All posts by joel

June Supply Managers’ Manufacturing Index and May Construction Spending

KEY DATA: ISM (Manufacturing): +1.5 points; Orders: -0.2 point/ Construction: +0.4%; Residential: +0.8%/ Ads: -51,000

IN A NUTSHELL: “Robust industrial activity should keep the economy strong for quite a while.”

WHAT IT MEANS: With trade issues starting to slowly, but steadily spiral out of hand, we need to know if the key sectors can withstand the potential problems that a trade war could bring.  Last week we saw that household income, especially wages and salaries, was not growing significantly. Today, though, it became clear that the industrial sector is in very good shape. The Institute for Supply Management reported that its manufacturing index rose in June. Orders continue to increase sharply, though not quite as quickly as they had been. Still, the expanding demand was large enough to force production to rise and order books to continue to fill (though also less rapidly). Both producer and customer inventories are low and that bodes well for future production. Finally, hiring continues at a very solid pace as well. All in all, it looks like the manufacturing sector should be able to lead the way for the rest of the year.

It is also looking like construction is starting to accelerate. Activity jumped in May, led by a surge in residential building, both private and residential. Office construction was also up sharply. However, excluding office, nonresidential construction was weak, which is something that needs to be watched. The economy needs a broad based strong construction to help offset any weakness that the trade battles may create.

MARKETS AND FED POLICY IMPLICATIONS: Can the U.S. economy withstand the counter-tariffs being put on by Europe, Canada, Mexico and China as well as the higher costs created by our tariffs? Right now, given that the level of the tariffs is not huge, it looks that way. That is not to say some industries will not be hurt badly or that growth will not slow, but unless things deteriorate further, a recession will not likely follow just from the current trade skirmishes. However, the longer the tariff mini-war continues, the greater the damage and the slower the economy will grow. That is causing investors to lose some of their exuberance and maybe even creating some caution in the market. But this week contains Employment Friday and some of the concerns about the future course of the economy could be either dispelled or heightened, depending upon the size of the report. The consensus is for strong gain in the 200,000 range. I don’t think that is likely. However, I do think the wage number could be hotter than expected. That would create worries. Regardless:

Have a wonderful and safe July 4th!

May Consumer Spending, Income and Prices and June Consumer Sentiment

KEY DATA: Consumption: +0.2%; Disposable Income: +0.4%; Prices (Over-Year): +2.3%; Excluding Food and Energy (Over-Year): +2.0%/ Sentiment: 98.2 (up 0.2 point)

IN A NUTSHELL: “Inflation to Fed: We have a liftoff.”

WHAT IT MEANS: There is a famous saying from the Apollo 11 mission, when we put the first people on the moon: “We have a liftoff!” Well, it looks like that is the case when it comes to inflation.   Consumer prices rose moderately in May, whether or not you include the more volatile food and energy components. But the real issue is that over the past year, both the headline number and so-called core numbers rose by at least 2%. The Fed’s target has been reached.

But we are just starting to see the impacts of the tax cuts hit. Indeed, consumer spending increased fairly modestly in May and when you adjust for inflation, it was flat. That is likely to change, hopefully, during the second half of the year. Moderate May weather kept utility spending down and that helped restrain consumption. Energy costs were up sharply, though. Meanwhile, household income expanded at a somewhat better pace. But even here, there are some warning signs. Wage and salary gains were fairly limited. What created the solid increase was a sharp rise in dividends. For the average household, if they hold stocks at all, their dividends wind up mostly in retirement accounts, so it is not going to be spent. That raises questions about how strong consumption will be going forward. So far this quarter, consumption is growing at a 2.3% pace, up quite nicely from the 0.9% rate posted in the first quarter. A likely decent gain in June could push the increase to the 3% range. That would point to much better second quarter growth.

The University of Michigan’s Index of Consumer Sentiment edged up in June, though it receded from its mid-month reading. Importantly, households are becoming more concerned about future economic activity. Respondents think the economy is in very good shape, but the trade issue is weighing on optimism. A growing share of people believe more trade is better than less.

MARKETS AND FED POLICY IMPLICATIONS: Right now, the extended period of strong growth that so many are predicting is just a wish and a hope. The numbers on wages continue to disappoint. In addition, households seem to taking their tax cuts and saving them, as the savings rate has risen recently. And while business capital spending is strong, it hardly matches the massive spending on dividends, stock buy-backs and mergers and acquisitions. I am not saying that the tax cuts are having no impact on growth, they are. But as of now, I think the added spending has been disappointing. That may or may not worry investors, but in a perverse way, should provide some comfort to the Fed. The members’ worse fear is a surge in growth that triggers even faster inflation. How long the Fed would be willing to allow the economy to “run hot” is not clear, but with backlogs building and labor shortages of critical workers, such as truckers, at crisis levels, the ability and need to raise prices is also increasing. Inflation may not be high yet, but the Fed has to be concerned that it will exceed its target by more and for longer than expected. It hard to think that we will not see another two rates hikes this year and the possibility we will get four more next year cannot be dismissed.

Revised First Quarter GDP and Weekly Jobless Claims

KEY DATA: GDP: 2.0% (from 2.2%)/ Claims: +9,000

IN A NUTSHELL: “A disappointing first quarter expansion is likely to be followed by robust second quarter growth.”

WHAT IT MEANS: Is the economy weak or strong? Did the tax cuts add to growth or do little? The answer to both those questions is, of course, yes. The third estimate of first quarter growth came in a little less than expected. The economy grew decently, but consumers did not spend a whole lot of money, especially on big-ticket items, restraining the expansion. Indeed, consumption grew at the slowest pace in five years. But the major reason for the downward revision to GDP came from less inventory building. Firms added to stocks at slower pace than previously thought. That, though, actually is a positive for second quarter growth. The data are indicating that both businesses and households picked up the spending pace in the spring. With less stock in the warehouses, production had to rise even more to meet the emerging jump in demand.

Corporate profit estimates were also revised and they grew robustly, to say the least. When taxes and certain adjustments are taken into account, profits were up nearly 17% over the level posted in the first quarter of 2017. Look for those numbers to get even bigger as we go through the year. Now if we can only get businesses to invest even more of those dollars, the economy would be in great shape.

Jobless claims jumped last week but that is hardly unusual. Smoothing out the ups and downs, the level remains extremely low. Conditions are so tight the firms are once again hiring teenagers. Challenger, Gray and Christmas reported that teenage hiring in May was up 73% over May 2017 levels.

MARKETS AND FED POLICY IMPLICATIONS: The economy does not grow in a consistent manner. Some quarters are disappointments while some exceed even the most optimistic forecasters’ estimates. So don’t make much of the first quarter number. Indeed, we could see second quarter growth at double the first quarter pace. Of course, averaging those two out would put us at where most economists expect growth to be this year: roughly 3%. Given the huge tax cuts, the massive surge in after tax profits, large increases in government spending and an already solid economy, that pace would be a disappointment. Three percent growth is what the president’s economists say is the sustainable level over the next ten years. That is in their forecasts. But if we can only get roughly three percent when you hype the economy at a pace maybe never seen before, you have to be concerned. The impacts of the tax cuts will wear off over the next twelve to eighteen months, so where do we go from there? Businesses may be at a much higher level of activity, but they still have to grow from that level and that means consumer spending will have to be a lot better. And that will require wage growth to accelerate sharply. But we have had no sign that will happen and if it does, what will happen to inflation and interest rates? If you are wondering why so many economists are raising their probability that a recession could start in late 2019 or the first half 2020, that is why.

May Durable Goods Orders and Pending Home Sales

KEY DATA: Orders: -0.6%; Excluding Aircraft: -0.5%; Capital Spending: -0.2%/ Pending Sales: -0.5%; Over-Year: -2.2%

IN A NUTSHELL: “The manufacturing sector is still growing, but maybe at a less robust pace.”

WHAT IT MEANS: One of the highlights of the current expansion has been the rebound in manufacturing. Well, that upturn may be moderating. Durable goods orders fell in May, marking the second consecutive monthly drop. Declines were pretty much across the board as the vehicle, civilian aircraft, computer, electronic equipment and metal sectors all were off. Demand for machinery, communications equipment and defense aircraft did increase. Still, backlogs rose sharply, indicating that production will continue to be strong for quite some time. Slowing vehicle sales and building inventory is not good news for the auto sectors. Finally, capital spending also slowed a touch. While the tax cuts provided the means of invest, firms have not done so consistently as spending has been up and down like a yo-yo this year.

The National Association of Realtors reported that pending home sales were off in May. Weakness in the South, the biggest region, offset gains in the other three regions. Housing’s big problem is not demand, as prices are up sharply. It is a lack of inventory that is restraining sales and that is likely to continue to be an issue for quite a while.  

MARKETS AND FED POLICY IMPLICATIONS: The housing sector is being buffeted by a lack of homes on the market, rising interest rates and soaring prices. That combination does not make for a stable market. The recent moderation in rates should help, but if growth is as strong as most economists expect, inflation and longer-term interest rates should continue to filter upward over the course of the year. And the Fed has made it clear that short-term rates will be rising as well. So, don’t expect this sector to lead the way. In addition, the rising costs to manufacturers from tariffs is just starting to bite and while initially, those costs might be absorbed, there is only so much some of the businesses can stand. We could see them raising prices as long as those tariffs are maintained. As for U.S. firms facing tariffs put on American made products, those impacts are also in the beginning stages. Thus, while the economic fundamentals are strong, some cracks are beginning to appear. Ultimately, investors will have to decide how much of the threats are real and how much bluster. They cannot keep getting whipsawed. Until then, volatility is likely to continue.  

May Leading Economic Indicators, June Philadelphia Fed Manufacturing Survey and Weekly Jobless Claims

KEY DATA: LEI: +0.2%/ Phil. Fed: -14.5 points/ Claims: -3,000

IN A NUTSHELL: “Strong growth this quarter should be followed by another quarter of solid growth.”

WHAT IT MEANS: The economy is strong, but will it continue that way? It looks likely. While the Conference Board’s Leading Economic Index rose somewhat modestly in May, it is still pointing to better growth ahead. The gains were in most components of the index, which indicates the economic expansion remains broad based. Still, as the report states, “the current trend, which is moderating, indicates that economic activity is not likely to accelerate.”

Manufacturing activity in the MidAtlantic region moderated in early June, but that is really not a surprise. The index is wildly volatile and it soared in May. Orders continued to expand, but not as robustly. Hiring remained very strong and employees are being asked to work longer. Surging shipments led to a thinning of order books, which does need to be watched. Looking forward, optimism continues to fade. While it is still high, it is coming back to more normal levels. That said, the special question this month was on production and respondents indicated current output has been rising sharply and activity is expected to accelerate going forward. Hiring should be strong in the summer, if firms can find the workers.

Jobless claims fell modestly last week, indicating the labor market remains tight. Given how low there are, it would be hard to see them drop much more.

MARKETS AND FED POLICY IMPLICATIONS: There may be some headwinds forming. Clearly, the tax cuts have created a huge amount of stimulus that will carry us through the rest of the year and well into next, but what do we do once the impacts fade? That is when confidence about the future sets in and there is a lot of chaos in Washington that is causing optimism to moderate. Of course, that just means we are backing down from the exuberance that has gripped the consumer and business community since the passage of the tax changes. Nevertheless, issues regarding trade and immigration, which directly affect businesses, are not viewed as being helpful. Growth will likely come in above 3% this quarter and next, but to keep growing at that pace, firms have to invest and an uncertain world is not a desirable one to make big capital spending decisions.

May Housing Starts and Permits

KEY DATA: Starts: +5%; Year-to-Date: +11%; 1-Family: +3.9%; Permits: -4.6%; Year-to-Date: +8%; 1-Family: -2.2%

IN A NUTSHELL: “The rebound in home construction means the sector might actually add to growth this quarter.”

WHAT IT MEANS: Home construction had been lagging this quarter, which was a bit of a surprise. And with mortgage rates rising, there was concern the sector could falter. Instead, housing starts rose solidly in May. But the data were all over the place. For example, construction in the Midwest surged by over 60%. Multi-family building activity nearly doubled and single-family starts jumped 45%. Those changes came after large declines in April. We are talking huge changes that are usually seen in the winter, not the spring. Meanwhile, starts were down in the other three regions, with the Northeast posting a double-digit decline. So we need to step back and see what happens in June before we make any major conclusions about the strength of the home construction sector. Looking forward, permit requests moderated, but they had been running well above the pace of construction and it was inevitable there would be a pull back. A massive increase in the Northeast and a more moderate decline in the Midwest were more than offset by weakness in the West and especially the South. For the last three months, permit requests ran higher than starts, so there is a reasonable expectation that the large jump in construction will be sustained, at least for a couple of months.

MARKETS AND FED POLICY IMPLICATIONS: Second quarter growth looks like it was solid and the remaining question is how big a number will print. Estimates range up to 4% or even more and that cannot be ruled out. I am more in the 3.5% range (actually, a touch below that), but there is still a lot of data to come that could change that. The strong housing number could push up GDP estimates. Regardless, the economy is in good shape, which just about everyone understands. Broad based growth would support the Fed’s expected four moves this year while not spooking investors too much. It is hard to argue that the economy will falter from a fairly modest one-half percentage point increase in short-term rates if the economy is expanding robustly. Indeed, if or when the current trade war fears fade, investors will get back to watching economic variables and those look good.

May Industrial Production and June Consumer Sentiment

KEY DATA: IP: -0.1%; Manufacturing: -0.7%; Motor Vehicles: -6.5%/ Sentiment: +0.8 points

IN A NUTSHELL: “A fire may have disrupted vehicle production in May, but that has already turned around, so don’t worry about the drop in output.”

WHAT IT MEANS: I often mention that it is foolish to look at the headline number for one month and assume it tells what is going on. Nothing shows that more than the May industrial production number. The decline in overall output and the sharp drop in manufacturing activity were largely due to the fire in Ford’s main parts supplier. Vehicle and parts production cratered. That is already turning around, so while the May number was temporarily low, the June number should be temporarily high. Put the two together and you get the trend. That said, manufacturing output still declined mildly in June as most industries were down. Six of the eight non-durable goods industry groups posted falling output, while only three of the eleven durable goods industries were up. Why the sudden drop in output is unclear, so I think it is best to just file this report away and see what the next couple of months have to offer.

Household confidence picked up during the first half of June. The University of Michigan’s Consumer Sentiment Index increased modestly, led by a sharp increase in the view about current conditions. However, and maybe more importantly, respondents were more pessimistic about the future. And they are beginning to notice the pick up in inflation. Anchored inflation expectations are something the Fed had often noted as being important and if they are becoming unmoored, that is a real concern.

MARKETS AND FED POLICY IMPLICATIONS: There have been so many strong economic numbers that one weak one shouldn’t indicate the start of a slowdown. Very simply, the economy is in very good shape. Looking forward, though, we need to be concerned about inflation. Pressure is building at every level for both producer and consumer goods. Households are noticing that, especially since it is eating into purchasing power, which has flatlined again. It is not enough to simply say growth is strong and conclude everything is fine. Too much of a good thing can be a bad thing as well. And investors are not very happy with the imposition of tariffs. While it is hard to argue that Canada is an unfair trader, especially given the U.S. runs a trade surplus with our Northern neighbors when both goods and services are considered, it is not unfair to say that China is an unfair trading partner. The issue is how you reduce the barriers. It is doubtful that the U.S. can cut greatly into the trade deficit with China without massive, wide-ranging tariffs and restrictions. Those would raise costs for consumers and businesses, reducing spending power, consumption and making U.S. firms less competitive internationally. About the best thing that has come from the talk of tariffs and trade wars is that people are finally recognizing that there is a thing called fair trade. Decades ago when that issue was raised, the free-traders of the world considered that approach nothing short of protectionism. Those same free-traders seem to have become tongue-tied when it comes to the ultimate protectionism, tariffs. Maybe now a rational, well thought out approach toward trade will be discussed, where trade barriers are reduced through trade agreements with our trading partners.    

May Retail Sales, Import and Export Prices and Weekly Jobless Claims

KEY DATA: Retail Sales: +0.8%; Ex-Vehicles: +0.9%/ Import Prices: +0.6%; Nonfuel: +0.2%; Export Prices: +0.6%; Farm: +1.6%; Claims: -4,000

IN A NUTSHELL: “Strong consumer demand and higher prices, perfect (or not) together.”

WHAT IT MEANS: How good is the economy? Very. Retail sales rose strongly in May. Even if you remove vehicles or gasoline or any of the other categories that can be volatile or are heavily impacted by price changes, this was still a really good report. Indeed, the numbers were so good that even department store sales surged! Only two categories, furniture and sporting goods, were down. Furniture demand was strong in April, weak in May but decent over the year. As for sporting goods, sales have been soft all year. I guess kids just don’t play outside anymore. And most impressively, the increase in retail sales was robust despite soft online demand. That is not likely to continue.

On the inflation front, conditions are heating up as well. Import prices surged in May, led by a jump in energy costs. Excluding energy, the cost of imported products rose more moderately. Consumer goods prices are not rising sharply, but the increases over the year have been consistently accelerating and have turned positive after being negative for several years. Imported food prices also increased. This is important because food has been a stabilizing factor in the consumer inflation measures. On the export side, the agricultural sector has been able to push through a lot of price hikes this year. This is again a concern if countervailing tariffs hit this sector, as has been threatened.

That the labor market is tight is hardly in doubt and the decline in jobless claims reinforces the view that the unemployment rate is heading downward.

MARKETS AND FED POLICY IMPLICATIONS: The Fed raised the funds rate yesterday and made it clear they are going up more this year and next. But there is every reason to think the projections in yesterday’s report will be the lower, not the upper bound of the rate hikes. As I have noted many times, we are in the midst of a Great Experiment: Can the economy survive massive tax cuts and huge government spending increases when it is already growing solidly and the labor market is at or near full-employment? The concern is that inflation will accelerate sharply because growth could become too strong. Yes, as I like to say, there is no such thing as a free robust economy. Right now, few economists really have a good handle on how to forecast inflation. Wages are simply not behaving as most models expected. The extensive nature of global trade has helped keep down both wages and prices. But tariffs add to the possibility that inflation will be higher than expected. The economic data are great, but can the growth be sustained if price gains move well above the Fed’s 2% target, forcing the FOMC to hike the funds rate more than currently projected? I think that outcome has a higher probability than the one where inflation is restrained and the Fed raises rates moderately.

June 12-13 2018 FOMC Meeting

In a Nutshell: “…the labor market has continued to strengthen and economic activity has been rising at a solid rate.” 

Decision: Fed funds rate target range raised to 1.75% to 2.00%.

The Fed did what the Fed was expected to do, raise the federal funds rate by one-quarter percentage point. But that is not the whole story. The members indicated the FOMC would continue raising rates and we should expect to see two more increases this year, bringing the total number of moves to four and the increase to a total of one percentage point. And there will be a lot more over the next two years.

As for the economy, the Committee is really optimistic. Growth is solid, not moderate. Household spending is picking up as against moderating. And the unemployment rate is declining, rather than just low. Put that all together and you see that the Fed believes the economy is doing very well, which Chair Powell said in his press conference.

Given the positive view about the economy and the belief that inflation will run at, if not above, the Fed’s target of 2% for at least the next two years, the rate hike was logical. Looking at 2019 and 2020, the Committee expects the funds rate to top out somewhere in the 3.5% range. So there are a lot more moves to come.

Finally, the so-called “dot-plot”, which shows the individual forecasts, pointed to the unemployment rate starting to rise in 2020, even as inflation continues to accelerate. By 2020, the funds rate is projected to rise above what the Fed members consider to be the long-term or neutral rate. This time frame coincides with what many economists think could be the first likely start date for the next recession. Just something to keep in mind.

So, what are the takeaways from today’s Fed action, statement and the Chair’s press conference? This was a fairly hawkish report. Look for rates to rise consistently over the next two years, with the funds rate topping out at around 3.5%. Last, the Fed Chair will be holding press conferences after every meeting rather than every other meeting, so rate hikes at any meeting becomes more likely.

(The next FOMC meeting is July 31-August 1, 2018.)

May Producer Prices

KEY DATA: PPI: +0.5%; Over-Year: 3.1%; Ex-Food and Energy: +0.3%; Goods: 1%; Services: +0.3%

IN A NUTSHELL: “Energy matters and right now the surge in prices is driving up businesses costs and making the Fed’s decision to raise rates, if that happens, easy.”

WHAT IT MEANS: As the Fed finishes its meeting and decides what to do with interest rates, the data on inflation makes it clear that its target rate has largely been reached. Yesterday’s Consumer Price Index showed that inflation is rising and today’s Producer Price Index reinforced that view. Wholesale costs jumped in May led by a surge in energy prices. That should ease in the June report, but businesses are still paying a lot more this year for energy than they did last year. Even excluding energy, producer prices were up solidly. Indeed, if you look at the detailed chart of price changes by industry, there were few areas where prices actually fell. And the major reason that wholesale costs didn’t jump even more was that food prices were up minimally. Fish and shellfish prices were down sharply, though I haven’t seen that in the markets I frequent, and I eat fish all the time. As for my beloved bakery products, their prices rose moderately, though they were up more at the consumer level. Oh, well. There isn’t a great schism between goods and services inflation, at least when you remove energy. That indicates the inflationary pressures have become widespread. Looking into the future, there are similar warning signs as intermediate costs were up solidly, especially for processed products.

MARKETS AND FED POLICY IMPLICATIONS: The Federal Reserve likes to look at prices that exclude volatile components such as energy and food. The resulting index is called the “core” and that is the case whether they look at wholesale or consumer prices. It does that, in part, because large movements in food or energy can overstate the trend in inflation. That was the case in May. At the consumer level, the core is a better indicator of future inflation than the overall index. But the reality is that businesses and consumers pay food and energy costs and if you look at price changes over the year, you get a good picture of what is happening. In the business sector, costs are rising sharply, which I would expect the FOMC will take seriously as they make not only their decision on whether to raise rates now but over the next year or two. Expect the Fed to announce a rate hike later today. Whether the members will signal they are concerned about inflation is the real issue and that might be made clearer in either the statement, Chair Powell’s press conference or the charts on inflation, growth and interest rates. We will know soon enough.