn in March. On the 12th, Parliament defeated a revised Brexit plan. On the next day, they were able to pass a ceremonial vote to “rule out” a no-deal Brexit, but on the following day, March 14th, a vote to hold a second referendum on Brexit was shot down by a huge margin (84-344). All of this flurry of activity with nothing productive to show for it led to a 2-week extension being approved by the EU to give May and the U.K. a little more time to agree on a plan to prevent a hard Brexit.
Our Takeaways: Brexit is still a real mess, and appears to be getting worse. However, it is unlikely the U.K. will be allowed to go off a cliff on this one. The result would be far too detrimental to the European (and global) economy, and the willingness for both sides to continue to kick the can down the road despite the deteriorating situation in Parliament is a clear indication that when the chips are down one, or both, of the sides will blink.
Late-Cycle Look at Capital Expenditure: Cumulative capital expenditure has been slower and lower this expansion cycle when compared to previous cycles in the U.S. since 1948. This current cycle, going on 45 quarters, has only been able to muster slightly above 25% cumulative capital expenditure growth when compared to the prior peak’s expenditure. It its own, this may seem like a good number, but this is compared to increases of 75% to 100% for expansions of similar length. Looked at another way, this kind of increase is more typical for an extension of 10 to even 30 fewer quarters in length. This is not to say that all capital expenditure has been conducted in a similar fashion. Soft Capex (e.g. investments in R&D, software, and other forms of less tangible infrastructure) has grown substantially, around 65%, over the previous peak. The divergence has come from Hard Capex (e.g. investments in physically equipment, structures, and other forms of tangible infrastructure) which has grown about 25% since the previous peak. Given that Hard Capex is a considerably larger portion of the overall amount of capital expenditure, it appears as though it is acting as a weight. Another factor that could be contributing to the lackluster capex figures is the overall environment for how large companies have been allocating excess capital. Share buybacks and other forms of returning capital to shareholders have been a major topic in the financial press, particularly in the last year, given the volume of capital that is leaving companies in this manner. By extension, this means that money is no longer available to be used for things such as capital expenditures.
Our Takeaways: It is likely the focus on returning capital to shareholders has been the biggest factor behind the low and slow trend we have observed with capital expenditure this cycle. Given other factors that should be positive influences on capital expenditure such as increased corporate profits, low interest rates, overhauled corporate tax policy, and the like, there are logically no barriers to more capital expenditure. Another aspect of the current economy, and this is somewhat reflected in the divergence in the Hard and Soft Capex numbers, is the make up large companies compared to those in previous cycles. A quote from Tom Goodwin summarizes this idea best: “Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate.” Throw in other companies such as WeWork, Amazon, Lyft, and others that follow this model and another explanation for capital expenditure begins to take shape. If companies can generate tremendous value without having to invest excessive amounts of money into physical resources, then that would also explain the trend.
News from March FOMC Meeting: In their March meeting, the Federal Open Market Committee (FOMC) announced what is being considered by many in the financial press a dramatic shift in their policy stance in just a few months time. Their statement, released after the meeting, acknowledged slower growth and consumer spending so far for the first quarter and identified the committee has weaker inflation expectations even compared to their January meeting. Furthermore, they have downgraded forecasts for GDP growth and inflation over the next two years. Even more surprising were the revisions to their “dot plot” (a measure of all committee participants interest rate expectations over the coming few years and in the long run) which indicated a few rate hikes this year and several more in 2020 as recently as their December meeting which now shows no increases for this year and perhaps only one for next year. This represents a significant reduction in the overall rate path from just a quarter ago. If all of these announcements were not enough for one meeting, the committee continued in announcing they would halt the balance sheet reduction activities they have been conducting for the last several quarters (they refer to it as “normalization”) starting in September. In order to maintain the balance sheet’s size at that time, as assets mature the Fed plans on reinvesting them in Treasuries across a broad range of maturities.
Our Takeaways: This represents a big departure from the previous policy path. The Fed had drawn a lot of criticism for what has been termed “double tightening” of both interest rate increases and balance sheet reduction. Now, in one swift move, they have put both feet on the brakes of their tightening course. On net, this should prove to be a positive for risk assets such as stocks, but at best this action is simply letting out a little extra line for this expansion to run. Time will tell if this decision (and more importantly if they decide to stand by it) was a mistake or not, but many in the financial community agree the Fed has not given itself enough breathing room to adequately support the economy in the next recession. Also, with their activities (or soon to be lack thereof) shifting out of focus, other aspects of the economy such as housing, consumer spending, manufacturing output, and the like are bound to come under more scrutiny. Like the supposed ancient Chinese curse says: “may you live in interesting times.”
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