Near the start of the fourth quarter, global equity markets were enjoying solid year-to-date gains. The S&P 500 Index, although flat year over year, was up strongly year to date and near an all-time high. GDP growth was also healthy across global markets. In the United States, economic growth has slowed since the first quarter, but remains in the positive range of the past decade. Likewise, GDP growth in Japan and Europe is also steady, albeit low. Over the past two years, growth has been higher than the 10-year average.
The U.S. consumer sector was a bright spot, especially at the low end. Comparable store sales growth for a number of businesses revealed underlying core strength in the most recent quarter. McDonalds and Chipotle, for example, reported a 6.5% and 10% rise in same restaurant sales, respectively. Walmart, Target, and Dollar General also delivered impressive growth. The same cannot be said at the higher end, however, where retailers such as Macy's, Kate Spade, and Tiffany, as well as premium cosmetics such as Clinique (owned by Estée Lauder), saw revenues decline.
"Sales growth for a number of U.S. businesses revealed underlying core strength."
While the consumer sector has been an area of strength, we have seen a modest slowdown in the U.S. housing and automobile industries despite lower interest rates. This could suggest that consumer confidence may be weakening. In fact, surveys show that confidence has pulled back from highs. However, the combination of record low unemployment, increasing wages, and very low interest rates has provided a favorable backdrop for the consumer. In our view, these positive trends could continue through the final quarter of 2019 and 2020.
Worrisome undercurrentsDespite these positive forces, the market is sending cautionary signals. The most notable may be the collapse in 10-year Treasury bond yields. The magnitude of the decline was sharper than almost any bullish bond investor would have expected at the start of the year. The 10-year yield hit its lowest level since July 2016. Declining yields are often a sign of an oncoming economic slowdown. Also, the yield of 10-year U.S. Treasury notes fell below the yield of two-year notes briefly in August for the first time since 2007. This inversion of the yield curve has often signaled a looming recession. Moreover, a mid-summer move higher in the price of gold suggested a heightened level of anxiousness about risky assets.
The valuation spread — the difference between the most expensive and the cheapest stocks — remains near one of its widest points in history. When P/Es are grouped by quintiles, the highest price/earnings multiples in today's market are extremely elevated relative to the market's lowest quintile P/Es. This confidence in only a narrow range of companies may be an indication of worry as well. Other periods of time when the growth/value spread has been at these extremes were 1991, 1999, and 2008 — all of which were amid or shortly followed by recessions.
So, what's wrong? Looking at a key growth driverInvestors are naturally wondering what is behind the market's mixed signals. In my view, the main cause of concern is China, a key driver of global growth over the past decade. Of course, we've had daily headlines about the U.S.–China trade conflict and worries over the impact of tariffs. However, I believe those issues are masking a broader problem — that China's age of infrastructure build has peaked and is at risk of contracting.
China's buildout has been extreme. One commonly cited statistic was that China consumed more cement between 2011 and 2013 than the United States did in the entire 20th century. And this trend has continued. Just since the global financial crisis a decade ago, China has consumed three times the amount of cement that the United States has consumed over its entire history.
China's yearly cement use could drop by 50% or more and it would still be consuming a lot. The same is true for other infrastructure-related building materials.
There are clear signs that this building boom, and China's growth overall, is subsiding. GDP growth in China recently slowed to its lowest level since 1992. Auto sales offer additional evidence of a slowdown. In 2009, 10 million cars were sold in China. By 2017, annual sales soared to 25 million. That dramatic increase had a significant impact on demand for a wide range of materials, from steel to semiconductors. Auto sales have now been in decline for 18 months. They were down close to 20% at the close of 2018, and are expected to be even lower for 2019.
Is a recession looming?I believe the likelihood is low for a U.S. recession between now and the end of 2020 given the underlying strength of the consumer sector combined with low interest rates. However, we are keeping a close eye on China. The trade war is exacerbating the country's underlying structural issues, and serious economic problems in China could lead to significant ramifications for the global economy. On the other hand, China is implementing stimulus measures, and we could see a resolution for some aspects of the U.S.–China tariff conflict. This could provide stabilization, or even a reacceleration of growth in China and globally in the months ahead.