U.S. Growth Accelerating/U.S. Recession Years Away - Wall Street’s #1 Economist Ed Hyman

[00:00:00] Speaker 1: - This week on WealthTrack, in our exclusive annual outlook with Wall Street's king of economists, Ed Hyman, he describes how much the world has changed. He and top portfolio manager, Matthew McLennan, tell us what it means for investors, next on Consuelo Mack WealthTrack. [00:00:30] Speaker 2: New York Life, along with Mainstays Family of Mutual Funds, offers investment and retirement solutions so you can help your clients keep good going. [00:00:48] Speaker 3: - Additional funding provided by Thornburg Investment Management, Active Management, Flexible Perspective, Rosalyn P. Walter, and the Fair Home Foundation. [00:01:00] Speaker 1: - Hello and welcome to our annual WealthTrack Tradition, an exclusive two-part interview with Wall Street's king of economists, Ed Hyman. Hyman, who is the founder and chairman of Evercore ISI, has been voted the street's number one economist for an unprecedented and probably unassailable 36 years by institutional investors for a reason. In an era of information overload and complexity, he and his ISI team pioneered a research product that is brief, accessible, comprehensible, and comprehensive. It is a daily must read for institutional investors all over the country, if not the world. So every year on WealthTrack, Hyman is joined by a top investment pro to put the macroeconomic outlook into investment perspective. For 2017, we asked First Eagle's Matthew McLennan to join us. McLennan, another WealthTrack regular over the years, is head of the global value team at First Eagle Investment Management, where he is also a portfolio manager for several funds, including the flagship First Eagle Global Fund, which he took over from legendary value investor, Jean-Marie Evillard in 2008. Rated five-star by Morningstar, the Global Fund is in the top decile or higher in its world allocation category for the past one, three, five, and 10-year periods, and is known for its above average risk-adjusted returns. This week, our primary focus will be the outlook for the US economy and markets. Next week, we will concentrate more on international conditions, although we recognize they are all interrelated. Hyman's team expects the US economy to pick up steam this year, forecasting real GDP, that's excluding inflation, of 2.5% versus an estimated 2% in 2016. They expect inflation to pick up as well, with the Fed's favored GDP deflator measure rising from 1.5% last year to 2.5%. As for the Fed funds rate, they're looking for a sizable increase from around 0.60% to 1.35% by year end. The yield on the benchmark 10-year Treasury should rise half a percentage point from 2.5% in December of 2016 to 3% by December of this year. And finally, they expect profits to improve, estimating that the combined earnings per share of the S&P 500 companies will rise about 10% year over year. Now a lot can change between now and then, but eight years into the post-crisis recovery, Hyman believes economic growth is picking up and that a recession in the US is years away. I asked him to give us the evidence behind the improving numbers. [00:03:48] Hyman: It's not strong right now. I mean, the evidence is not strong, so it's really a forecast. And I feel a little insecure about it because we've had seven years where every now and then it looks like it's picking up and it's not. But the Trump pro-growth policies are sort of the main motor. Plus it looks like the world economy is picking up some. Europe is a little bit better. China is a little bit better. And here in the States, I would say the main thing that looks like more growth are wages are accelerating. And you still have strong employment. And I think that combination of employment and wages will get consumer spending up. And that's the beginning of it. But as you know from our previous visits, we surveyed companies every week. Right. And that has not picked up. What they tell us, business conditions, we do zero to 100 and they're still 50. And back in 2014, when growth was 3%, they were 55. So I'm waiting on pins and needles to see things pick up a little bit. [00:05:03] Speaker 1: And yet when I look at the earnings estimates, you are expecting about a 10% increase in the kind of composite S&P earnings per share. So where does that come from? [00:05:15] Hyman: Well, so far, that is one space that has picked up. So the earnings that I look at in the first quarter were $105. And a year and a half before that, they were almost $120. So the U.S. earnings, S&P earnings had a big fall. And now they're basically back up to $120. So there's been a big rebound in earnings. And looking forward, you should have, in particular, big gains in earnings for oil companies and for banks. [00:05:52] Speaker 1: So that could make a big difference. [00:05:54] Hyman: Plus it looks like the world economy is picking up some. Right. After slowing a lot and almost going into a recession early this past year, now it's picking up. [00:06:07] Speaker 1: So I know, Matt, that you read Ed's research and you don't make your investment decisions based on the macro outlook. You basically make your investment decisions from the bottom up and you look at individual companies. What's your assessment of this pickup and growth that we're seeing in the U.S.? [00:06:27] Speaker 5: Well, I think there's no doubt that we've seen sort of a steady improvement in the U.S. economy over the last handful of years, not just this recent couple of months. I mean, we've seen unemployment go from 10% to 5%. We've seen bank loans go from shrinking to growing. Even though energy prices have picked up somewhat here, they're still a lot lower than they were on average over the last decade. And that's a source of stimulus for the economy as a whole. And as Ed referenced, there are some signs of corporate earnings improving at the margin here. And layer on top of all of that, the proposed stimulus that Trump was talking about. And I think you have a range of different reasons why the market is reflecting better fundamentals and why people are feeling better about the economy. In fact, consumer confidence and expectations is quite high relative to history at this point in time. My only concern as an investor, you know, it's difficult for me to foresee the future and to have the same kind of granularity that Ed does when he's looking at all these different variables of the economy is that much of this may be priced- Into the market. Into the market. Into the market. So it's an environment where valuations have improved a lot, bottom up when we look security by security. And with the backup in the bond market here, we've seen that largely absorbed by riskier credit markets, which implies that credit spreads have come down as well. And if you look at other measures of risk perception, such as implied volatility, they're very low relative to history. And hedge assets like gold are quite cheap relative to risk assets like equities. And so when we look at financial markets, they're telling us that they're already confident. Right. And so that makes our task difficult as investors. [00:08:15] Speaker 1: And what difference- you know, you mentioned the Trump expansionary policies, Ed, how much of a difference can a President Trump make? [00:08:26] Hyman: Well, first, to keep things on the right path. Yes. Last year was a good reminder of how different things can turn out to be, like the Brexit vote or Trump being elected or the market crashing early in the year. So there's a lot of uncertainty out there. Recognize, yes. But that said, there are three channels that this works through. One are just the fiscal policies, the tax cuts, the spending, more defense spending. And then the second channel is through deregulation. The first part you can put a pencil to. Deregulation, what that does, you don't. And the third channel is through increased animal spirits. So the president of Ford Motor Company announced they're going to build a billion and a half dollar plan here as opposed to Mexico. And he said because he felt better about Trump's pro-growth policies. Right. I'm thinking, well, that's just animal spirits. Maybe he's being nudged a little bit, too. So that third channel is impossible to measure. The second one, deregulation, is difficult. And the first one is also pretty difficult when you get the tax cuts and the repatriation of profits working through the system. So it's difficult. I think that Trump will get—unless something, you know, really unusual happens, which is frankly pretty possible, an errant tweet here or there—but I would guess that we'll probably see a good part of the tax cuts come through, both the corporate tax cut as well as individual tax cuts. And the deregulation looks as though it's pretty much going to happen early on. And the animal spirits seems as though they are increasing much, much more than I thought possible after the election. Right. [00:10:31] Speaker 1: And, Matt, you always strike a more cautious note, because at First Eagle, your first job is to avoid the permanent impairment of capital, so you don't want to lose your clients' money. You want to preserve their capital. And yet, in the global fund, you've got about, what, 30-some-odd percent of the portfolio in U.S. equities. So, clearly, you're finding some opportunities here. [00:10:56] Speaker ?: Right? [00:10:57] Speaker 5: Well, let me strike a cautious tone first. Yes, please. You know, we reference the improvement that's happened in the U.S. economy thus far. And, you know, part of that is indeed due to the resilience of the U.S. economy, but part of that is reflective of years of cumulative stimulus. We had dramatic fiscal stimulus, very easy monetary policy, we've had QE, and now we're talking about fiscal stimulus at close to the peak of the cycle, as opposed to the trough of the cycle, unemployment's below 5 percent, not 10 percent. This is not usually the time that you'd expect to see a fiscal stimulus. And so, you know, it raises the risk of a more inflationary dynamic evolving. And I think that we've seen a move up in long-term interest rates, which has started to price that to a very small extent. But the fact is, the recovery in oil prices from their troughs, the move up in interest rates from where we've seen, and the dramatic appreciation of the dollar reflecting that move up in interest rates, prospective headwinds to the economy. And I think if you have that stimulus, you know, and you have the emergence of labor cost pressure, it's not necessarily a great thing for corporate profit margins at some point into the future. But I guess the other thing I would sort of worry about in broad brushstrokes is that there are factors that work against the stimulus. The currency appreciation that I referenced before could lead to a meaningful deterioration in the current account position of the U.S. savings investment imbalance. [00:12:35] Speaker 1: So our exports will be much more expensive and therefore they could- [00:12:39] Speaker 5: Unless we see some dramatic tax policy targeting imports. Right. You know, I think we could see the re-emergence of the dual deficits discussion with fiscal deficits and the current account deficit, you know, which is not really factoring much into the markets thinking at this point in time. So for us, looking at the markets as a whole, we don't see it as a market full of bargains. In fact, it's an incredibly different backdrop from, say, the mid-'80s, where all you had to do was show up to get an attractive real rate of return. You had double-digit interest rates, you had single-digit PE ratios. Today you have repressed real interest rates, which you need, and you have, you know, PE ratios for most companies that are of quality north of 20 times earnings. So it is not an opportunity-rich environment, you know, relative to history. And the final thing I'll say is that even though things feel a lot better, we have more debt today relative to GDP than we had in 2007. And we're talking about easing fiscal policy. If we get higher interest rates, that's a real headwind given the stock of debt. And so these are sort of some balancing considerations. [00:13:50] Speaker 1: Right. Ed, how do you figure that into the outlook for the economy and how businesses feel? [00:13:56] Hyman: I've been, you know, for a long time in a slow and steady race. Yes. That's been my sort of touchstone. And it's been a comfortable one. And as Matt, you're pointing out, maybe that changes. Maybe it gets a little too fast and inflation picks up, which, you know, could be one of the big surprises this year. As I study the economy on a different way, I travel around all over the U.S. and every city I go to is just flat, booming. I've just been in Salt Lake City. It's booming. I flew up to Portland, Oregon. It's booming. Fort Wayne, Indiana. [00:14:39] Speaker 1: Right. [00:14:40] Hyman: Doing great. [00:14:41] Speaker 1: And I just have to interrupt you. I mean, one of the reasons why your research is, you know, your number one economist for 36 years is that you keep coming up with these indicators of, you know, your feet are on the ground. You're visiting cities. You have this 40-some-odd cities that you've noticed conditions are booming. And you did that with, I remember, with the stimulus from the central banks that kind of no one else in the world was putting it all together. And you were, you know, you had, I remember this, you know, it's now up to, there were 280 stimulus moves across the, you know, across the globe. And we'd be counting them. And now it's up to 315. So you're doing that with cities now. And you're saying that you're sitting, seeing on the ground that cities across the country are booming. [00:15:31] Hyman: So, and now I get into, into arguments. So Fort Wayne, Indiana. [00:15:37] Speaker 1: Right. [00:15:38] Hyman: Doing great. And I worked with a guy who was from Buffalo. And he said, Buffalo's booming. And I said, we're not putting Buffalo on the list. And he kept pushing and pushing and pushing. And finally, I got enough information. Okay. [00:15:53] Speaker 1: Buffalo is a recent addition. [00:15:55] Hyman: Doing in Des Moines, Iowa, et cetera. So I'm very in tune with what Matt was talking about, about inflation picking up and adding more stimulus to an economy that's already, I really don't know how a place like Seattle or San Francisco or Miami can do much better than they've done now after seven or eight years. And so that could be a surprise. So in that regard, I like the dollar going up because it's a governor. It's a headwind in the economy, which I'm sort of now thinking I wouldn't mind having a little pushback on the economy. So far, the economy has not taken off from what I can tell. But the things that are driving local economies are healthcare, higher education, new tech like Facebook, e-commerce, and then sports and entertainment. [00:16:54] Speaker 1: But I'm listening to this, I mean, you know, so healthcare, telecommunications, technology. [00:16:58] Hyman: Can I just add? [00:16:59] Speaker 1: Education, yes. [00:17:00] Hyman: Your point on debt is dead on. Right. That's going to be a killer at some point. [00:17:05] Speaker 1: So at some point, we'll have to pay that Piper if interest rates go up a little bit. I mean, something's got to give. But listening to what Ed was saying, that strikes me as, gee, isn't the U.S. a really good place to invest? And given how the markets have done, should you have been more invested in the U.S.? Well, it depends on price. [00:17:23] Speaker 5: Right, price. Always as an investor. Right. And, you know, I would say that, you know, if we look at markets as a whole, you know, prices haven't been super attractive. You know, whether you look at the low level of real interest rates or the high levels of valuations overall, if you just naively look top down at the markets and think about what prices imply about the next 10 years' returns, they're pretty modest. Particularly if you start from a base of having above-average debt, typically in those scenarios, you have fairly constrained growth in the economy. And so if you have low yields and low growth, it's not necessarily opportunity rich per se. But if you think about what Ed was saying about the pockets of vibrancy in the U.S. economy and the services sector, we do see a number of interesting companies in the U.S. that have dominant market position in certain services, whether it's software, advertising services or other niches of the economy, where those businesses are essentially a royalty on nominal GDP growth. Their businesses grow in line with the economy. And if you can provide and find an opportunity to buy into those businesses at windows of time where they are priced with attractive free cash flow yields, they're not pricing a lot of growth, then you can get sound returns investing in the U.S. [00:18:47] Speaker 1: So would those be, for instance, like an Oracle, which is one of your largest holdings, or a Microsoft? [00:18:52] Speaker 5: Yeah, if you think about Oracle, for example, which is a large holding in our funds. Here's a business that controls 40% of the relational database market and is also quite dominant in all the applications that attach to databases. And the majority of their income comes from recurring maintenance fees on the installed base of databases. And that grows gradually over time, but it's all free cash flow to us as shareholders. And the company itself, if it grows in line with nominal GDP and has a 7% free cash flow yield, offers a nominal GDP plus type of return. Whereas bonds in the U.S. are offering nominal GDP minus returns. And the reason for that is with high levels of debt in the economy, it takes low interest rates on the debt relative to economic growth to deleverage the economy over time. So, you know, in a world where real returns are scarce, top down, you have to look for individual situations where you've identified a company that offers the prospect of sound real returns. [00:19:59] Speaker 1: Right. And as you said, at a proper price. Yeah. Right. With a big margin of saving. And one of the things, I'm just looking down at my notes, that you said in a recent report was that the, I think the odds of a U.S. recession are like way out. I mean, several years away, why, I mean, eight years into a, in a recovery, you know, why isn't the danger of recession? Why is it not closer? And why is it way out? [00:20:26] Hyman: The first reason, before I get to the timing. Yes. Is, I think that we'll get a recession when inflation goes up, like you're warning me, it might happen. And if it happens quick, then I'll change my view. Right. But that's the first thing. And then the Fed responds to that and rates go up. So I'm sort of expecting inflation to go to, you know, five or six percent at some point in the future. But years. [00:20:52] Speaker 1: Years, no, but right. But not this year or next year. [00:20:55] Hyman: And Fed funds to be five or six percent. Uh-huh. But getting back earlier, there may be a half different, a half dozen different indicators that tell you where you are in the business cycle. They're sort of like rings on a tree. It tells you how old the tree is. [00:21:12] Speaker ?: Uh-huh. [00:21:12] Hyman: One of them is when the Fed tightens. And so here we are, you know, eight years into an expansion. And the Fed, you know, tightened a year ago, waited. And then they did another tightening, you know, just a few weeks ago. And now we're up to a big 60 basis points. And so that tells me we're still, we're old chronologically. Right. But about middle of the road economically. Housing starts are still, you know, worse or lower than most recessions. The U.S. leading economic indicator, which does, you know, move up from lower left to upper right over years, it has not yet moved above its 07 peak. And in the past, once it makes a new high, you start the clock and the recession is about five years out on average. I see, uh-huh. This is also getting to be a pretty standard view. I'm very sensitive to when I'm stating the obvious with a thrill of discovery. Right. And most people now think the recession is about three years out. Okay. Most people, when I survey investors. So three years out is more or less infinity for me. Mm-hmm. But I don't expect a recession, you know, next year or this year or next year, probably not in 19, what's that, 20? [00:22:36] Speaker 1: Well, the clock is running here too. And so I have to ask each of you my one investment question. The one investment for a long-term diversified portfolio in the U.S. Matt, do you have one that you would recommend? [00:22:49] Speaker 5: Well, I think we spoke about Oracle as an example before of a business with a high free cash flow yield and a stable growth profile. Another example of one of our larger holdings in the U.S. would be a company like Omnicom, which is the leader in marketing services. Whether it's advertising, you know, creative production or affinity marketing programs, they're essentially a services company that, you know, where their earnings over time grow in line with the economy. And they generate around about a 6% free cash flow yield. It's businesses like this that make up our portfolio one at a time with a hedge in our portfolio in gold. Right. And the final thing I'll say is that, you know, our portfolios have above average cash at the moment. This is not because we have a negative market timing call, but because the kinds of businesses we talked about have been hard to find at the right price. And so we're probably a little more conservatively positioned than we have been on average for the last five or six years. [00:23:44] Speaker 1: And, Ed, what would yours be U.S. based? [00:23:47] Hyman: So we have a collaborative research effort. We have our analysts. We have our strategists. I do the economy of a technical analysis. And we are all coming to one space, which are financials. So that's our main, we're leading with financials. They also happen to not be particularly expensive, which is -- [00:24:10] Speaker 1: They've had a big run up in the last -- [00:24:11] Hyman: They've had a big run up, but they're still -- Year. Nosebleed. [00:24:15] Speaker 1: All right. So you two have to stay right here because we are going to continue the conversation, which is going to air next week, on the outlook for the global economy, you know, everything else kind of ex-U.S. So Ed Hyman and Matt McLennan, thanks so much. And we'll continue our discussion in just a minute. [00:24:33] Speaker 5: Thank you. [00:24:34] Speaker ?: Thank you. [00:24:35] Speaker 1: At the close of every WealthTrak, we try to give you one suggestion to help you build and protect your wealth over the long term. This week's action point is review your risk tolerance for the U.S. stock portion of your portfolio. The U.S. market has had an impressive multi-year bull run, which accelerated after the election. It is expensive by just about any historical measure. That means it is more risky than it was last year or the year before that. Take some profits, raise some cash, take a breather, and start making a list of some beaten down assets, industries, or regions, which might be of interest in a correction. I hope you can join us next week for part two of our exclusive global outlook with Ed Hyman and Matt McLennan. Hyman's headline is Global Growth Accelerating. We'll find out by how much and how to take advantage of it. In the meantime, please visit our website, WealthTrak.com, for this show and others, and keep reaching out to us on Facebook and Twitter. Thank you so much for watching. Have a great weekend and make the week ahead a profitable and a productive one. [00:25:47] Speaker 2: New York Life, along with Mainstay's family of mutual funds, offers investment and retirement solutions, so you can help your clients keep good going. [00:26:02] Speaker 3: Additional funding provided by: Thornburg Investment Management Active Management Flexible Perspective Rosalind P. 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