As Q3 ended, the economy continued on its tepid growth path. Unknown is the value of the economic carnage of two hurricanes that hit the mainland and a third that completely devastated Puerto Rico. The bond and foreign exchange (FX) markets have a sense that all is not well, but, the equity indexes haven’t yet espoused that viewpoint.
Meanwhile, at its last convocation in mid-September, the Fed’s Federal Open Market Committee (FOMC) convinced market participants that they will raise the Fed Funds rate by .25% (i.e., .0025) in December. This, of course, is “data dependent.” The problem is that it is a certainty that the hurricane events of September will have had an impact on the reported data by December, and the Fed, at that time, will have to decide whether or not to accept the flawed narrative that the lower level of economic activity can be ignored from a policy perspective. As explained below, the biggest danger is that equity market participants ignore the fact that economic activity has been lost.
Today’s Softening Data
Let’s start with the latest economic observations:
1) The economy grows when the auto and housing industries are on the upswing:
a) Mortgage applications for the week ending September 15th are off 21.5% from year earlier levels;
b) Existing home sales fell in August (pre-hurricanes);
c) Auto sales have clearly peaked, and now Ford has temporarily shut down five assembly plants (three in the U.S.) and GM is idling a plant that produces the hotter selling SUVs and pick-up trucks!
2) Employment data are less than meets the eye despite the headline number from the September Bureau of Labor Statistics (BLS) employment report:
a) Full-time employment is falling (-166,000 from BLS’s September Household Survey);
b) The workweek fell in August by .1 hours, equivalent to earnings from 400,000 jobs;
c) There has been no employment growth in the 25-54 year old age cohort since March; this is the cohort of people in their prime working years.
3) Inflation is benign, now bordering on deflation. Despite the interpretation that the latest CPI data shows a significant uptick, deflation remains alive and well:
a) All of the inflation in the latest CPI report was due to higher auto insurance premiums, and rising rents. Without these two items, the CPI would have been flat;
b) Headline inflation in the U.S., year over year, has fallen from 2.5% at the turn of the year to 1.9% today; the Cleveland and Atlanta Fed inflation models are forecasting lower, not higher, inflation going forward;
c) There is deflation in the prices of autos, airfares, toys (BK at Toys R Us), home improvement goods, communications (cellular services in particular), college tuition (first time in 17 years), drug prices, and legal fees. Wait! Drug prices, legal fees! When, in our lifetimes, has this happened outside of recession?
The Bond and FX Traders Have Left the Party
As the year began, both the Fed and the Street forecast the 10-year T-Note yield to be over 3% by the end of 2017. Early in September, that yield flirted with 2.0% and today sits near 2.25%. The U.S. Federal Reserve stands alone as the only one raising rates. A currency, whose central bank is tightening, is supposed to rise in value. Yet, for most of 2017, the FX value of the dollar has fallen. So, both the bond market and the FX markets are not buying the view that rates can rise over the medium to long-run. The underlying economic data says the same thing. It is the equity market that looks to be the outlier.
The Coming Reconstruction Boom
I have been asked by several colleagues why I don’t see any uplift to the equity markets from the coming hurricane-induced reconstruction boom (this ignores the very real labor force constraint – not enough construction workers). Assume that the GDP was 100, and the impacts of the hurricanes knocked economic activity back to a GDP of 95. The economy has taken a 5% hit, similar to what would happen in a recession. The rebuilding then begins. Here is the major issue no one is discussing: in a recognized recession, the equity market contracts because there is a lower level of economic activity. Then, as the economy begins to recover, equities rise in value. What the current flawed narrative seems to be promising is that the “growth” from the reconstruction will push equity prices higher from their current levels. What is ignored is the natural process of equity market contraction that goes hand in hand with lower levels of economic activity.
Conclusions
1) There is a real danger of a Fed policy misstep in December if the FOMC interprets the economic softness to “transitory” hurricane factors and proceeds to raise interest rates;
2) The economy does well when housing and autos do well; both have peaked for this cycle;
3) Underlying employment data continue to concern;
4) Demographics, deflation, bond and FX trader behaviors all point to an interest rate environment that will be lower for longer;
5) The “coming” reconstruction boom is not, on net, additive to the pre-hurricane level of economic activity and the equity market has not taken the lost activity into account. Be careful how you interpret that narrative!
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial and is the head of Fieldstone Research www.FieldstoneResearch.com
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information