Economic Data Are Springing Higher, but Stay Level-Headed

Spring has sprung, and so has the US economy. Last Friday’s employment report showed non-farm payrolls jumping by 916,000 in March, dropping the unemployment rate to 6.0%.^[i] ISM’s Services Purchasing Managers’ Index (PMI), released Monday, jumped to a record-high 63.7, far above 50 (the dividing line between growth and contraction) while the Manufacturing PMI rose to 64.7.^[ii] IHS Markit’s PMIs, which have less history but include more companies, put Manufacturing at 59.1, Services at 60.4 and the composite of the two at 59.7.^[iii] Headlines from coast to coast are hyping these results. Consistent with recent trends, pundits aren’t looking for gloom buried under the hood. Nor are they couching this as a temporary boom. Instead, they see much more in store, with stimulus and hiring sure to fuel a lasting surge. While it pains us to be party poopers, we think a reality check is necessary, lest hot expectations prompt you to chase returns in corners of the market unlikely to do well amid slower economic growth.

After years and years of widespread skepticism, sentiment’s optimistic turn is a refreshing change. But questioning prevailing sentiment is always one of investors’ key tasks, whether the universal emotion is more fearful or greedy. So when we see an abundance of cheer over data, we think it is time to apply some tests. Is the cheer rational? Are people missing something? Making logical errors?

In the realm of unemployment, we think they are, for a simple reason: Labor markets are late-lagging indicators. In this case, March data reflect a rush of businesses reopening as restrictions eased throughout the country. From Texas lifting basically all restrictions to California restarting limited indoor dining and movie theaters—and everything in between—services businesses finally had cause to bring back many employees furloughed over the past year. That is what they did, adding 597,000 to payrolls.^[iv] Judging from public sector payrolls’ 136,000-person jump, non-essential government workers are also trickling back to the office.^[v]

This is all great news for the people and businesses impacted, but it isn’t a forward-looking economic driver. Hiring doesn’t drive spending or future growth. If it did, the economy would never shrink, because the virtuous cycle of hiring and spending would negate the need for businesses ever to make cuts. So yes, March’s hiring is good news. So is the widely discussed National Federation of Independent Business survey from last week, which showed a record-high 42% of American small businesses with job openings—another source of bigtime hiring optimism.^[vi] But this is all just confirmation that economic life is returning to normal. Markets are already acutely aware of this.

PMIs are less backward-looking than employment data, but they, too, merely reflect reopening. That is abundantly clear in ISM’s published snippets of surveyed businesses’ responses. The release of pent-up demand is a powerful force, but it isn’t a lasting one. People generally get it out of their system on the first or second trip to Main Street after businesses reopen. Just because we all haven’t been able to have a nice cozy indoor restaurant dinner for the past year doesn’t mean we will all start going out every night of the week in perpetuity. More likely, we will just return to whatever our routines were before life shut down.

That means economic growth in the post-pandemic environment probably ends up looking a lot like pre-pandemic growth. We never agreed with the financial press’s general characterization of that growth as “sluggish” or “painfully slow,” but it wasn’t rapid. GDP grew 2.2% in 2019, 3.0% in 2018 and 2.3% in 2017.^[vii] This year, it probably grows a lot faster as it claws back last year’s -3.5% decline.^[viii] But in 2022 and beyond, we don’t see a logical reason to expect swift growth to continue. As we detailed last week, the much-ballyhooed federal infrastructure plan—presuming it passes in anything resembling the initial proposal and a subsequent government doesn’t override it—amounts to spending dripping out over eight years. The Fed’s quantitative easing asset purchases continue stimulating bank balance sheets only. Reserves are piling up there, while banks aren’t lending hand over fist. Asset purchases also prevent the yield curve from steepening much, which likely keeps weighing on loan growth. This is the same force that coincided with (and in our view, directly contributed to) slow GDP growth in the first half of the 2010s. We don’t see why this time would be different.

Slower growth isn’t inherently bad for stocks, as the last decade proves in spades. It gave us history’s longest bull market. But it generally doesn’t do many favors for value stocks, which tend to do best when growth accelerates early in the cycle. Later on, when economic growth slows, growth stocks gain favor. These companies don’t need swift expected growth to generate revenues—their strong brand names, diverse product lines and huge global footprint enable them to do well as the cycle ebbs and flows.

Expectations for super-fast economic growth go hand in hand with calls for value to lead for years. Those viewpoints are very, very widespread, and if markets are at all efficient, they must be priced in, likely to a very large degree. Therefore, piling into value stocks now risks following the herd—a tactic that generally doesn’t work out well. Keeping expectations tame and emphasizing growth stocks may seem boring. But we think it should pay off as markets return to pricing in slower growth ahead.