The U.S. economy itself appears to be doing well, but we see many end of cycle signs, including less than 4% unemployment, rising interest rates, emerging consumer inflation, a strained housing market, slowing growth worldwide, and huge instability now developing in the emerging market space.
Economy Still Healthy
The 0.8% rise in retail spending in May would seem to confirm that the U.S. economy is still expanding. We believe that number is high due to the fact that the Commerce Department has a differing view of auto sales than that of the auto industry. Commerce reported a 0.5% increase in new auto sales, while the industry reported a decline. With such an unclear view, we will wait for June’s number before concluding that retail spending is accelerating. Still, ex-autos, retail advanced 0.3% in May, still respectable, but not quite as hot as the Commerce Department report would lead one to conclude.
Housing Indigestion
The housing data, however, should cause investors some indigestion. Housing is usually the best leading indicator of the economy. When housing is strong, so are most other indicators. Lately, however, the housing data have softened. And, for some reason, in the Fed’s post-meeting statement and live interview, the topic of housing was conspicuously absent. New purchases fell in April (latest data) as did existing home sales. Of further concern, all of the forward looking sentiment indicators weakened. Mortgage applications also continue to fall as interest rate issues and rising home prices (lumber and labor costs, supply shortages, and even tariff talk) put a damper on affordability. No wonder home builder stocks are in a bear market, down 20% from their near-term highs.
Synchronization and Emerging Markets
The theory pushed by the large Wall Street firm analysts that the equity markets will keep rising because of “synchronized” world growth was dispelled right after Memorial Day by Mohammed El-Erian on CNBC. Japan’s Q1 showed negative growth, although Q2 seems a bit better for them. Growth in Europe is about half of what it was in 2017, and the tariff game will only serve to hurt worldwide growth. China is still growing, but all of the data emanating from there point to slower and softer growth ahead. Same for India.
The stronger dollar, led by rising U.S. interest rates, has had a negative impact on emerging market (EM) economies. The currencies of Argentina, Thailand, Turkey, Indonesia, and others have fallen dramatically in value vs. the dollar over the past month. In early June, the International Monetary Fund (IMF) made the biggest loan in its history to Argentina, but neither that nor a new central bank chief has halted the continued fall in the value of that currency. EM countries with significant dollar denominated debt are having real issues with a stronger dollar and rising U.S. interest rates, as it is now much more costly to service that dollar denominated debt. A stronger dollar and rising rates may push some EM economies into recession. At the very least, it will significantly slow their growth; and that is in line with what we are seeing. As an aside, anyone who has followed EM economies in the past is aware that they tend to lead U.S. markets. According to Bloomberg, $250 billion of EM debt needs to be refinanced over the next year and a half. The stress is such that, for the first time in 13 years, EM bond yields are higher than U.S. high yield (junk) debt.
Inflation
The term “inflation” has been so narrowly defined that it has been limited to the prices of consumer goods and services. As a result, we have become oblivious to the presence of inflation in other forms. The famous monetarist economist, Milton Friedman, had it correct when he said “Inflation is always and everywhere a monetary phenomenon.” We have had 10 years of excessively easy monetary policy, not only from our own Federal Reserve, but their quantitative easing experiment has been mimicked by the world’s other central banks. Any while we haven’t yet seen inflation in the narrowly defined prices of consumer goods and services, it has been present for the past nine years in the rapidly rising prices of equities and real estate. With only a small segment of the population feeling any negative impact, mainly the retired population and first time home buyers, there has been little pressure on the Fed to move to a more rational policy.
Nevertheless, as a result of years of easy money and other end of cycle phenomena, pressures are now building in the area of consumer prices, i.e., the more narrowly defined inflation gauge:
• Wages are now moving upward at the fastest pace in a long time. In Q2/17, the YOY rise in wages was -1.2%; in Q1/18, the YOY rate was +2.9%, and the three month annualized rate is 3.3%;
• The Atlanta Fed’s gauge of inflation was a YOY rate of 3.7% in May;
• The Producer Price Index is a reliable indicator of future consumer inflation. In May, its YOY change was 3.1%, the highest since December, 2011. But its rise in May alone was at an annual rate of 6%. Of greater concern are the price increases at the intermediate and crude stages of production. At the intermediate stage, prices rose 1.5% in May (18% annualized), and at the crude stage they rose 2.5% (at a 30% annual rate);
• The labor markets: In May, for the first time since records have been kept, there are more job openings than there are people actively looking for work, implying upward wage pressures will continue;
• In the National Federation of Independent Business’ (NFIB) most recent survey, the net share of small businesses intending to raise wages is at a record high;
• Import prices rose 0.6% in May (that’s a 7.2% annual rate). This is before the latest round of tariff increases.
The underlying data are daunting and it now appears that we are at the beginning of a bout of narrowly defined consumer price inflation – not like that of the 70s when inflation was at double digit rates, but certainly more than 3% and perhaps even approaching 4% – much higher than what we have become used to for the past nine years. The Fed of the past few years has kept monetary policy too easy in the face of asset inflation and has now let traditional inflationary pressures build up.
The Fed’s Statement
At the conclusion of the June Fed meeting, through written (the official statement), verbal (the after-meeting press conference), and non-verbal (the dot plot – a graphic plot of where each member of the FOMC believes the Fed Funds rate will go over the three year time horizon), the Fed communicated to the markets that 1) there would be a total of four rate increases in 2018 (we’ve had two so far this year) and three more in 2019. At the end of 2019, that would put the Fed Funds rate in the 2.75%-3.00% range, right where the Fed says the non-inflationary full employment Fed Funds rate (2.875%) should be. That is still a year and a half away, and those five rate hikes only get them to neutral. Meanwhile, policy is still on the easy-side, and that means inflationary pressures will keep on building.
The Fed has made it clear that short-term rates are going to rise. The question is, will longer-term rates also rise? One has to wonder, because in the immediate aftermath of the Fed’s announcement and the communication of expected future rate hikes, the 10 Year U.S. T-Note yield actually fell. While this may be due to liquidity or other short-term noise, if such a reaction persists, it means that the bond market gurus either 1) don’t see that current inflationary pressures are long-term in nature (i.e., the inflation will be a small cyclical upswing in a long-term secular disinflationary environment), or 2) believes that a recession is closer than the economics community has forecast. The real danger here is that the yield curve inverts (short-term rates become higher than long-term rates). The Fed, itself, believes that yield curve inversion is the best predictor of recession.
Conclusions
Despite a healthy looking economy, there are trends lurking beneath the surface that may ultimately impact the prices of financial assets. Housing, traditionally a driver of economic growth, is sputtering as is synchronized worldwide growth. All of the data portend a revival of consumer price inflation which will be countered by rising interest rates engineered by a Fed not as concerned about market values as their predecessors.
Investors in life stages, where they don’t have the time horizon to endure a significant market drawdown, should move toward more conservative asset allocations.
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, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
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.
