Down Under Daily, 1 April 2014

Strength Required
Macro data need to bounce in the US to confirm that Of course, the more important reason forecasts
recent weakness was due to nasty winter weather. have held up is that weakness is weather-driven, so
I think theres a risk of disappointment: yes, temporary. Hence the view that the return of
weather had an effect, but the slowdown in housing normal weather should see the data improve from
and business investment pre-date cold weather, and now. (Im at least banking on better weather: Im
household income growth remains tepid. On the writing this on a flight to the US.)
other hand, if the macro rebound is as solid as
consensus expects then short-end rates will likely Weather clearly has affected growth. However, I
move further towards pricing in Fed tightening. think there are non-trivial downside risks to the
consensus view. My first concern is that household
Consensus economic forecasts have pointed to a income growth remains weak (Exhibit 3).
return to trend growth (2-3%) in the US every
year since 2009 (Exhibit 1). Whats different this Exhibit 3

year is that investors seem to believe the forecasts. Nice Spending; Shabby Income
US REAL DISPOSABLE INCOME AND CONSUMER SPENDING
My sense is that there is unusually high confidence 7
NBER RECESSIONS SHADED
BOTH SERIES IN TREND TERMS
amongst investors that this will be good macro year. 6
5
12M% [TREND SERIES]

4
Exhibit 1 3
2014: The Year Investors Believe Forecasts 2 2.3

CONSENSUS US GDP FORECASTS 1 1.0

3.4 0
3.2 2015 -1
REAL DISPOSABLE INCOME
ANNUAL % CHANGE

3.0 -2
REAL CONSUMER SPENDING
2.8 -3
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
2.6
2014
2.4 Source: BEA, NBER; Minack Advisors
2.2
2.0 2012 2013
The strength in consumer spending last year was
1.8 2011 largely driven by falling saving. Exhibit 4 shows the
1.6
Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Federal Reserves household net lending series (the
DATE OF FORECAST
best measure of household saving, in my view) and
Source: Bloomberg; Minack Advisors
household wealth (inverted, so the line falls as
This conviction explains, in part, why US growth wealth rises). Net lending fell to 4.2% of income in
forecasts have not been revised down through the the second half of 2013. Net lending may fall
recent period of data disappointments (Exhibit 2). further, but if it doesnt then spending will slow
towards current anaemic income growth.
Exhibit 2
Macro Disappointment But No Downgrades Exhibit 4
US DATA SURPRISE AND GDP FORECAST CHANGE Saving Less
1.0 1.0
DATA SURPRISE (RHS) HOUSEHOLD CASH FLOW AND WEALTH
15 440
0.5 0.5 H2 2013 AT
12 470
ANNUAL RATE
3M % CHANGE

% INCOME [INVERTED]

9 500
Z SCORE

0.0 0.0
% INCOME

6 530
-0.5 -0.5
3 560

0 590
-1.0 -1.0
GDP FORECAST -3 620
CHANGE* (LHS) * 3M CHANGE IN 12M-AHEAD NET LENDING (LHS)
CONSENSUS US GDP FORECAST
-1.5 -1.5 -6 WEALTH/INCOME* 650
2008 2009 2010 2011 2012 2013 2014 2015
* ASSETS NET OF LIABIITIES; INVERTED
-9 680
Source: Bloomberg; Minack Advisors 1950 1960 1970 1980 1990 2000 2010

Source: BEA, NBER, Federal Reserve; Minack Advisors

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Tuesday, 1 April 2014
More important concern is that two cyclical drivers
seem to be slowing. The deceleration pre-dates bad
weather. Exhibit 5 shows housing starts and the
contribution to GDP from residential construction.
Weather can obviously affect housing starts, but the
peak in starts was a year ago and the residential
contribution to GDP seems set to moderate.
Exhibit 5
There Goes The Housing Recovery
HOUSING STARTS & RESIDENTIAL GDP CONTRIBUTION
2.0
1.6
4QTR PERCENTAGE POINT
What does patchy growth mean for investors?
Conviction in the recovery will improve if labour
income rises. That seems plausible given the decline
in the unemployment rate and the rise in real
wages. The key upshot for equity investors is that
this will likely see the end of margin expansion.
Margins lifted late last year coinciding with the
drop in household saving and are now at high
levels (Exhibit 7). If labour costs start to rise,
margins will flat-line, and EPS growth will likely fall
RES GDP IMPACT* (LHS)
50 short of consensus forecasts.
HOUSING STARTS** 40

1.2 30 12M% (TREND SERIES) Exhibit 7

0.8
0.4
20
10
The Peak For Margins?
0.0 0 US PROFIT MARGINS
17
-0.4 -10 PROFIT SHARE OF GDP*
-0.8 -20 15 SPX OPERATING MARGIN**
-1.2 -30
13
-1.6 -40
* 4QTR % POINT IMPACT ON GDP ** TREND SERIES.
%

-2.0 -50
11
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

Source: BEA, Census Bureau, NBER; Minack Advisors 9

Likewise, the deceleration in durable goods orders
which leads business investment spending pre-
dates poor weather. The contribution to GDP from
business investment peaked 18 months ago (Exhibit
6). To be fair, the near-term signals on investment
are mixed, but weather is not the main game.
Exhibit 6
There Goes The Investment Recovery
US DURABLE ORDERS AND BUSINESS INVESTMENT
40
CORE ORDERS* (LHS)
7
* NONFINANCIAL CORPORATE PROFIT SHARE OF
CORPORATE GDP. ** S&P 500 OPERATING MARGIN
5
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Source: BEA, Standard & Poors; NBER; Minack Advisors
Rate markets are puzzling. Expectations implied by
short-rate futures have moved higher, but remain
below the forecasts explicitly laid out by the Fed
(Exhibit 8). Short rate markets either dont believe
the Feds macro outlook or dont believe the Fed
4 will react to such a macro outcome the way the Fed
REAL INVESTMENT**
is telling us it will react. I think the Fed has an edge
4QTR PERCENT CONTRIBUTION

30 * NON-DEFENCE DURABLE ORDERS EXCLUDING AIRCRAFT 3

DEFLATED BY CAPITAL GOODS PPI ** 4 QUARTER

20
CONTRIBUTION TO GDP GROWTH
2 on the latter aspect. I think that even patchy macro
12M% 3MMA

10 1
data would see expectations for short rates
0 0
continue to rise (at least) to the Feds guidance.
-10 -1
Exhibit 8
-20 -2
Still Not Pricing In Fed Forecasts
-30 -3 FED FUNDS TARGET, MARKET AND FOMC FORECASTS
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2.5
MEDIAN FOMC
Source: BEA, BLS, NBER; Minack Advisors MEMBER FORECASTS

2.0

While I think the downside macro risks are larger FED FUND
FUTURES
1.5
than the consensus expects, there is not enough FED FUND LATEST
%

3M LIBOR TARGET

evidence to make serious macro weakness an 1.0 FED FUND

RATE
investment base-case. My base case is that this is a
0.5
patchy growth year that falls short of the robust FED FUND
18 MARCH
return-to-trend-growth year implied by consensus 0.0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
forecasts.
Source: Bloomberg, Federal Reserve; Minack Advisors

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Tuesday, 1 April 2014
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Tuesday, 1 April 2014