The Consumer Is Moving Forward, So Will The Equity Markets

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: D. H. Taylor
Summary

Better-than-expected income and consumption data bodes well for the economy.

The trickle-through effect of the consumer pushing economic growth at higher levels will push the equity markets upwards, eclipsing recent all-time highs.

Headwinds with interest rates and the trade war appear to be abating.

Last Thursday, it was announced both personal income and personal expenditures rose above expectations. The consumer is earning income at a higher rate on a year-over-year basis. And, subsequently, the consumer is shopping more. The recent record numbers for Black Friday are a tell-tale sign of how well the consumer is at this moment. The US economy is 70% services and driven by the consumer. If the most significant driver is pushing faster, so too will the economy as the expenditures work their way through the business landscape. With interest rate increases looking like they will moderate, and the potential of pressure from the trade war alleviating, the equity markets should do well in the coming environment. I have been bullish on the US consumer. The recent activity reaffirms that conviction. The equity markets will follow suit; equities will move higher along with the economy.

S&P 500 rises on Fed Remarks

Personal Income & Expenditures

The higher-than-expected income and expenditure growth bodes well for the economy. Both data releases pushed higher for the month coming in at 0.5% higher for personal income M/M and 0.6% for personal expenditures:

Personal Income

Personal Spending

First, and foremost, I am an economist. When I start my analysis, I always start with the consumer and their incomes. If the rate of growth of incomes is increasing on a year-over-year basis, so too will the rate of growth of expenditures. The below chart is a graphic example of that, comparing personal income and personal expenditures:

Personal Income and Conusmption

Normal rates of growth are in the range of 2.5-3.5%. Both of these indicators are inching back up towards these numbers. This month's release reiterates the strength of this portion of the economy.

The US economy is 70% services. And that is driven by the consumer. By extension, if the consumer is pushing forward with expenditures from a higher rate of growth in incomes, this drives business activity from sales, suppliers and manufacturers. The trickle-through effect means that business activity will remain robust and will increase in line with the growth of consumption. From that, businesses will see gains in revenue and earnings.

A normal rate of growth for GDP on an annual basis is about 2-3%. Currently, the GDP growth rate for the United States is 3.5%, just printed 28/11/2018. With an increasing personal income and expenditures, this will keep growth rates on the higher end of normal.

This economic growth is in the face of interest rate increases; short-term interest rates have been edging higher. Also, there is the trade war. But I largely see these concerns being contained and not having a long-term negative impact on growth of expenditures and GDP.

Interest Rates Should Remain Subdued, But...

Federal Reserve Chairman Jerome Powell stated that he believes short-term interest rates are just below neutral. I believe that long-term interest rates are likely to continue higher (outlined below) and that it is a matter of time before the curve conforms to where interest rate levels should be. The Fed pressured interest rates lower via its bond-buying programs. The effects of this will take some time to unwind. The front part of the curve is "just below neutral". The long end will move upwards more slowly, but eventually it will elevate towards neutral for the economy.

Below is a graph on the yield curve. I plotted the most recent interest rate yield curve and the lowest point the curve hit in the aftermath of the Great Recession to show how far interest rates have risen:

United States Yield Curve

Interest rates are one of the key concerns I have with the future of the economy. But it is not the short end that has me in a watchful state; however, it is the long end and potential pressure from the Federal Reserve unwinding its balance sheet as well as the Federal government spending at a faster rate. There are two other concerns: the effects of higher interest rates on emerging markets, and ramifications of ballooning debt loads and higher rates on lower-grade corporations.

For now, the short-term interest rate outlook is positive for the consumer and the economy. On a relative basis, interest rates are still quite low. Throughout the end of the 1990s, during the Dot Com boom years, short-term rates averaged about 5.5%. Today, short-term interest rates are 2.25% with a likelihood of moving up to 2.50%. And, again, just prior to the most recent recession, interest rates stood firmly at 5.00%. So, short-term rates of 2.50% are likely to remain accommodative.

But I am cautious on the outlook of long-term rates over the longer term. This is something that I will keep a sharp eye on to see if developments in higher interest rates on the longer end of the curve have a negative effect rippling through the financial world.

You may read my full analysis on the potential threat to interest rates here: Bonds: Sell If You Still Own Them.

Tough On Trade

I am not one who believes that the trade war will be a long-term concern. I believe Trump is grandstanding and some deal will be easy to come to terms with. This would not be the first time he has done this; very slight changes to NAFTA being the perfect example. At the G20 Meeting, Trump and China came to an accord and a "time out" over the trade war. This very minute detail will allow the president to grandstand all around the country as to how the new and improved deal is a major victory for America. This is basically what happened with NAFTA.

The outcome of the G20 Meeting will probably end up easing a lot of concerns over trade. While the two sides came to a minor agreement, both sides agreed to have progressively more serious talks - and a 90-day cease fire. The end result will be an easing of concerns with equity markets. Because of that, I do not see long-term pressure on economic growth from higher tariffs.

Equities Will Rise Amid Strong Economic Growth

The consumer remains robust; their incomes are moving higher on a year-over-year basis. Interest rates are moderating, removing any potential weighting on interest expenses. With the likelihood of a trade negotiation moderating the concerns of tariffs, there are a lot of reasons for a bullish outlook on the economy. The most recent personal income and consumption data, as well as the robust news coming from the holiday shopping sprees, reiterates my bullishness on the economy.

I believe the economy will continue to expand. And I believe that the result of this will be continued increases in corporate profits and, by extension, continued increases in the broader equity markets. I believe we will see the equity markets pass the recent all-time highs. And I believe this will happen fairly methodically and quickly; I look for this over the next 3-6 months.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPY, DIA, QQQ over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.