Deflationary Forces Abate in the Midst of Mixed Economic News

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Investors are setting themselves up for another surprise. This will be the opposite of the surprise they received early in 2016.

As we rolled into 2016, investors were expecting steady increases in interest rates and inflation and a growing economy. Instead, economic growth stalled and events in China triggered a global panic. Suddenly, everyone was concerned about deflation. Interest rates declined. Bonds and other defensive investments rose in value, while stocks and commodities fell.

Central banks quickly reversed policies to combat deflation. Markets haven’t responded as much. In general, markets are pricing in very gradual increases in interest rates. They also anticipate very low inflation for at least the next five years.

Yet, many of the strong deflationary forces have abated. I’m not anticipating inflation like we saw in the 1970s, but inflation could very well rise faster than markets anticipate in the next six to 12 months. That would trigger increases in market interest rates and perhaps action by the Federal Reserve. The changes won’t be immediate, but we’ll be anticipating them in our Retirement Watch portfolios in the coming months.

The Data

This month’s employment report was positive in some ways and disappointing in others. Some analysts disliked the number of jobs created, topping out at just 160,000. But with unemployment at 5%, we shouldn’t expect a high number of jobs to be created. Monthly job creation at this rate is more than enough to keep unemployment low, though we still have issues with a lot of part-time employment and underemployment. The good news is that both hours worked and hourly earnings increased. These have been stagnant for a while.

The JOLTS (Job Openings and Labor Turnover Survey) also was mostly positive. There was a substantial increase in job openings, and the quits rate stayed near historical norms, indicating employees are confident enough about the labor market to seek new jobs.

Consumer credit rose the most in years, perhaps reflecting the higher wages and hours worked. Credit card use, which has lagged in the recovery, increased sharply.

Not surprisingly, retail sales also increased sharply, rising 1.3% for the month. Retail sales are a good indicator of the health of the economy, so the number indicates the economy is doing better in the second quarter than it did in the first quarter.

Consumer Sentiment, as measured by the University of Michigan, also sharply increased. It’s back to the highest level since June 2015. The expectations component, which has been weak for months, had a big rebound in this report. These readings often are good indicators of future retail sales, so this is another piece of data that indicates a good second quarter is underway.

Small business owners also increased their optimism a bit, according to the Small Business Optimism Survey by the National Federation of independent Business (NFIB). Business owners indicated they have problems hiring enough qualified employees for the job openings they have. But only five of the 10 components of the survey were positive, and business owners still aren’t positive about growth prospects and future sales.

New unemployment claims rose last week but decreased by almost the same amount this week. The four-week average had a sizeable increase because of recent rises in claims. The claims reached a historic low in April, so it’s not a surprise that they’re rising. New unemployment claims still are well below average and indicate a strong labor market.

There finally are signs of rising inflation. Even after subtracting food and energy, both producer prices and consumer prices rose in the last month. The Consumer Price Index, excluding food and energy, now is 2.1% for 12 months. The headline number, including food and energy, is 1.1% and rose a sharp 0.4% in the last month.

It is not clear if the recent bottom in manufacturing is holding. The Empire State Manufacturing Survey turned negative after two months of gains. The index reading was a negative 9.2 with expectations for a positive 7.0. The Philadelphia Fed Business Outlook Survey was slightly negative at minus 1.8, following a similar number last month and a positive reading in March.

Industrial Production turned positive, but a lot of that was due to an increase in utility production. Utility production tends to be weather related. The manufacturing component did rise a modest 0.3%. So, at this point we’re looking at mixed news in manufacturing with uncertainty over whether the sector is reaching its lows for this cycle.

Two housing reports were mixed. The Housing Market Index for the National Association of Home Builders (NAHB) was the same reading, 58, for the fourth straight month. This is positive, since any number above 50 indicates growth. Builders still complain of low traffic in their model homes and, in particular, little interest from first-time home buyers. Likewise, housing starts and permits increased, but at a modest rate. It looks like the boom in multi-family homes is tapering while there is more activity in single-family homes. In fact, growth in single-family homes looks fairly strong compared to recent years.

The Index of Leading Economic Indicators, as measured by The Conference Board, rose sharply, its first gain since November. The only negative factor in the index was Consumer Confidence, which has since recovered.

The Markets

Stocks have had ups and downs, but mostly are down. The S&P 500 is down 0.77% for the week ended with Wednesday’s close. The Dow Jones Industrial Average is down 0.94%. The Russell 2000 is worse, with a decline of 1.01%. The All-Country World Index is down 0.84% and emerging markets stocks are down 2.31%.

Bonds aren’t doing much better after indications the Fed might raise interest rates in June. Long-term treasuries are down 1.61%. Treasury Inflation-Protected Securities (TIPS) lost 0.74%. Investment-grade bonds lost 1.24%. But high-yield bonds broke the trend by gaining a very modest 0.07%.

Commodities had a good week. Energy-based commodities gained 1.72%. Broad-based commodities gained 0.51%. Gold went the other direction, losing 1.78%.

Some Reading for You

This article reviews the Securities and Exchange Commission’s greatest worry about the markets.

Corporations buying back their own stock have been a major support for the stock market. Now it appears that support is weakening.

This article is a detailed look at a little-known, but very influential company, Bechtel.

I comment and link to these and other items on my public blog at http://www.bobcarlson.net.