The stock market is making new highs, unemployment is at record low levels, and GDP has never been better. Corporate revenue and earnings are near records. Borrowing rates are low and inflation is low. It’s difficult to find any data that suggests a recession is on the way. Yet everywhere we turn, pundits are bearish. Why do we hear so many economists talking about a big chance of a recession sometime in the next few years? Earnings comparisons are tougher, tariffs are terrible, they say, a weak Europe is the start of a global recession, all the benefits of the tax cuts are over, negative interest rates are bad for asset values, among other things. When pressed, though, the most common reason is that the economy has been good for too long and that can’t last much longer.
This seems new. Perfectly capable economists are predicting recession simply on the basis of a recession being “due.” The longevity of the current recovery is simply too long for some people to stomach, believing that the “natural cycle” of recoveries is just 3.2 years, the average of the 1854-2007 time period. So, we are “overdue by 4.5 years,” according to an October 2018 Forbes article. The recent market corrections in the fall of 2018 and in May 2019 both unfolded with a healthy dose of concern about near-term earnings, GDP growth, China tariffs, and the policy of the Fed, all of which together formed a mosaic of imminent recession, pundits say by late 2019, or certainly by 2020 at the latest.
Two economic metrics that are key to this discussion are real GDP and inflation. In part, it is low real GDP growth compared to past recoveries that creates concerns about the longevity of the current expansion. Inflation estimates are used to make real output estimates from nominal sales reports, which then are used to estimate real GDP. Real GDP growth estimates obviously help drive analysts’ revenue and earnings growth assumptions and help to inform the Fed’s policy decisions. The problem with this is that these estimates are wrong and economists know it.
The CPI is the inflation measure used in these estimates. It is created using baskets of goods in dozens of locations around the U.S. The current survey methodology ignores certain substitution behaviors, doesn’t account for discounts at outlet stores, doesn’t account for new products, and quite often ignores quality differences between discontinued products and those that replace them in the baskets. The CPI is known to overstate inflation by as much as 0.4% per year. The PCE is a better, lower, inflation estimate but it is not as timely and goes unused. That leads to an understating of real GDP growth, which is of course the remainder after adjusting nominal GDP by the inflation estimate. While that’s a modest error in the short run it’s a giant error in the long run. Not only is real GDP growth understated, but with inflation overstated, real wage gains are understated. With real GDP growth and real wage gains understated, the current economy seems more tenuous and it makes near-term recessions easier for economists to predict.
Another element to the mismeasurement thesis is the mismeasurement of GDP itself. In addition to the problem of measuring general inflation discussed above, there is also the problem of determining whether a price increase is a feature enhancement or inflation. It’s likely that many feature enhancements are being misdiagnosed as inflation. There’s the problem of not measuring the convenience of using OpenTable and the time it saves to do other things. This isn’t captured. In fact, it’s likely that a whole host of new conveniences along with productivity and lifestyle enhancers from Waze to Live Nation to Amazon Fresh are not being captured in GDP growth because the benefits are hard to measure in terms of time saved, not to mention what beneficial activity is created during that extra time.
Finally, traditional causes of recession, the mismatched timing and bad forecasting of inventory and end demand, are increasingly tamed by transparency in the supply chain. In general, the vast benefits of the instantaneous flow of information to everyone or anyone are still working their way through the economy, quite possibly in ways that are difficult to measure with tools originally designed to count units and weigh output. With long-term real GDP growth and living standard gains mismeasured and the full economic benefits of the internet still not fully understood, we believe there is a reasonable case that the economy is not only better than generally believed but also that real wages have risen more than believed for 30 years. If only we were using the PCE instead of the CPI.
Not surprising then that we remain positive on the economy and that we believe our portfolios are well positioned for good results ahead. By identifying companies with good balance sheets that offer products or services that are better, cheaper, or faster than the competition, our portfolio companies stand to thrive no matter how the predictions of economists turn out. Our strategies performed well in 2Q 2019, with our Small-Cap Value Focus concentrated strategy earning a 5.9% return net of fees and our Small-Cap Value Diversified strategy earning a 4.02% return net of fees versus the 1.37% return of our Russell 2000 Value Index benchmark. Details on our results are discussed later in this commentary (see attached PDF).
Thank you for your interest in Sterling Partners Equity Advisors.
Kevin E. Silverman, CFA
Chief Investment Officer