“What if this is as good as it gets?”
Melvin Udall, in ‘As Good As It Gets’, 1997
In the Comedic Drama, As Good as it Gets, Melvin Udall, played by Jack Nicholson, walked into a psychiatrist’s waiting room and asked the group of patients, “What if this is as good as it gets?” If you haven’t seen the 1997 film, Nicholson plays the part of a misanthropic obsessive-compulsive novelist, who is heavy on the insults and criticism and short on the charm. When he asks this open-ended question to the group of ailing mental-health patients, Udall is inquiring from a state of frustration, anguish and despair.
From my seat, as the CIO at DBR & Co., I ask the same question, but from a completely different place. We are in the state opposite of despair: economic euphoria. A comprehensive fiscal stimulus has replaced the monetary stimulus provided for seven years by the Fed. Employment is running beyond full. Earnings at the corporate level have surprised to the upside each and every quarter for the past eight.
The high-frequency economic data that we measure and map on a daily basis has been extraordinary in the 3rd Quarter of 2018. The preliminary GDP report for 3Q 2018 is set to be released next week and will likely represent the ninth consecutive quarter of year over year (YOY) acceleration. Putting that into context, we are in uncharted territory. The previous record for consecutive quarters of YOY GDP growth was set in the 1990’s with a streak of seven.
Underlying the GDP data, here are some of the data points that hit a cycle peak in 3Q2018 (data: Bloomberg):
Headline Retail Sales – Cycle peak of y/y growth of 6.75%
Industrial Production – Cycle peak of y/y growth of 4.20%
Factory Orders – Cycle peak of y/y growth of 8.27%
Personal Consumption Expenditures (PCE) – Cycle Peak of y/y growth of 2.80%
In support of these “hard” data points, economic surveys suggest extreme optimism as consumer confidence, small business optimism and quit rates all hit cycle highs last quarter.
The non-conformist in me hears the echo of consecutive “cycle-peak’s” and alarms begin to sound in my head. Bloomberg Consensus Estimates for GDP expects economic activity to continue on its’ steady climb at least through 2Q 2019. A few tailwinds are embedded into these expectations which include rising wage growth and the fiscal impulse (expectation that tax cuts will hit the real economy in a meaningful way).
Like our hero Melvin Udall, it depends on where you stand when it comes to the wage push. To those of us earning a wage, “rising wages” is welcome news. The absence of the wage push has been the most frustrating aspect of the recovery for the Fed and policy-makers over the past nine years and is finally being realized. But before we dance into the sunset, we should also recognize this simple and troubling statistic: Wage Inflation has preceded the end of every business cycle over the past 50 years. There have been seven recessions since 1968, and rising wages has been a constant at the end of each of those economic expansions.
The reason is simple enough to understand. For corporations both large and small, the largest expense on the balance sheet are wages and benefits of their employees. Therefore, as wages rise, profitability and margins suffer. Investors “pay up” for companies with rising profitability and expanding margins. And of course, the opposite is true.
To be clear, we are not calling for some horrendous crash or recession in the coming months. We are of the belief that we are in a secular bull-market. The United States enjoys a tailwind that is unique in the developed world: the millennials. This demographic is entering the 35-54 year old cohort at a staggering pace. Historically, this is an age where household formation and earning potential come to a head and result in a multiplier effect that echoes through the economy. But even secular bull-markets have corrections and pull-backs that can take investors by surprise. And they usually occur when growth slows from cycle peaks.
A race horse running at a full gallop does not stop on a dime. And neither will our economy, which has been running at a full head of steam. We believe it will take a period of time before the cycle inevitably comes to an end.
But from all these cycle peaks, we must continue to ask the important question: “Is this as good as it gets?”
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