Too little capital

Key points

  • The Federal Reserve is taking comfort in the labour market and consumption data. This could be misleading. Weak capex is a major issue.
  • Has the Fed really done enough? The quantum of reassurance provided by the Fed’s cuts should not be overstated
  • The mysteries of French resilience: it’s not just public spending. Investment is strong. France is bucking the trend
  • Dividend investing: finding substantially positive yields is still possible…in equity

Focusing on US labour data may be misleading

When in doubt, stick to what worked before. This seems to be the Fed’s motto as it is navigating a complex macro configuration, in which uncertainty is high, sentiment is poor but hard data remain decent. Last week the members of the Federal Open Markets Committee (FOMC) chose to replicate the 1998 path. Then, the Fed – reacting to the stress generated by the Russian default and the LTCM crisis – rapidly cut its policy rate by 75 basis points in 3 months. It then remained in observation mode, before hiking again in the summer of 1999. By stating during the press conference that he believes monetary policy is now “in a good place”, Jay Powell conveyed his sense that the Fed has provided a large enough reassurance buffer to the economy. Now that the monetary stance is accommodative (the effective Fed Funds rate is today some 100 basis points below the FOMC’s median estimate of the “long run policy rate”), and with some of the most obvious global macro risks receding (Powell played up the “phase one deal” between the US and China), the Fed believes it can spend some time in observation mode.

In a favourable scenario, the “truce” on trade war would feed through sentiment relatively quickly. In 1998, the manufacturing ISM index found its trough in December 1998, one month after the Fed’s last cut. If history is a guide, this should help ignore the additional downside surprise in the ISM for October 2019 released two days after the Fed decision, which came out in contraction territory for the third straight month at 48.3 against consensus expectations at 48.9. Beyond the vagaries of the surveys, it seems the FOMC is particularly focused on the resilient labour market as a protection against a slide in consumer spending, and at least on this front the dataflow is reassuring.

Indeed, while the soft data has been pointing to a significant loss of momentum on hiring intentions, hard data for employment continue to do well. In spite of the General Motors strike which has shaved around 40k jobs on the month, overall the US economy added 128,000 jobs in October, and the September data were revised significantly up to 180,000. On a 6-month average job creation is standing at 156k, below the post Great Recession average but by a fairly small margin.

It seems that for now the US is following a rather unusual pattern, in which firms maintain a very decent demand for labour while curtailing their capital expenditure. Indeed, the good news on jobs are not matched by positive developments on non-residential investment, which fell by 3% annualised in Q3 after an already concerning 1% decline in Q2.   We experienced a similar configuration during the “mini downturn” of 2016 when non-residential investment also fell, but payroll data remained perky (just below 200k per month per month an average that year).

Normally, firms’ demand for labour and capital should follow a similar cycle, determined by expected output. And indeed in the US, as can be seen in Exhibit 1, the contemporary correlation between the two variables used to be quite tight. This has changed since 2010 (we have excluded from the sample the Great Recession of 2008/2009). A decline in investment can now perfectly co-exist with a decent labour market.

Exhibit 1 – In the US low investment no longer is a harbinger of job destruction

Exhibit 2 – …and the same is true in Germany

There might be several explanations behind this. First, the current headwinds are affecting specifically the manufacturing sector given its exposure to world demand. Since the capital intensity in this sector is higher than in services, a decline in expected demand in manufacturing will trigger a bigger drop in aggregate investment than what the share of the sector in GDP would suggest. Second, the share of wages in GDP has been declining for the last 30 years. With higher profitability firms are probably less incentivised to shed labour in adverse cyclical conditions. Third, corporate default rates remain very low.  Bankruptcies did not increase during the mini-slowdown of 2016 and haven’t in this one. We think the still historically low level of interest rates can explain some of this.  With a higher proportion of companies surviving thanks to comfortable financial conditions, major layoffs can be kept to a minimum.

We do not think we should be complacent with such state of affairs though. Of course, the resilience of the labour market – and hence consumer spending – provides some reassurance against a steep downturn in the months ahead. However, continued weakness in capital expenditure would dampen potential growth. Beyond the direct impact of investment on production capacity, strong capex lifts Total Factor Productivity as technological innovation is embedded in the new capital stock.  In addition, the decline in mortgage rates over the last few months has spurred a rebound in housing activity, a significantly low-productivity sector which adds little to the economy’s potential.

True, resilient jobs support potential growth in the long run as well by protecting human capital, but by turning investment into the sole adjustment valve in this cycle, we may be trading a steeper recession against a long wallowing in economic mediocrity, taking the natural interest rate further down. Plentiful jobs coinciding with slow productivity gains is the perfect recipe for keeping wage growth “surprisingly low” and we note that wage growth seems to have settled back towards 3.0%, while it was tentatively reaching towards 3.5% at the beginning of this year. This is not going to help the Fed’s quest for a 2% inflation.

Has the Fed really done enough?

The quantum of “reassurance” provided by the Fed is actually lower than it seems. US policy space is massively smaller today than in the late 1990s. In 1998 the US posted a fiscal surplus of 0.8% of GDP, leaving plenty of capacity to deal with the downturn. The central bank was not the only game in town. Today the deficit has already ballooned to 4.5% of GDP. In 1998 both houses were controlled by the Republicans, but the backlash after the Impeachment procedure against Bill Clinton triggered a small drop in their majority in the House after the November 1998 mid-term elections and the demise of the combative Newt Gingrich as Speaker. This heralded a more collaborative mood between the White House and the Hill on fiscal matters. There was no government shutdown between 1995 and 2013.  This type of institutional accidents has become more commonplace since then. Another shutdown is unfortunately possible very soon if the two parties cannot find an agreement by November 21st. The acrimony around the Impeachment process is not going to help forge a consensus, even if both parties probably need to avoid being seen as “disruptors” less than a year before the presidential election.

The same lack of space applies to monetary policy. At trough in 1998 the Fed could have cut by another 475 basis points before hitting zero. Using the Fed’s own model’s elasticities, this would have been enough to lift US GDP by 2.4% over two years. A very decent buffer. Today, going to zero would provide a measly support of 0.8% of GDP on top of the 0.3% already in the pipeline after the last three cuts. This could be magnified by resuming QE, but in theory a central bank deprived of large space should use it up very quickly, simply because “nipping the recession in the bud” becomes more important when it is obvious that the capacity to deal with it once the downturn has materialised is lower. In a nutshell, cutting by 75 basis points today is not the same thing as cutting by 75 bps twenty years ago.

The timeline for global risks is also quite different. While the immediate cause of the Fed’s series of cuts in 1998 was the LTCM crisis after the Russian default and its ramifications for financial conditions (credit spreads tightened, equity prices fell in the summer of 1998), from the point of view of aggregate demand the true headwind at the time was the lingering effect of the 1997 Asian crisis. The minutes of the September 1998 FOMC meeting are awash with remarks on the “turmoil in Asia” having a significant impact, for instance on US manufacturing employment. But by end of of 1998 most Asian nations had gone beyond the initial shock and had started to recover (the IMF had started providing support to South Korea in November 1997). The LTCM crisis was ultimately contained to the financial system without major ramifications. By the time the Fed cut rates in 1998 the seeds of a rebound had already been sowed.

Today, it is brave to say that we have already “turned a corner”. The suspension of the tariff hikes planned for October and December is obviously an important “non negative”, but proper resolution on trade war remains elusive. The story by Bloomberg last Thursday on Chinese officials casting doubts about reaching a comprehensive long-term deal with the US beyond the “phase one agreement” deserves attention. The chances of a “no deal” Brexit are undoubtedly lower now but the general elections on December 12th will keep observers on their toes, while negotiating a free-trade agreement between the UK and the EU is going to take a lot of bandwidth throughout 2020 (and probably beyond). On the domestic front, the impeachment saga is gaining momentum with potential knock-on effects on investment programmes given the resurgence of a “non-centrist” Democratic candidate in the person of Elisabeth Warren. The race is still tight, but the latest New York Times poll is now putting her in pole position, 5 points above Joe Biden who is now only 4th, for the Iowa caucus which will start the Primaries in earnest on February 3rd.

The mysteries of French resilience

At 0.3% – same pace since Q1 2019 – qoq GDP growth surprised to the upside in France in Q3. It was a “small 0.3%” actually, and in annualised terms momentum is not as strong as in Q2 (1.0% against 1.4%) but France has been managing to grow roughly in line with potential so far in 2019, in stark contrast with Germany (we will have German GDP for Q3 on November 14th only, but available data points to near-stagnation at best this summer after a contraction in Q2). Lower sensitivity to emerging markets and the global investment cycle is often offered as a good reason for French resilience in the current configuration, and we share this view. But fiscal policy is also playing a role. Without the contribution from government consumption and investment, annualised GDP growth would have reached only 0.5% in Q3. If one adds to the mix the indirect effects of the tax cuts offered earlier this year in response to the “gilets jaunes” movement, which has supported consumer spending, the fiscal footprint on the current French over-performance is large.

It is not the only factor though. What is also reassuring is that private investment is remaining quite strong. From this point of view, France is bucking the trend observed in most other developed economies. After an already strong Q2 with a 4.4% annualised growth rate, corporate investment rose by 5.1% in Q3.

Before the Great Recession, corporate investment rates were very similar across the Rhine. It is now back to peak levels in France, while it is more than 2 percentage points below in Germany (Exhibit 3).  Germany has been following a similar pattern as the US, with a new divorce between a resilient demand for labour and a decline in the investment effort (Exhibit 2). Relative to the US, German employment has always reacted later than investment to cyclical shocks, which probably reflects the higher rigidity of the labour market there. But even with long lags the relationship between capex and labour demand has loosened massively in Germany.

Exhibit 3 – French investment powering ahead

Exhibit 4 – France and Germany converging on corporate profit

Several reasons may explain the better resilience of capex in France. First, since investment is mostly funded through leveraging in France whereas self-funding dominates in Germany, the investment cycle is probably more sensitive to the extraordinary supportive monetary stance offered by the ECB. Second, although the absolute levels still differ significantly, in France corporate profitability has been improving lately, whereas it has been steadily deteriorating in Germany, eating into the self-funding capacity (Exhibit 4). In addition, there may be an angle to the fiscal story there as well. Indeed, both the current and the previous French governments reduced payroll tax.

In a nutshell, beyond the usual structural factors – France’s lower sensitivity to the global cycle – aggregate demand there is supported by significant fiscal support, while improved profitability and high sensitivity to the monetary stimulus are also contributing. A very simple accelerator/profit model explaining corporate investment by the lagged change in output and profit does a decent job at predicting the actual capex pattern in France (exhibit 5).

In a configuration of “low for long” interest rates, it is a perfectly reasonable macro strategy to pursue. Beyond the cyclical support, the resilience in investment is conducive to decent prospects for potential growth as well.

Exhibit 5 – A simple accelerator/profit model still predicts investment fairly correctly in France

Dividend investing

The “search for yields” has become a motto on financial markets, and AXA IM Research has been looking into equity also for that (See Varun Ghotgalkar’ AXA IM Research Insights comment “Dude, where is my yield” published last week). Indeed, in the Euro area the average dividend yield is currently at 3.1%, with a gap relative to government bonds unseen in several decades, and is almost on par with high yield credit. Of course this would call for prudence if signs were emerging that such dividends are unsustainable in the current macroeconomic conditions.  We are not alarmed. True, dividend pay-outs increased recently to 55% of earnings, but free cash flow buffers remain healthy. Of course,  the high cyclicality of dividends makes this sort of investment risky, but Varun looked into various strategies to find decent risk/reward opportunities.

From a macroeconomic point of view, there is a good reason why the gap between low-risk fixed income and dividend yields should remain elevated in the current configuration. Ultimately, on trend dividends should grow in line with nominal GDP. In theory the risk-free interest rate should also be close to trend nominal GDP growth. But in a situation where central banks are taking extreme measures to keep the effective interest rate below equilibrium to avoid another cyclical downturn, fixed-income investors would be rational to bet on low rates along the curve even if a protracted recession is not their baseline. In a nutshell, low interest rates are the price to pay to keep effective economic growth not too far away from potential and hence allow dividends to remain decent. Of course, if said monetary stimulus proves ineffective, said dividends would have to converge back towards low-risk bond yields.

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