Economic Data Shows Continued Strength

The big issue for investors in the coming months is how the Federal Reserve will react to continuing strength in the labor market.

Right now, the labor market is strong almost any way you measure it. Indeed, the unemployment rate is extremely low and has been for some time.

The number of job openings exceeds the number of unemployed workers. Businesses say their biggest problem is finding qualified workers to fill their job openings. New unemployment claims, as well as continuing claims, are near their lowest levels in 45 years.

The only weakness in the labor market has been compensation growth. Increases in wages and salaries were less than 2% annually for much of the recovery. Only recently did annual pay increases steadily exceed 2%, and now earnings increases are nearing 3%. Businesses report that they plan to increase compensation at faster rates.

The Federal Reserve is a big believer in the Phillips Curve, which indicates there is a direct relationship between employment and inflation. Increases in employment lead to increases in inflation, and decreases in employment lead to lower inflation, according to the theory.

That’s a major reason why the Fed is dedicated to raising rates for at least the next year. Wage growth has increased and is likely to continue increasing. The Fed is concerned that will lead to higher inflation.

But employment is a lagging indicator of the economy. Employment often doesn’t decline until a recession already has begun. If the Fed focuses on employment data, it is likely to raise rates too much and for too long.

Outside the labor market, we see clear signs in recent data that economic growth is slowing. Housing and vehicle sales are slumping. Energy prices declined sharply. Business investment in core capital goods is barely increasing. Industrial production and durable goods orders have been weak for months.

Also, market interest rates have increased much faster than the rates the Fed controls. The yield on the 10-year Treasury bond recently closed at its highest level since May 2011. While the yield still is low by historic standards, the rise since its mid-2016 low has been rapid and steep. Interest rates on the 10-year Treasury aren’t much below their highest levels in 10 years.

The early recession indicators I use don’t yet hint that a recession is imminent. But growth clearly is slowing in response to higher interest rates. In addition, the 2017 tax cuts offset some of the Fed’s tighter monetary policy, and the effects of those tax cuts are beginning to fade.

That’s why the big issue for investors is what the Fed does over the next year. Ideally, it will examine a range of economic data and adjust its policy based on broad changes in the data.

It wouldn’t be good for investors or the economy if the Fed primarily uses the labor market and the rate of compensation increases to set its policy. If it does, the Fed likely would tighten too long and have a difficult time reversing the ensuing economic decline.

Complicating the situation are President Trump’s periodic criticisms of Fed interest rate increases. Each time a new criticism is issued, at least some Fed officials believe they have to raise rates again to establish that they are independent.

The economy clearly is leaving the late growth phase of the cycle. Fed policy will be the main determinant of whether this is a long phase of slower growth or the economy rolls over to a decline phase. If the Fed restrains itself, we could stay in this phase of positive but slower growth for a considerable time. If the Fed is too aggressive, the economy could start to decline.

The Data

Inflation, as measured by the Producer Price Index, increased a surprising 0.6%, up from 0.2% for last month. Excluding food and energy, the index still increased 0.5%. The 12-month increases were 2.6% and 2.8%, respectively. Over the last few years, a sharp monthly increase in the PPI has been followed by several months of modest increases. Sharp monthly increases haven’t been sustained.

The Consumer Price Index (CPI) increased only 0.3%, compared to 0.1% last month. Excluding food and energy, the CPI increased 0.2%. Over 12 months, the increases are 2.5% and 2.1%, respectively. With energy prices tumbling in the last month, the headline CPI is very likely to decline in the coming months.

The Small Business Optimism Index from NFIB declined a bit to 107.4, down from 107.9, but still is near the 45-year high reached in August. A net 16% of business owners said they plan to raise prices and 34% report pressure to raise compensation.

Manufacturing continues to grow but at a slower rate than earlier in 2018. The Philadelphia Fed Business Outlook Survey declined to 12.9 from 22.0. That was well below expectations. All components of the survey declined but still are at levels that indicate growth. Firms say they generally are optimistic growth will continue.

The Empire State Manufacturing Survey, on the other hand, improved a bit to 23.3 from 21.1. Analysts expected a slight decline. Components of the survey increased modestly. The survey continues to show capacity constraints with increases in delivery times, employment, the work week and prices paid.

Consumer sentiment, as measured by the University of Michigan, declined only a little to 98.3 from 98.6. The current conditions component increased a small amount while expectations declined a bit more. The recent high for this measure was reached in February. This is likely to be the best year for this measure since 2000.

Retail sales increased by 0.8% in October, but the headline number can be misleading. After excluding autos and gasoline, sales increased only 0.3%. Increased sales of building materials also helped boost the headline number. Restaurant sales, which have been leading overall retail sales for some time, decreased for the third consecutive month.

New unemployment claims increased by 2,000. Claims have increased the last few weeks by modest but steady amounts. Most economists attribute this to the effects of recent hurricanes. Unemployment claims remain near record lows.

The Markets

The S&P 500 tumbled 3.85% for the week ended with Wednesday’s close. The Dow Jones Industrial Average fell 4.15%. The Russell 2000 declined 5.06%. The All-Country World Index lost 3.67%. Emerging market equities gave up 4.08%.

Long-term treasuries returned 1.40% for the week. Investment-grade bonds declined 0.63%. Treasury Inflation-Protected Securities (TIPS) rose 0.24%. However, high-yield bonds lost 1.78%.

As for currency moves, the dollar rose 0.98%.

Energy-based commodities lost 3.48% for the week, while broader-based commodities rose 1.59%. Gold fell 1.19%.

Bob’s News & Updates

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