The Rest of the Story: An Economic Brief
According to latest May FOMC communication, the Committee is increasingly comfortable with a sidelined approach to policy with the data failing to make a “strong case for moving in either direction.” At this point, with “solid” growth and “muted” inflation, the majority of officials continue to argue for a “patient” approach to policy until there is a clear indication – or at least a better understanding – of the underlying directional momentum of the economy one way or the other.
“We think our policy stance is appropriate at the moment and we don’t see a strong case for moving in either direction.” - Federal Reserve Chairman Jerome Powell, May 1st FOMC Press Conference
While the data rarely move entirely in lockstep within a steady economy, let alone at inflection points in the economic cycle, nevertheless, the Committee’s “wait and see” approach is a good reminder to market participants to look beyond the latest data point or headline reading into the details to better assess the health of the U.S. economy. After all, in many instances headline strength has masked growing weakness underneath or vice versa.
With a nod to Paul Harvey, this week we sort through some of the key themes impacting the market and the outlook for monetary policy, and include “the rest of the story” for context.
Growth: First-quarter GDP rose 3.2%, well above the median consensus of 2.3%, according to Bloomberg. A two-quarter high, growth at the start of the year also marked the strongest first quarter in more than three years.
The rest of the story: The vast majority of support for growth at the start of the year was the result of temporary or one-off factors ranging from a surge in inventories to an unexpected narrowing of the U.S. trade deficit – both of which are largely expected to reverse course in the coming months. Coupled with government spending, inventories and trade accounted for more than 2% of the headline rise January to March. Stripping out the aforementioned categories, real private domestic sales, arguably a more organic indication of the underlying momentum in the economy, grew just 1.3%, the weakest in nearly six years. With waning momentum in key categories such as investment and consumption, topline growth will expectedly slow in the coming quarters.
Inflation: Inflation remains “near” the Committee’s longer-run objective with the headline at 1.5% as of March and the core – which excludes food and energy prices – rising 1.6% over the past 12 months. Furthermore, the Committee remains optimistic that as the economy and labor market continue to strengthen, price pressures will rise back to the Fed’s 2% inflation target over the medium-term.
The rest of the story: Historically, the Federal Reserve has perpetually anticipated a 2% annual rise in inflation yet prices have failed to meet the Committee’s longer-run target for the better part of the past decade. More recently, after a brief period above 2% mid-2018, inflation has continued to trend lower since September of last year. Additionally, rising fears of weak international growth will expectedly translate into declining demand for global goods and services resulting in a further importation of deflationary pressures exacerbating the downward trend in prices already established and undermining the Committee’s expectation of reaching their price goal in the coming months.
Inflation Expectations: During the May FOMC press conference, the Federal Reserve Chairman struck a noticeably less dovish tone than that of the policy statement; with a spotlight on the persistently sluggish level of inflation, the statement itself seemed to boost expectations for a potential rate cut in the near-term. The Chairman, however, suggested recent “low readings” of inflation have been influenced by “transitory factors” and would not at this point materially impact the Committee’s policy decisions.
The rest of the story: This type of reasoning by the Chairman is nothing new for the Federal Reserve; in 2017, declining price pressures driving the headline PCE away from the Committee’s 2% target were disregarded by policymakers as “transitory.” Back then, however, some of the components including apparel, gasoline and health care costs, which were blamed for “artificially” restraining prices, later helped to boost inflation in 2018. Apparel prices, for example, fell 0.6% in 2017 but rose 0.2% the following year. Thus, if early price declines are dismissed, by the same logic, later price gains should also be discounted. A similar scenario is occurring again today; financial services costs, for example, as the Chairman specifically noted in his comments, rose 5.1% in 2018 but have since weakened materially in the early months of 2019, contributing to headline weakness.
Employment: Payrolls rebounded in April, rising 263k, well above even the most optimistic expectations to a three-month high, and pulling down the unemployment rate from 3.8% to 3.6%. The lowest level of joblessness since December 1969, the April decline furthermore marks nearly five years at or below the Fed’s full employment target range.
The rest of the story: Amid rising volatility on a month-to-month basis, the occasional better-than-expected payroll report has failed to reverse an established downward trend in hiring. The three-month average fell from 186k to 169k at the start of the second quarter after slipping from 198k to 186k the month prior. Furthermore, household employment fell outright, down 103k in April. Thus, with the nearly 500k workers dropping out of the labor market last month, and nearly 800k net dropouts since the start of the year, the labor force participation rate continues to retreat, tumbling to 62.8%. In a broader calculation, adding marginally attached and discouraged workers back in, the unemployment rate more than doubles.
Housing: Housing prices have slowed from a recent peak of 6.7% in March 2018 to 3.0% in the latest February report. While real estate remains a compelling investment opportunity – particularly in some of the “hottest” or tech-driven sub-markets – more broadly, affordability has also improved rising from 154.6 to 156.9 in February, the best reading in a year, according to the National Association of Realtors Affordability Index.
The rest of the story: Home price appreciation has slowed dramatically over the past 12 months after years of outpacing earnings growth by roughly 3 to 1. On a nominal basis, however, home prices remain elevated and, in many cases, out of reach for the average American resulting more recently in a year’s worth of negative sales activity. Despite a more recent pickup in wages, with an average income of $46,644 in the U.S., one would need more than nine times that to purchase a home in Denver ($426,200), for example, or New York ($681,600) or San Diego ($590,100), or nearly thirty times that to purchase a home in San Francisco ($1,353,500). With an erosion in consumers’ ability to afford such a big-ticket purchase, residential investment has trended negative for the past five quarters, shaving off a combined 0.62% from topline GDP since the beginning of 2018.
Production and Trade: Manufacturing activity continued to expand in April, maintaining a reading above fifty (breakeven) for nearly three years. Despite trade uncertainty, production remains positive with manufacturing-based hiring rising 4k in April and more than 25k new payrolls created since the start of the year.
The rest of the story: According to the Institute for Supply Management (ISM), manufacturing activity slowed from 55.3 to 52.8 in April, the lowest level since October 2016, exacerbating the broad-based decline over the past eight months from a recent peak of 60.8 in August 2018. Escalating trade tensions – particularly between the U.S. and China – remain at the heart of the weakness, which have resulted in a similar decline in activity oversees. According to the Purchasing Manager’s Index (PMI), Chinese manufacturing activity bottomed out at 49.9 in February, the third consecutive month of contraction, before rebounding minimally to 50.2 in April. A further deterioration in trade relations including a fresh round of tariffs will likely exacerbate manufacturing-sector weakness both at home and abroad.
Consumption: Consumer spending rose 1.2% in the first-quarter, contributing 0.8% to headline GDP. With a recent back up in wages over 3% as of October 2018, the average American is feeling relatively confident about individual finances, as well as, the broader domestic expansion. According to the Conference Board, consumer confidence rose from 124.2 to 129.2 in April, only slightly below an almost nine-year peak of 137.9 in October 2018.
The rest of the story: While still positive, consumer spending slowed noticeably at the star of the year, dropping to a four-quarter low. Furthermore, on a month-to-month basis, amid an ongoing pullback in traditional discretionary purchases, retail activity has trended lower, turning negative in five of the last eight months with an average pace of just 0.3% since the start of the year. Additionally, while welcome, recent wage gains follow years of stagnant income growth forcing consumers to rely on temporary factors such as drawing down savings and ramping up credit – supplemental supports which have begun to dissipate. As a consumer-based economy, a sustained reduction in consumer spending will expectedly erode topline momentum in the near-term.
Corporate Investment: Business investment slowed to a two-quarter low January to March, rising just 2.7% after a 3.1% gain at the end of 2018. Fading effects from the Trump tax cuts, as well as, uneven economic conditions have seemingly drawn down the incentive for businesses to loosen corporate purse strings. On a monthly basis, business investment – as proxied by durable goods excluding aircraft and defense – has trended negative for four of the last eight months, suggesting further potential weakness mid-year if such low levels are sustained.
The rest of the story: After bouncing along at roughly zero for nearly two years, in 2017 business investment improved markedly amid a pro-growth, pro-business agenda which included regulatory and tax reform. Investment, however, plateaued in 2018 before losing momentum at the start of the new year. Despite a more broad-based declining trend, however, investment in technology remains an area of strength, boosting corporate efficiency and helping to offset the negative impact from restrictive trade policies. Productivity, for example, rose 3.6% in the first quarter, the strongest gain in more than four years and well above the trend pace of 1.5% for the better part of the past decade. Rising productivity will furthermore help stave off future inflationary concerns even at the first-quarter’s more elevated growth rate.
International Markets and the Fed: At the start of the year, the Federal Reserve outlined a number of international factors that had dampened the domestic outlook. In May, however, according to the Chairman’s press conference, the risks from such factors have been mitigated: recent data suggest growth overseas is improving, reducing the threat of a global slowdown, and the prospect of a disorderly Brexit has been pushed off. Additionally, prior to this week’s developments, the Chairman noted further progress in U.S./China trade talks was a positive factor in the domestic outlook supporting the Committee’s sidelined approach.
The rest of the story: While growth in some major economies abroad, including China and Europe, has arrested a steep downward trajectory, activity levels remain disappointing. Chinese GDP rose 6.4% in the first quarter, for example, unchanged from the quarter prior, and maintaining the weakest pace in nearly a decade. European growth, furthermore, increased 1.2% at the start of the year but remains threatened by a further contraction in Germany, the largest economy in the bloc. Additionally, while Brexit negotiators have been granted a prolonged extension into the second half of the year, officials report little progress has been made since bypassing the first extension of April 12th, perpetuating a heightened probability of a no-deal Brexit or a hard Brexit. Finally, trade talks between the U.S. and China have more recently moved “backwards” with the Trump administration growing impatient for progress after ten months of negotiations. Noting progress has been “too slow,” the president this week announced an increase in tariffs on the already targeted $200 billion of Chinese imports from 10% to 25%, as well as additional levies on the remaining balance of $325 billion, potentially “soon.” Undermining the Chairman’s more positive view of international cross-currents, a further deterioration in U.S./China trade relations is likely to exacerbate volatility in global equity markets and reinforce the more dovish argument among Committee members in support for increasingly accommodative policy sooner than later.
-Lindsey Piegza, Ph.D., Chief Economist