Is the U.S. the “last man standing” when it comes to the (previously) synchronized global expansion? I don’t know, but what I do know is that the idea of synchronous global growth has been undermined recently by soft data in Europe.
Surprise – it’s falling apart:
I mean, maybe not. There are some supply-side constraints there and if you wanted to, you could trot out the usual list of reasons why the deceleration is “transitory”, as Draghi did in the April ECB meeting presser.
The idea behind the U.S.-centric, “last man standing” story is simple: the sugar high from Trump’s late-cycle fiscal stimulus will prolong the stateside expansion despite it now being the second-longest in record history.
But, as Goldman notes, the data is starting to slow in the U.S. as well and when it comes to what clients are asking about, they’re looking straight through upbeat Q1 earnings to the larger issue about the cycle. To wit, from a note out Friday evening:
Despite the strong 1Q earnings growth reported by so many companies, the top question from portfolio managers is actually macro-related: “What is the timing of the next economic downturn?” Although the US Current Activity Indicator (CAI) suggests an economy growing at an above-trend pace of 3.1%, the second-derivative shows growth deceleration, raising investor concerns. The Goldman Sachs US MAP index – a measure of economic data surprises – turned negative in April. Friday’s non-farm payroll gain of 164K jobs was below the 192K consensus forecast although the unemployment rate fell to 3.9% vs. 4.0% expectation. The ISM manufacturing index registered a nine-month low and disappointed relative to the consensus forecast (57.3 vs. 58.5). Similarly, the ISM non-manufacturing index was also below expectations (56.8 vs. 58.0).
So that’s the “bad” news.
The good news is that according to Goldman’s recession probability models (and I mean, I’m going to go out on a limb here and say that no one wants me to get into a lengthy discussion about how those are constructed on Sunday), the chances of a recession in the near-term are “remote”:
They cite a number of factors here, the most obvious being that consumer confidence is near a 20-year high, but concerns persist, especially considering the fact that with the Fed seemingly determined to stick to its guns and the long-end anchored by a variety of factors (the recent push above 3% on 10s notwithstanding), curve inversion seems ever more likely.
Goldman is still recommending an Overweight in financials in this environment and they’ve got seven reasons why. Here they are, in order, with short excerpts from the longer rationales:
- Rising interest rates. Financials typically outperform when 10-year Treasury yields rise, but lag when the yield curve flattens. However, a sharp divergence has occurred as the recent back-up in Treasury yield has corresponded with sector underperformance (chart below).
- Increased capital return. In early April, banks submitted to the Fed their proposed plans under the Comprehensive Capital Analysis and Review (CCAR) program. By late June, the Fed will render its opinion. Last year, the government approved a 43% jump in capital returned to shareholders via buybacks and dividends.
- Further deregulation. Proposed amendments to the CCAR rules that would take effect next year would increase balance sheet capacity and give boards more control over the use of their capital.
- Strong M&A advisory fees. In the past two weeks, deals totaling $150 billion were announced, lifting YTD growth to +100% vs. the same period in 2017.
- NIM expansion. As the long end of the yield curve rises, benefits accrue to banks through higher investment and loan yields.
- Loan growth. The major investor pushback we receive on our overweight recommendation for banks relates to the perceived anemic loan growth [but] small banks have registered a 7.7% jump in loan growth boosting the overall bank loan growth to 4.6%.
- Attractive valuation and growth. The Financials sector trades at an above average relative valuation discount vs. the S&P 500 across several metrics. However, Financials operate with much lower leverage than in the past. Consequently, the median return on tangible equity (ROTE) for the sector equals just 13%.
On that loan growth point, Goldman contrasts small bank loan growth with comparatively sluggish numbers for the top 25 banks and critics would invariably point to a disparity between charge off rates at large versus small financial institutions. Albert Edwards brought this up a couple of weeks ago, citing a February 6 report from TCW which you can find here. Here’s the relevant excerpt from that piece:
The Federal Reserve (FRED) graph in Exhibit 2 above illustrates rising NCOs for the entire U.S. banking universe. NCOs increased from a trough in 4Q15 at 2.9%, which coincidentally was the same quarter the Fed executed its maiden interest rate hike of this cycle. The larger U.S. banks that dominate credit card issuance have focused on prime and super prime consumers post the Great Financial Crisis (GFC), and have enjoyed a prolonged period of low charge off rates concurrent with the Fed’s almost decade long ZIRP. However, since 2015 the Fed has progressively raised interest rates from ZIRP while NCOs at the larger banks have started to rise, albeit off a low base. NCOs were 3.6% at 3Q17, closing in on a 4% rate, a level that matched the end of previous business expansions in 2000 and 2008. Interestingly, smaller banks (those not in the Top 100 by asset size) are experiencing far more rapid charge off rate deterioration at 7.9% (See Exhibit 3). Is this a precursor to larger banks experiencing much higher loss trends as well or just anomalous? Time will tell.
It’s also worth noting that some of Goldman’s points rely on long end yields rising further, but Goldman thinks that’s likely – if you read some of their other recent work you know they think a rebuilding of the term premium is in the cards.
Although everything listed by Goldman makes for a decent investment case (assuming it plays out), don’t expect the questions about curve flattening to go away anytime soon and remember, there was a demonstrable tendency for investors to fade Q1 bank earnings (see here, here, and here).
I’ll leave you with one last chart from Goldman: