Q1 2017 - Covenant · At the beginning of 2017, consensus estimates called for growth in Q1 of more than 2% and in the second half of 2016 actual growth averaged 2.8% (real, annualized)

2017 Q1 Economic Review and Outlook

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During the first quarter, the economy expanded at a real, annualized rate of 0.7%. Relative to consensus estimates for Q1 growth and recent real growth rates in the latter half of 2016, this can only be described as a disappointing start to the year. At the beginning of 2017, consensus estimates called for growth in Q1 of more than 2% and in the second half of 2016 actual growth averaged 2.8% (real, annualized). Even as economic sentiment remains near the highs seen following President Trump’s election, the hard-economic data has yet to meet those optimistic expectations. In short, despite a seemingly new found euphoria, the economy remains largely in the same state as before the election.

Q1 Review In Greek Mythology, Sisyphus (the king of Corinth) is eternally condemned by Hades to roll a rock to the top of a mountain, only to have the rock roll back down every time he reaches the top. In some respects, domestic economic activity has resembled the mythical rock. For several years now just as the economy is seemingly beginning to get on track, growth stumbles in the first quarter and we begin the year digging out of a hole just to get back to the subpar post-crisis 2% average annual growth rate. The gray bars in the chart below highlight the relative weakness of Q1 growth in most years – the pattern is not perfect, but it’s been a frequent feature in the Great Recovery.

Sources: Bureau of Economic Analysis and Covenant Investment Research.

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Quarterly Real Annualized GDP Growth

Since 2010, real annualized GDP has averaged only 0.9% in the first quarter, as compared to 2.4% average growth in the other three quarters.

2017 Q1 ECONOMIC REVIEW & OUTLOOK

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This year is beginning on a similar footing, with real annualized GDP growth estimated at just 0.7%. Like other years, we expect improved growth in the second quarter. Yet, our “good, but not great” economic theme (sustainable annualized real GDP growth of roughly 2% - 2.5%) remains a good guideline for the near future. As for the sustained 3% - 4% real annual GDP growth rates targeted by the new administration…we suspect reaching such a lofty goal is about as likely as Sisyphus’ getting his rock to the top of the mountain.

Takeaways Below is a summary of key takeaways from first quarter economic data. A more detailed review of the data, including our insights into the current state of the economy and what to expect going forward is included in the pages that follow.

• Personal Income & Consumption – Consumption declined in Q1 as unsustainable spending trends from 2016 began to reverse course.

• Labor Market – The pace of hiring fell during the first quarter, but overall, the labor market remains on a solid footing.

• Inflation – The modest rise in inflationary readings that began in late 2016 peaked in the first quarter and are now moving lower.

• Manufacturing – Outside of a recovery in the energy sector, manufacturing remains weak. • Housing & Construction – Continues to be a source of economic growth, but the best days are likely

behind us.

Economic Review PERSONAL INCOME & CONSUMPTION After accelerating in the back half of 2016, consumption stalled in January and February - dragging on first quarter economic growth. As we remarked in last quarter’s letter, consumption levels in 2016 were unsustainable as they were fueled by borrowing and a drawdown in savings. Recently, those trends began to mean-revert as the savings rate moved higher to 5.6% (from 5.2% at the end of 2016) and growth in consumer revolving debt fell to 2.1% in the first quarter (from 5.5% at the end of 2016).


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Sources: Federal Reserve and Covenant Investment Research. Absent credit expansion or a further drawdown in the savings rate, higher income levels will be required to boost consumption levels. Unfortunately, the modest improvement in wage data that began in early 2015 appears to have peaked. The chart below provides a picture of this trend rolling-over.

Sources: Bureau of Labor Statistics and Covenant Investment Research.

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Average Hourly Wage - Nominal(Production & Non-Supervisory Workers)

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The short and intermediate trends in wage growth are important indicators for future consumption levels.


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While we expect consumption to rebound somewhat in the second quarter, the foundation for a meaningful long-term acceleration in consumption remains difficult to identify under current circumstances. On the one hand, consumers are over-leveraged with likely little additional borrowing capacity (and a need to reduce their debt obligations). Indeed, Consumer Debt as a percentage of Disposable Personal Income is higher than in 2007 (see chart). Moreover, much of this burden is student debt that, by law, cannot be discharged (aka “forgiven”) in a bankruptcy and must be repaid over time. On the other hand, to reduce leverage, dollars that would have otherwise been spent on goods and services (i.e. consumption) must be directed towards debt repayment.

Sources: Federal Reserve and Covenant Investment Research.

The clearest catalyst for accelerating consumption levels is for the government to implement personal income tax cuts - particularly for the middle class. Corporate tax reform would also be beneficial if it added to the recent positive trend in high paying domestic manufacturing jobs. In short, a reduced tax burden would increase Disposable Personal Income and provide a tailwind to consumption.

LABOR MARKET The Labor Market data was mixed in the first quarter, reflecting a mature market that is beginning to soften. A softer labor market is not a surprise at this stage of the cycle. The headline unemployment rate (U-3 Unemployment) has dropped to just 4.5% after peaking at 10.0% during the Financial Crisis. It’s worth noting

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Consumer Debt / Personal Disposable Income

Total Consumer Debt Ex Fed Gov

This gap is comprised largely of student loan obligations.


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that in the first quarter, mining payrolls (which are categorized in the Manufacturing Sector) saw their biggest jump since late 2010 as a rising rig count supported additional oilfield labor. Mining is a small industry as a percentage of the economy, but it produces relatively high paying jobs. Moreover, after dragging down economic activity since late 2015, growth in this sector is a welcome change. In the aggregate, however, job creation continues to slow from its peak in early 2015. In March, only 98,000 new jobs were added, and previous estimates of new jobs for January and February were adjusted downward. Although this is a short-time frame to assess new job growth, it is consistent with the longer-term trend of slowing job creation. Indeed, total employment has increased just 1.7% from a year ago, with the six-month average declining from 237,000 new jobs at the end of Q1 2016 to 163,000 at the end of the first quarter this year. On the bright side, a softer labor market allows the Federal Reserve flexibility in determining the pace of future rate hikes. Largely, the Fed focuses on a level of unemployment that would cause a meaningful rise in wages, something they call the Non-Accelerating Inflation Rate of Unemployment (“NAIRU”). The Fed focuses on NAIRU as an unemployment level that falls below NAIRU (which they currently estimate to be 4.7%) can lead to accelerating wage growth but can also result in inflation as companies are forced to pay up for an important input — labor. Yet, the headline unemployment rate has been at 5% or less for 18 months and wage growth has yet to meaningfully reassert itself. Indeed, even as unemployment rates were plumbing new cycle lows in the first quarter, wage growth continued to trend lower. In short, there seems to be a disconnect between a low unemployment rate and meaningful wage growth in the current cycle. We believe wages are not reacting as expected because there is additional slack in the labor market that is not captured in the U-3 Unemployment rate statistic. Slack in the labor market today comes from two sources: an underemployed cohort of workers and workers that have statistically dropped out of the labor force (and are not counted at all). A broader measure of employment, the U-6 Unemployment rate (which includes discouraged workers and part-time workers desiring full-time work) has declined from a crisis-peak of 17% to 9%. During recent cycle lows, the U-6 Unemployment rate has reached 7% - 8%. While this rate is likely close to what would be considered structural full employment (where wage growth would start to pick up), there is still untapped and/or underutilized workers that could be drawn into the economy in a full-time capacity.


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Sources: Bureau of Labor Statistics and Covenant Investment Research. Another source of full-time labor are those workers who have dropped out of the work force all together. The Labor Force Participation Rate (which measures the total number of workers divided by the working-age population, typically defined as those who are 16 years and older) was approximately 66% at the end of 2007.


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Participation Rate - Left scale

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After bottoming in late 2015, the Participation Rate has slowly increased from 62.4% to 63.0% adding new bodies to what’s considered the “labor force”. To put this into context, as of the last census in 2010, there were 243 million US citizens aged 16 and older. Each 1% increase in the Labor Force translates into 2.4 million laborers. While structural issues, such as aging Baby Boomers will likely prevent participation rates from reaching pre-Financial Crisis levels, there is a substantial base of available labor that could migrate back into the work force.

INFLATION As we’ve expected, and noted in prior letters, measures of inflation are beginning to ease following a move higher in the first couple of months this year. While the headline Consumer Price Index (CPI) jumped from 2.1% at the end of 2016 to 2.7% in February, it has since declined to 2.4% (as of March 31st). Much of the initial move higher in the CPI was related to a “base effect” pertaining to a bottoming in oil prices in early 2016. In short, after crude oil prices fell to $26 per barrel in February of 2016, they’ve more than doubled to $54 per barrel at the end of this past February. This increase, coming off a very low base, filtered into the year-over-year prices used in calculating CPI, producing a misleading inflationary signal this year. In contrast, the Fed’s favored measure of inflation, the Core Personal Consumption Expenditures (Core PCE) measure, is not showing signs of acceleration. The CPI and CPE measures of inflation differ in the weights assigned to the various categories of goods and services used in their respective calculations. For example, Housing and Utilities prices are approximately 35% of the CPI calculation, whereas they are only about 18% in the PCE calculation. As the chart below highlights, Core CPE is not showing any signs of a near-term breakout above the Fed’s 2% inflation target.


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Fed’s 2% Inflation Target

Inflation remains below the Fed’s target and looks to be rolling over.


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MANUFACTURING Following President Trump’s election, manufacturing sentiment jumped in anticipation of a combination of reduced regulation and fiscal stimulus under the new administration. While those actions may come to pass, the hard data (i.e. actual orders) have yet to catch-up to the optimistic sentiment. That being said, Manufacturing Production did improve on the margin during the first quarter, aided by the resurgent energy sector.

Sources: Federal Reserve and Covenant Investment Research.

However, just as the energy sector is recovering, auto sales are showing signs of weakness. Auto sales have provided stability to the manufacturing sector in recent years, but they began trending lower at the start of the year and were particularly weak in March (despite record buyer incentives).

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Manufacturing Production

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After languishing since the Financial Crisis, domestic production ticked up in the first quarter.

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Sources: WARD’s Automotive Group and Covenant Investment Research.

Promises of fiscal stimulus and deregulation have not yet translated into tangible orders in the manufacturing sector. Aside from a surge in “optimism”, the manufacturing sector remains in the same predicament as before the election: hamstrung by a strong US dollar and weak global demand. Perhaps action on the campaign promises will provide a much-needed boost to this flagging sector of the economy.

HOUSING & CONSTRUCTION In contrast to the Manufacturing Sector, Housing has remained a consistent source of growth since the Financial Crisis. However, all good things must come to an end, and while we don’t foresee housing becoming a drag on the economy, the best growth from the sector is likely behind us.

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Auto sales, which have been a solid growth source for the manufacturing sector, fell back in the first quarter and were particularly weak in March.


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Sources: Census Bureau and Covenant Investment Research. The housing sector could potentially benefit from an increase in first time buyers, such as the massive Millennial generation. For the decade ending in 2015, 39.5% of 18-34 year olds (aka Millennials) were living with family members. This is the highest proportion within any 10-year period for this age cohort since World War II (source: Hoisington Management). With continuing strong job creation in the 25-34-year-old cohort, more Millennials may be able to purchase their own residence (assuming that is a goal) which could provide support for growth in residential construction.

Looking Forward Following another weak start, we expect economic growth to fare better in the second quarter of this year. Yet, sustained growth of more than 3% is very unlikely. An expanding economy requires one or more of the following:

• Growing labor force • Productivity gains • Credit expansion

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When all three of these factors are accelerating in concert, an economy can experience above average growth. In contrast, absent stout growth in any or all three, potential economic output is constrained. Unfortunately, this is where the U.S. economy (and most developed nation economies for that matter) has been since the Financial Crisis. As the chart below illustrates the rate of growth in both workers and productivity are at 50-year lows. And, indeed overall economic growth in the Great Recovery has fallen short of that found in most other business cycles. While it’s certainly possible that some new technology reverses the negative trend in productivity going forward, that is not something we can bank on at present. Moreover, further impeding economic growth are societal and demographic trends that are inhibiting growth in the U.S. working-age population. The U.S. Census Bureau, for example, forecasts further declines in immigration and in the growth rate of the native working-age population (owing to an aging Baby Boomer age cohort and low domestic fertility rates).

Source: JP Morgan.

These factors, combined with a consumer base that is likely nearing its borrowing limits (given overall high debt levels), will weigh on economic growth. As noted, policy changes such as income tax reform and deregulation will provide a lift to the economy, but they are not powerful enough to counteract demographic and productivity headwinds. In summary, we are realistic about the growth potential of the economy. Counter to some notable economists’ beliefs that we are destined for a recession within twelve months, the economy could continue to expand slowly for several more years before finally succumbing to a contraction. It’s worth noting that as painful as they can be, recessions are a necessary evil for properly functioning free-market economies. Like a forest fire that clears out the dead leaves and brush on the forest floor to make way for new growth, recessions shake out

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weak companies and correct for malinvestments that build-up over time. This creative destruction, in turn, allows for the proper pricing of capital, new productive investment, and eventually a stronger economy going forward. We’re not looking forward to the next recession, but understand that they’re as natural as forest fires and serve a similar purpose in the economic ecosystem.

- The Covenant Investment Team

Disclosures The principal sources used in the preparation of this Report include: Bureau of Economic Analysis, The Conference Board, Bureau of Labor Statistics, Census Bureau of Economic Indicators and Covenant Multifamily Offices, LLC. Some data included in this report including government reports and other data has been taken from secondary sources and were not derived from the primary sources. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this report (including the investments and/or investment strategies recommended or undertaken by Covenant Multi-Family Offices, LLC), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this report serves as the receipt of, or as a substitute for, personalized investment advice from Covenant Multi-Family Offices, LLC. Please remember to contact Covenant Multi-Family Offices, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you want to impose, add, to modify any reasonable restrictions to our investment advisory services, or if you wish to direct that Covenant Multi-Family Offices, LLC to effect any specific transactions for your account. A copy of our current written disclosure statement discussing our advisory services and fees continues to remain available for your review upon request.

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Q1 2017 - Covenant · At the beginning of 2017, consensus estimates called for growth in Q1 of more than 2% and in the second half of 2016 actual growth averaged 2.8% (real, annualized)