Q4 2015 Economic Review and Outlook - Covenant...Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 However, it’s important to recognize that employment is a lagging indicator of economic

2015 Q4 Economic Review and Outlook

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During the fourth quarter, U.S. economic growth slowed to a modest 0.7% real (inflation adjusted) annualized

rate, following a 2.1% rate of growth in the third quarter. Weak fourth quarter growth can be attributed to a

higher savings rate amongst consumers, disappointing retail sales, and a struggling industrial sector. In spite of

closing the year on a soft note, for the whole of 2015, the economy expanded at a 2.4% real annual rate, which is a

notch higher than the average annual growth rate of 2.0% experienced since the economy emerged from the

Financial Crisis.

Q4 Review Overall, the fourth quarter proved to be a disappointing quarter for economic growth in the United States.

Perhaps the slower pace of expansion should not be all that surprising, as the economy is simply not firing on all

cylinders. While the labor market, consumer demand, and housing remain solid and are buttressing economic

growth, the industrial sector continues to suffer. A strong US dollar, global overcapacity, and weak demand are

all conspiring against domestic manufacturers. Exports have fallen precipitously, and there is little likelihood of

their recovering anytime soon. Low oil prices also negatively impacted fourth quarter GDP growth as crude

producers cut high paying jobs and further reduced expenditures on capital equipment. While there is a long‐

term expectation that low gasoline prices will ultimately result in a stronger consumer, to date we’ve not seen a

resulting increase in retail sales. Indeed, the decline in the price of oil has done little except to reinforce the

disinflationary pressures stemming from a strong US dollar.

Looking deeper into the economic data, not all is bad, and there are some positive economic trends. In this

category, we point to a strong labor market, good personal income levels, a recovering housing market, and a

healthy consumer. While we are concerned about the aforementioned economic detractors, overall, it is a very

mixed bag. The diagram below illustrates the relative strength and weakness of various economic sectors – the

left side of the chart includes areas of contraction, while the right side of chart represents areas of economic

growth.

Sources: Foleynomics and Covenant Investment Research.

2015 Q4 Economic Review & Outlook

2 ©2016 Covenant Multifamily Offices, LLC

Economic Review

Inflation The headline Consumer Price Index (CPI) improved from a negative reading in Q3 to a modestly positive year‐

over‐year rate of 0.7% in December. Core CPI (which excludes food and energy) also increased from 1.9% in Q3 to

2.1% year‐over‐year in December. Still, it’s worth noting that the majority of price increases are attributable to

rising costs of healthcare, shelter and lodging. Indeed, if shelter is excluded, the headline CPI value declined 0.6%

year‐over‐year in December and Core CPI was only 1.3% (falling well short of the Federal Reserve’s 2% target

inflation rate).

We believe it’s unlikely that shelter costs in the CPI calculation will continue to rise at their current pace of 3.2%

year‐over‐year and their impact on consumer prices will likely diminish going forward. Moreover, we do not see

evidence of inflation further up the value chain in the producer pipeline as input costs have trended downward

due to the pervasive decline in commodity prices. We expect the current commodity pricing environment will

continue to inflict disinflationary effects on the economy (at least during the first half of the year), placing

downward pressure on measures of consumer prices and frustrating the Fed’s effort to reach its inflation target.

The diagram below provides a snapshot of the current state of inflation in the domestic economy. Current

sources of disinflationary pressure are shown on the left side of the chart, while areas of stronger inflation are

shown on the right.

Sources: Foleynomics and Covenant Investment Research.

Labor Market The labor market remains on solid footing and 2.65 million jobs were added in 2015. Though, as noted last

quarter, there are signs that the rate of job growth may have peaked for this cycle. The good news is that the

headline unemployment rate dropped to 5% (from 5.1% in Q3) and the broader measure of unemployment (the

U6 Unemployment Rate) declined to 10% (from 10.1% in Q3). Although some have argued that the new job mix

has been excessively tilted to lower paying jobs in the Retail and Hospitality sectors, those claims are simply

inaccurate. We do not dispute that these sectors have seen an increase in hiring, but nearly half of the new jobs



have been created in higher paying segments of the economy including Construction, Financial Services, and

Professional Services.

Sources: Bureau of Labor Statistics and Covenant Investment Research.

(4.9%)

9.9%

1.1%2.5%

10.3%

3.6%

0.4%1.9%

5.5%

22.8%24.7%

15.8%

2.6%3.7%

(5.0%)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

New Job Creation Over the Past 12 Months(2.65 Million New Jobs By Economic Sector)

Sectors paying higher wages (dark blue) account for nearly 50% of the new jobs created over the last 12 months.

(200)

0

200

400

600

800

1,000

1,200

1,400

16 - 19 20-24 25 - 34 35 - 44 45 - 54 >55

Sources: Bureau of Labor Statistics and Covenant Investment Research.

Moreover, much of the new hiring has been within younger age cohorts — a good indication of future household

formation and supportive of the housing market in general.

Employment Changes by Age(Year-Over-Year through December 2015)

Hiring in the 20-24 and 25-34 year-old cohorts is supportive of the housing sector.



Sources: U.S. Census Bureau and Covenant Investment Research.

Though we have discussed this previously, it is worth repeating why we believe that retail sales may be lower

than would otherwise be expected given the reasonably solid condition of the U.S. consumer. In short, the

explanation relates to changing consumer preferences and demographics:

0%

1%

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5%

6%

7%

8%

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However, it’s important to recognize that employment is a lagging indicator of economic growth (meaning that

employment levels are not a good predictor of the future path of the broader economy). On this note, there have

been warning signs that job growth has likely peaked for the cycle. Job openings, while still at a high level, are off

their peak and Weekly Jobless Claims have been trending higher at a modest rate since mid‐November (though

this is a volatile data series).

If job growth has indeed peaked for the cycle, it is not necessarily an indication that a broader economic recession

is in the offing. In fact, if hiring remains anywhere near its current level, the U6 unemployment rate should

decline further, even if the headline U3 unemployment rate remains stable (as discouraged workers come off the

sidelines and begin actively seeking employment). However, a peak in hiring will likely coincide with a peak in

aggregate personal income, which in turn, could feed into a reduction in the rate of consumer spending.

Personal Income and Consumption Though that may come to pass, currently, the all‐important consumer is in good standing due to improving real

wages, lower debt levels (as a percentage of disposable personal income), and improved access to credit. These

circumstances are generating confidence among consumers as indicated by the Michigan Consumer Sentiment

survey which at 93.3, is consistent with pre‐Financial Crisis levels. Still, in spite of all of the tailwinds bolstering

consumers’ income statements and balance sheets, consumer spending levels in the retail sector have fallen short

of expectations – especially in the fourth quarter. We warned this might be the case in the Q3 Economic Review and

Outlook, when we observed that after a strong start to the quarter, retail sales in the last two months of Q3 were

weak. That weakness persisted into the fourth quarter with Core Retail Sales declining to a 3.2% year‐over‐year

growth rate (down from 4.2% a year earlier).

Core Retail Sales(Year-Over-Year)

Core Retail Sales

After peaking in January 2015, core retail sales have been in a downward trend.



Consumers have shown a preference for higher savings. The savings rate has been increasing since late

2014 and currently represents 5.5% of disposable personal income. Although this level is below the long‐

term average savings rate of approximately 7%, increased savings represent delayed consumption.

An aging population has transformed consumption patterns. It’s understandable that we should see an

increase in healthcare spending, but a more nuanced effect is the resultant decline in discretionary

purchases as health care spending cannibalizes other types of spending. Moreover, the Affordable Care

Act has likely exacerbated this issue as healthcare spending now accounts for more than 25% of real

personal service expenditures. From a purely economic perspective healthcare expenditures contribute

to economic growth, but as healthcare increasingly becomes a quasi‐government program, we have

concerns about the sector’s vitality and productivity.

It’s also worth noting that the real total spending on services data series has rolled over and begun to decline.

After peaking at a growth rate of 3.1% in May, the year‐over‐year growth rate has declined to a 2% rate in

December. While 2% growth in this segment of the economy can’t be categorized as bad, it comprises the

majority of personal consumption expenditures. As such, it is an important category, and total GDP growth will

likely not be able to achieve much more than a 2% annual growth rate until services spending moves higher.

Sources: Bureau of Economic Analysis and Covenant investment Research.

Manufacturing In contrast to labor market and consumption data, conditions in the manufacturing sector are, to put it mildly,

poor. A strong US dollar, weak global growth, and overcapacity have dragged on factory orders, shipments, core

capital expenditure orders, hiring plans, and rail traffic. Indeed, the manufacturing sector officially entered into a

technical “contraction” during the fourth quarter, as the ISM Manufacturers Index fell to 48.2 (a level below 50

indicates contraction) from 53.5 at the start of the year.

-2%

-1%

0%

1%

2%

3%

4%

Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15

Services Expenditures(Year-Over-Year)

A continued slide in services spending will limit GDP growth.



Sources: Institute for Supply Management and Covenant Investment Research.

Weak global demand and overcapacity are affecting manufacturers on a global basis. Yet, the strong US dollar is

an additional headwind, acutely impacting domestic manufacturers’ ability to compete for what little

manufacturing business is available. The dollar began appreciating meaningfully in September 2014,

commensurate with the beginning of the decline in the ISM Manufacturing PMI shown above. The speed with

which the US dollar appreciated offered little time for management teams to adjust costs to remain competitive in

the new operating environment. As a result, manufacturing activity fell precipitously. The chart below overlays

the trade‐weighted value of the US dollar (USTW$) on the ISM Manufacturing Purchasing Managers Index. The

value of the dollar is inverted to highlight the tight relationship between the strong rise in the US dollar and the

sharp decline of the ISM Manufacturing Purchasing Managers Index.

Sources: Institute for Supply Management, Bloomberg, and Covenant Investment Research.

30

35

40

45

50

55

60

65

70

ISM Manufacturing Purchasing Managers IndexGrowing = >50, contracting = <50

A reading below 50 indicates a contraction. This is the fourth time since the Financial Crisisthat the manufacturing sector has experienced contractionary conditions.

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Man

PM

I

ISM Manufacturing PMI vs. USD (inverted) (PMI left - USD right)

ISM Manuf. PMI USTW$ Index

UST

W$

…coincides nearly perfectly with the precipitous decline in the ISM Manuf. PMI.

The sharp rise in the trade weighted value of the USD beginning in Aug ’14…


7


The growing number of new housing starts appears sustainable and in‐line with (if not slightly behind) the

demand for homes. In fact, housing developers appear to have learned a valuable lesson during the Financial Crisis as inventories are being kept tighter due to a lack of speculative fervor amongst builders. Reduced

supplies have, in turn, constrained the number of new homes available for sale and as a consequence contributed

to higher prices for homes that are sold.

Affordability will present a headwind to the housing sector if inventories do not rise to meet increased demand

being boosted by low interest rates and increasing income levels. At this time, the median new home price is

©2016 Covenant Multifamily Offices, LLC

0

500

1,000

1,500

2,000

2,500

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16

However, while the current environment is difficult, there is a silver lining. Domestic manufacturers are currently

implementing substantial changes to their business models in an attempt to squeeze out as many unnecessary

expenses as possible. These changes will make operations more efficient and when the US dollar inevitably

reverses course, domestic manufacturers will not only be well‐positioned to compete for business on a global

basis, but will likely be some of the most efficient manufacturers in the world.

Housing and Construction Early last year, we commented that the housing sector could be a positive “surprise” in 2015. Housing has indeed

been a solid contributor to economic growth – and, it’s no longer a surprise. That being said, with weakness in

manufacturing and soft retail sales data, housing needs to maintain momentum for the US economy to grow at

2% or better in 2016.

Thus far, the data is supportive, with new home sales set to record their best year since 2007. Although recent

home sales data has been a little lower than expectations, new home sales are still expanding by 9% year‐over‐

year.

New Housing Starts (Annualized)

Single Family Total




Looking Forward In one respect, the fourth quarter represented a turning point: the beginning of the end of the post‐Financial Crisis

era of coordinated monetary policy amongst major central banks. The Federal Reserve’s decision to increase

interest rates by 0.25% in December, while small in magnitude, signaled an important shift in domestic monetary

policy. That decision appears even more dramatic when contrasted against the Bank of Japan’s (BOJ) recent

decision to adopt a negative interest rate policy. Moreover, the European Central Bank (ECB) and the Peoples

Bank of China (PBOC) have indicated that they stand ready to supply additional liquidity to their flagging

economies.

Having raised interest rates once, the question now is how fast will the Fed raise rates going forward? The Fed is

putting on a brave face and (as recently as the January meeting of the Federal Open Market Committee)

predicting they will raise rates four to five times in 2016. If it comes to pass, such a scenario would result in a

target Federal Funds rate of 1.4% by the end of 2016. In contrast, the market is forecasting only a 0.3% probability

that interest rates will rise above 1.25% by the end of the year and a 39.4% chance that interest rates will even

reach 0.5% by year‐end (according to data provided by Bloomberg). Keep in mind that when the Fed issued their

latest interest rate forecast, the members were fully aware of slowing GDP growth in the fourth quarter. So what

does the Fed see, or think they see, in the economy that others don’t?

We suspect that the Fed believes inflationary pressures are building in the economy, and they want to get ahead

of them. By beginning to raise rates now, the Fed is trying to create a smooth path of interest rate increases and

-10%

0%

10%

20%

30%

40%

50%

May-11 May-12 May-13 May-14 May-15

approximately seven‐times household disposable income, per capita. This is a bit high in relation to the historical

average of six‐times household disposable income. The good news is that increased supply appears to be

imminent as developers are responding to higher prices. Indeed, as the chart below illustrates, growth in

building permits continues to trend higher – a strong leading indicator of future construction.

Building Permits(Year-Over-Year Non-Seasonally Adjusted)

Single Family

Building permits are a leading indicator of future construction. It is a volatile series, yet it has been trending positively since May ’14.



avoid a situation where they’re forced to surprise the market by raising interest rates quickly to stave off high

inflation in the economy. To this end, the Fed’s main boogeyman appears to be wage inflation.

Though there is scant evidence of wage inflation currently, the Fed is of the opinion that continued tightening in

the labor market will inevitably lead to higher inflation. We agree with the Fed in principle on this issue,

however our opinion is that the labor market may not be as tight as the Fed believes and therefore wage inflation

will not be a significant issue for the foreseeable future. Moreover, we see evidence of outright disinflationary

pressures elsewhere in the domestic economy, as well as globally. These pressures should keep broad‐based

inflation at bay. As such, our expectations for the pace of interest rate increases in 2016 are closer to those of the

market than they are to the Fed’s forecasts.

That being said, we are sympathetic to the Fed’s position and especially to Chairman Janet Yellen. They inherited

an economy that in addition to being hobbled by the Financial Crisis has been further impacted by a dysfunctional

government body offering little fiscal support. As a result, the onus has been on the Fed to engineer an economic

recovery using monetary policy alone. Easy monetary policy has its limits in accelerating real economic growth.

Indeed, there is no clearer illustration of this than the slow realized pace of global growth in spite of massively

accommodative central banks (i.e. Fed, ECB, BOJ, and PBOC).

In closing, absent a major exogenous event or a monetary policy mistake (a non‐trivial probability), we believe

the U.S. economy is destined to remain in a growth trajectory of approximately 2% ‐ 2.5%. Many of the strongest

areas of growth, including auto sales, employment gains, and consumer spending appear to have plateaued. That

is not to say that these areas are destined to contract, but their rate of growth is slowing. Our baseline scenario

does not include a recession in 2016, but we acknowledge that the risk has grown since the end of the third

quarter. Analogous to flying an airplane close to the ground, a low economic growth rate does not provide much

margin for error.

‐ 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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Q4 2015 Economic Review and Outlook - Covenant...Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 However, it’s important to recognize that employment is a lagging indicator of economic