We’ve heard many complaints from the broad investment community about the lack of organic, economy-driven sales growth in the current economic expansion, and understandably so. The S&P 500 Index’s trailing four-quarter sales per share (SPS) growth fell from the third quarter of 2015 through the second quarter of 2016, and has grown at an average rate of only 1.2% year-over-year since the second quarter of 2009, when the economic recovery began.
However, the recent improvement in U.S. gross domestic product (GDP) bodes well for business sales. Last week, the Bureau of Economic Analysis (BEA) released its second estimate of GDP for the third quarter of 2016. The good news is nominal GDP growth was revised up to 4.6% quarter-over-quarter from 4.4% quarter-over-quarter in the advance estimate.
Looking ahead, professional forecasters expect nominal GDP growth to pick up from 2.8% year-over-year in the third quarter of 2016 to 4.1% year-over-year in the fourth quarter of 2017, pointing to an accelerating recovery in business sales growth (Exhibit 1).
Conceptually, nominal GDP is a good proxy for SPS, given their correlation coefficient of 0.79 since 1995. In other words, the R-squared value (0.63) is high, meaning movements in nominal GDP explain 63% of movements in SPS (Exhibit 2).
Companies’ top-line growth is highly geared to the economic cycle, which hurts in downturns and helps in upturns. Specifically, S&P 500 trailing four-quarter SPS growth (a standard deviation of 5.8%) has been three times more volatile than the four-quarter moving average of nominal GDP growth (a standard deviation of 2.0%) since 1995.
Why? Basically, the S&P 500 is a concentrated basket of the biggest, highest-quality, publicly traded companies in the U.S. As such, it doesn’t capture the total production of the U.S. economy, which includes big and small, high- and low-quality, public and private businesses, as well as households and governments.
Less diversification and greater sensitivity to the business cycle means S&P 500 SPS growth falls below nominal GDP growth in recessions and rises above it in recoveries and expansions, a quality that should work to our advantage in the quarters and years ahead.
U.S. Dollar Strength Isn’t a Big Headwind for Fundamentals
As many observers are aware, the U.S. Dollar (USD) Index―the average international value of the dollar against a basket of other major world currencies―has surpassed the top of its range since 2015. The list of catalysts for a strong dollar is long, including the surprise presidential election result, possible fiscal stimulus and infrastructure spending, associated reflation trades, expected Federal Reserve (Fed) interest rate hikes, and U.S. monetary policy divergence from the rest of the world.
Do all of those factors risk hitting the pause button on the budding recovery in S&P 500 sales? In short, U.S. dollar strength is a fundamental headwind but it isn’t as big a risk as many believe. True, the revenues of big, globally-oriented U.S. companies are partially exposed to USD strength. According to Standard & Poor’s, foreign sales were 28% of S&P 500 global sales in 2015.
If there were a perfect negative correlation coefficient of -1.00 between changes in the USD and changes in SPS, sales would have fallen by as much as the dollar rose last year (i.e., ~20% year-over-year). However, there has generally been a weak, inverse connection between currency dynamics and sales trends across time (Exhibit 3).
Why? Despite a Fed rate hike in December 2015, sales growth troughed at -3.1% year-over-year in the fourth quarter of 2015, thanks to the resilience of activity at home, the consumer, and the services side of the economy.
Back to the 1990s: Strong Economy, Dollar, and Sales
In the strong-dollar regime of the mid-1990s to the early-2000s, which overlapped with the longest economic expansion on record, both nominal GDP and SPS grew at an average pace of more than 5% year-over-year, demonstrating that the economy and sales can and have increased smartly alongside a strong dollar.
More recently, nominal GDP growth perked up to 2.8% year-over-year in the third quarter of 2016 from 2.5% year-over-year in the second quarter, which was the weakest growth since early 2010. Encouragingly, S&P 500 sales grew 0.2% year-over-year last quarter, the first positive reading in five quarters. Meanwhile, the dollar has appreciated by just 1.0% year-over-year this quarter, and the lagged impact of mild currency depreciation in the first three quarters of 2016 has yet to work its way through sales over the next 3-4 quarters.
Buy Stocks on Fiscal Policy-Induced Growth
After a highly contentious and turbulent presidential election contest, U.S. fiscal stimulus of some kind seems likely in 2017, judging by President-elect Donald Trump’s rhetoric on the campaign trail. Admittedly, the fiscal multipliers are larger when there’s more slack in the economy, and monetary policy is supportive. Suffice it to say that the era of fiscal austerity is probably behind us and government spending has shifted from being a headwind to becoming a tailwind for the economic outlook and companies’ top-line growth prospects.
The bottom line: a brighter fundamental outlook raises the floor under the stock market, and helps confidence move higher. In turn, confidence drives consumption and investment, which reinforces business sales and the advance in share prices. As a result, we believe U.S. equities will remain an asset class of choice for the foreseeable future.
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R2: R-squared, or the coefficient of determination, is a statistical measure of how close a set of data values are to their fitted regression line. R-squared values always lie between 0%-100%. 0% indicates that the linear regression model explains none of the variability of the response data around their mean. 100% indicates that the linear regression model explains all the variability of the response data around their mean. Generally, the higher the R-squared value, the better the model fits the data.
Standard Deviation: Standard deviation is a statistical measure of the amount of variation or dispersion of a set of data values around their mean. A low standard deviation indicates that the data values tend to be close to their mean, while a high standard deviation indicates that the data values are further from their mean.
USD: The U.S. Dollar Index (USDX) indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. The ICE US computes this by using the rates supplied by some 500 banks.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.