THE ECONOMY:
A still decent economy getting much maligned.
Not every economic report is coming in with gains the past few months unlike 2003 and 2004. After growing sharply with the fiscal incentives it is normal for the economy to slow some. We saw these issues arising a few months back because we were focused on oil prices and the Fed. At the beginning of the year we said those were the two issues that would dominate the market's action, and that is how it has played out. Add onto those two some economic that has started to soften and you now have a lot of pundits jumping on the bandwagon of a slowing economy, stagflation, recession, etc.
That is all possible of course, though you almost have to chuckle a la Greenspan at the suggestion that low single digit inflation and 5% unemployment is somehow comparable to the 13% inflation and 10+% unemployment of the 1970's and early 1980's. It was just two years ago everyone was worried about deflation. Some normal 're-flation' has everyone nuts.
The economy slowed late Q1. Slowdowns within expansions are not unusual, however. Economic expansions trend higher and there can be down cycles within the ongoing up cycle. The key issues this time are the same ones: the Fed and oil prices. Oil is going to test lower now toward the mid to low forties. The Fed funds futures are showing just a few more rate hikes. Perhaps that will be enough to stave off turning a slow cycle in the expansion into a sharp slowdown. If it is, however, we will see the market start to recover before the data verifies that the economy has recovered. Perhaps the 'double bottom' the past two weeks on several indices is the start of the bottom. As noted above, it will have to show it.
Friday's weak economic data.
Michigan sentiment weakens.
Friday revealed additional weakening economic data, but it was more psychological than substantive. The final Michigan sentiment survey for April came in at 87.7, less than the 89.7 preliminary report and the 88.9 expected. As with the Conference Board's confidence poll earlier in the week, these levels still indicate confidence at sufficient levels to drive consumption.
Most articles you read about confidence these days note that what the consumer says and what the consumer does are two separate things. In other words they proffer the proposition that sentiment and consumption have become disconnected. In reality there is no change. It is the level of consumption that makes the difference. Fluctuations in sentiment from the seventies to 100 or more show little change in consumption. Only when sentiment levels drop into the low seventies and really into the sixties does consumption alter significantly enough to impact the economy.
Thus while the there is worry about flagging sentiment, at these levels it is not an issue. The issue is whether this is setting up a trend of lower confidence that will eventually end up in the sixties. It definitely hurts confidence to see the gasoline bill $10 higher per tank, airlines charging fuel surcharges, service providers tacking on additional fuel charges. That saps enthusiasm and it also actually diverts dollars from the productive economy.
Personal spending increases, but it is all in the price.
Spending rose 0.6% in March, more than the 0.4% expected. It was less than February's 0.7% gain, but that was revised higher. Now typically you would think spending was up so the consumer must still be hot to trot. Well, the consumer is at least spending. The problem is the consumer is having to shell out more for less. Adjust the spending figures for inflation and spending rose just 0.1%. In February the inflation adjusted spending rose 0.4%.
Seems that the higher prices are biting into actual spending. Overall dollars are higher, but it is buying less meaning less production needed to replace the goods sold. Also there is that problem with money diverted to higher gasoline prices that is not going back into the economy to buy more goods that have to be replaced. Thus the rise in spending is not what it was back in 2003 when the Fed was worried about deflation or even in 2004. We are spending more because prices are higher, and yet we are not slowing our spending in total dollars. That tends to create a vicious cycle: more money chasing the same amount of goods keeps the inflation rise feeding on itself.
Friday's positive economic data.
The Chicago PMI measure of Midwest manufacturing activity fell to 65.6 from 69.2, but when you consider March was a record and expectations were for 63.9, it wasn't chopped liver. The sub-indices were down across the board, but they all remained strong. Employment fell to 62.3 from 66.0; new orders were 71.0 (76.7 prior); even more positive, prices paid fell to 66.1 from 68.2. Lower but solid readings.
This report dovetails with the Philly Fed from last week and leaves the New York report looking like the odd man out. Chicago and Philly are harbingers for the national ISM to be released Monday, so we do not anticipate much of a drop nationwide.
One of the Fed's inflation gauges, the Employment Cost Index, slowed slightly in Q1 to 0.7% (1% expected) after a 0.8% gain in Q4. Year over year costs rose 3.4%, the lowest in 6 years. As for the components, salaries and wages rose 0.6%, a 2.4% annual rise, holding steady from Q4 and Q3. That is the smallest advance since the records were first kept back in the early 1980's. Benefits rose 1.2% versus Q4, the smallest gain in 3 years. That puts the year over year gain at 5.9%, the smallest cost advance in two years. Of course, health benefits rose the most.
The Fed looks hard at this data because the Fed believes that wages can lead to inflation. If people are paid more they must be spending more, thus driving up prices. This assumes that supply is steady. This is hogwash. In a healthy economy supply will meet demand. If employees are getting more money they are being more productive (particularly in this current economy). In other words they are making more of the goods and services that are being consumed and doing so more efficiently. There is no 'wage-led' inflation unless regulations really hinder supply in meeting demand. This is the old Phillips Curve mentality where prosperity is viewed with fear. It is so strange; politicians campaign with promises to deliver prosperity, and when we actually get it the Fed tries to stall it out. Does the Fed believe we have a death wish because we strive to prosper? Seems to be that way.
Bond Yield Curve continues to Flatten as Fed prepares to meet, China rumored ready to float yuan.
Back at the end of 2004 (just four months ago), the difference in yield between the 2 year Treasury and the 10 year Treasury was 116 basis points. Two weeks back it was 63 BP. Friday it was 55 BP, a four year low. It is not inverted, but it is not far from it.
Inverted curves mean that near term money is valued more than longer term money. In other words there is the perception of less demand for money down the road than there is for that money at the present time. That is prompted by the belief that the economy will be slow and money in less demand because of less building and other projects. Inverted curves almost invariably mean recession is coming.
Some say this is just a response to the Fed raising short term rates and the long end not yet starting its commensurate rise. The closer the curve comes to inverted, this argument loses weight. Thus the Fed meets Tuesday with this 'conundrum' to deal with. Once again reality is not fitting in neatly with the Fed's view. If the economy is expanding as sharply as the Fed suggests, then the bond curve should be responding. Instead it is flattening as oil prices, though softening some, remain strong (indeed, until the Friday close pushed prices below $50/bbl it had been February 18 since oil prices closed below $50).
This led to the conclusion of some Friday that the Fed is going to raise rates 25 BP next week but then stop or pause to see what happens. As noted above, that is based more in hope than what history indicates the Fed will do. The Fed is indeed looking at the data, but it rarely, rarely changes course in mid-hike. Even the Fed funds futures are showing three more hikes this year before the Fed stops. It would take a major shift in Fed dynamics to stop after one more 25 BP hike.
Even if the Fed was inclined (and we know some on the Fed definitely are as the Dallas Fed wanted no hike at the last meeting), it has another huge issue to deal with. The administration has been harping at China to do some sort of float of the yuan re the dollar. That will supposedly rectify the trade imbalanced and current account and maybe cure the flesh eating virus as well. The problem if China does float the yuan, however, is an instant surge in US inflation as the yuan rises 30% overnight versus the dollar. Chinese import costs shoot higher. We either curtail our spending on them or pay more. China loses a big part of its market; its citizens may have to start consuming those goods. Their standard of living jumps as we struggle to maintain ours.
It is a real pickle for the Fed, and when in doubt the Fed will continue to raise rates in a 'measured' pace. After all, it sees some inflation even if Greenspan thinks the trade deficit will take care of itself (was he hinting at the China float last month when he said this). The Fed feels it is not in position to stop hiking rates at 3%. Maybe 3.5%, and that is exactly what the fed funds futures contract is pricing. If there is a big upheaval the Fed wants a few more arrows in its quiver. We would be shocked if the Fed said it was going to pause after another hike. It is the kind of shock we could live with, but we are not banking on it. |
