Weekly Update: Stagflation, seriously?

10-28-2016

 

I started the week in fabulous Chicago, part of a day-long agenda with my Federated colleagues. Our bond team believes the Yellen-led Fed is hyper cautious and that if low rates would have stimulated inflation, it would have happened by now. In any case, the issue of inflation is what everyone is talking about. There are signs it’s bottomed and on a path that would clear the Fed to act. Year-over-year (y/y) CPI, for example, rose in September by the most in 2 years, though some of this is mathematical, i.e., as the 2014-2015 plunge in oil prices fades, so does the y/y comparison. U.S. wages and incomes are rising—Q3’s employment cost index rose at a 2.3% y/y rate for a third straight quarter—and survey data such as the NFIB’s suggest these gains are likely to continue. Home prices also have been steadily climbing (more below). On the other hand, the bulk of inflation’s rise has been due to exogenous forces, not stronger growth. To wit: CPI for medical care has accelerated from 2% y/y in 2014 to 4.9% y/y in September, largely because of the Affordable Care Act. Oil is up mainly because of supply reasons, not demand. And the gains in wages are still well below what would be normal for this stage of the cycle. In reality, ex-housing and medical care, there has been little CPI inflation over the last year, and as this month’s Michigan sentiment report showed (more below), inflation expectations are non-existent. Inflation watch? Not yet.

Some are worried about a weak economy. Even with this morning’s estimated better-than-expected 2.9% bounce in annualized Q3 GDP (more below), the economy this year is on track to grow at or near its slowest pace since the beginning of the weakest recovery of the post-war era. Nominal GDP growth over the past year has only been this low 6 times since WWII, and each of those other times occurred in a recession (1950, 1954, 1958, 1961, 2001 and 2008). Low nominal growth, particularly in the face of low productivity, makes the economy very vulnerable to small increases in costs and raises concerns about potential stagflation. But slow growth and recession are 2 different animals, and the evidence to date suggests there just aren’t the sort of supply excesses or collapses in demand that tend to cause recessions. To be sure, at 87 months, the current expansion is well beyond the typical cycle, but focusing simply on the duration of expansion tells you nothing about whether the cycle is mid or late, Renaissance Macro says. It notes since 1960, there have been a couple of expansions that lasted at least 100 months, others that lasted at least 70 months and yet others that did not even make it to 60. Sure, there are headwinds, including a tight labor market, high labor costs relative to corporate revenue, tightening bank lending standards and excessive business spending on buybacks, not capital expenditures (capex). September’s durable goods report continued to reflect no signs of acceleration in equipment investment. But there’s little to suggest a recession anytime soon—Ned Davis Research’s proprietary model says the odds are minimal. Recession watch? Not yet.

Then there’s the Fed. Worried about the doves’ silence on rate moves, the hawks chirped about hikes all fall until Yellen weighed in, suggesting it might be worth exploring the potential benefits of temporarily running a "high pressure" economy. Not “hot,’’ Medley Global Advisors says, just a deliberately modest monetary path that would let robust demand build and possibly reverse scarring to the supply side of the economy from the Great Recession and its long aftermath. Leading academics have long argued such an approach can reignite capex and boost productivity, undoing structural damage caused by deficient investment. Not everyone agrees. They see retiring boomers, regulations, tax policies, health-care reform and minimum-wage increases as key impediments. Still, a lower-for-longer rate path seems more likely. With a December hike baked in, the Fed is projecting just 2 moves for 2017 and 3 each for 2018 and 2019, putting the neutral funds rate under 3%, well below its historical norm. To be sure, bond yields have been moving up and the yield curve is steepening. But the moves aren’t dramatic—the 10-year Treasury's still well below 2% and yields remain negative in Japan and parts of Europe. As for equities, history suggests tightening doesn’t depress activity until at least 3 rate hikes in a row. The immediate focus is on earnings and a Q3 reporting season that’s providing green shoots, with S&P 500 earnings on track to surpass 2014’s record high and earnings-per-share (EPS) set to post its first positive y/y growth in 2 years. Confidence in earnings growth has been missing; if that changes, the S&P could be set to break out of its 2-year trading band with any pullback short-lived. Inflation? Recession? Fed? Not yet. Carry on.

Positives

GDP surprises The first estimate on Q3 GDP put annualized growth a 2.9%, above expectations, as consumer spending, exports and inventory investments contributed. Evercore ISI viewed the report as supportive of the cyclical bounce story and confirmation of the “slow and steady’’ outlook going forward. It is the sort of not-too-hot, not-too-cold trajectory that keeps inflation relatively in check, a potential recession down the road and the Fed on its lower-for-longer policy path.

‘Flashes’ signal Q4 momentum Markit’s preliminary take on October manufacturing jumped the most in almost 2 years to its highest level this year, while its companion services PMI jumped the most since February 2015 to its highest level in almost a year. Markit said factory activity accelerated strongly, with both output and new orders increasing at their fastest rates in a year. Regional Kansas City and Richmond Fed surveys also showed improvement, though the latter remained in contraction territory.

Housing plods forward September pending and new-home sales rose more than expected, although the latter only because of a sharp downward revision to the prior 3 months. The reports continued to reflect a housing market that’s back to pre-recession levels, with prices on the rise. Case-Shiller’s gauge rose the most in 9 months to its highest since April 2007, while the FHFA purchase-only price index increased at its fastest pace since February 2014.

Negatives

Are consumers ready for Santa? October’s Conference Board confidence gauge declined the most in a year to a 3-month low, and Michigan’s take on sentiment also fell more than expected to a 13-month low. Analysts cautioned against reading too much into the pullbacks; they noted confidence remains consistent with continued economic expansion and even acceleration going into 2017, while the big driver on sentiment was expectations. The current conditions component remained relatively robust, though at a level hinting of a potential slowing in spending.

Spillover from shale’s slowdown Economic growth narrowed across states over the past 2 years, the latest Philly Fed State Coincident Indexes show, with the number of states declining or stable up significantly from the late 2014-early 2015 cycle lows. This coincides with cutbacks in rigs following the collapse in oil and natural gas prices. The y/y change in the coincident index also was its slowest in 5 years. Still, the average change in the indices across states rose in September, suggesting faster growth in some states is more than offsetting declines in others.

Should we be worried about what tax revenues are telling us? Federal tax revenue—the most reliable evidence of income growth—rose only 0.6% in the fiscal 2016, the worst performance since the recovery began and substantially below the 7.5% compound annual growth rate that prevailed from 2009 to 2015. At the same time, outlays jumped by 4.5%, with veterans’ benefits and Medicare driving the increase as Obamacare pushed more people into government-funded health-care programs. A doctor I met in New England says she hates what the Affordable Care Act has done to her practice.

What else

Policy Watch Even under the most ambitious plans by either presidential candidate, infrastructure spending likely will boost GDP by just 0.3%, with most if not all of the money not even entering the economy until 2018 because of the lag time of such legislation. By comparison, tax policy tends to kick in much more quickly, Strategas Research notes. When the 2003 Bush tax cuts became law in May 2003, changes in withholding from income taxes and incentives for savings and investment were immediate. GDP averaged 5.5% in the second half of that year … The last repatriation tax holiday, in January 2005, gave companies 15 months to bring home an estimated $600 billion in overseas earnings. More than half was repatriated at a 5.25% rate, helping boost U.S. stocks and the dollar. Critics complained the tax holiday didn’t produce any real jobs, but the data show an uptick in nonfarm payrolls during the 15-month repatriation period. When it ended, job creation fell back to its pre-repatriation levels.

I finished the week in New England Mostly in tony Greenwich, Conn., which Wikipedia says is the wealthiest town in the 4th-wealthiest U.S. state, with an adjusted equalized net grand list per capita (a combination of both the property tax base per person and income per person) of $680,000. I met some very wealthy—and vocal—people, speaking under a tent (a first for me!) over the sound of heavy rainfall. After my remarks, a retired hedge-fund manager told me he “doesn’t own a single stock, not since 2011.” His friend invests almost exclusively in real estate—“no stocks.” Concerns were voiced about politics controlling government agencies, the possibility of a 20% jobless rate as machines continue to take middle-class jobs, fake EPS from stock buybacks … as good luck would have it, the owner of a diamond and gold business came over, and I completely lost focus on what the others were saying.

We had hippies in my day My favorite topic, the millennials, was highlighted by a colleague who says “they are advancing technology—everything from driverless cars to health-care solutions.” But, I learned, they are weary of the “M word” and much prefer to be called hipsters. I wonder if they know that, back in the day, “hipsters’’ was a reference to jazz lovers.