The Days Ahead: Fed meeting.
One-Minute Summary Markets seem quite unperturbed these days. U.K. leadership battles, no trade news, except the Mexico “soya beans for immigration” deal, tech in the sights of regulators, oil tankers shot at, Hong Kong riots. But equities have their eye on a rate cut and ended up 0.5% after a four week losing streak. Still some 2.5% behind the all-time high but retracing much of the May correction.
Hardly a day goes by when the 10-Year Treasury doesn't seem to rally. We're at 2.09% on Friday. They rallied when the not-so-great NFIB and low CPI numbers came out mid-week, gave some back with the OK retail sales on Friday…only to rally again going into the weekend. No one wants to be short Treasuries over a weekend in these markets.
We still have differing messages from equities and bonds. Bonds are saying slower economy, rate cuts, low inflation. Stocks are saying earnings are cheaper to buy and a slowdown will be temporary. They can both be right and so far this year, investors have been rewarded with a 15% gain in equities and 11% gain in long Treasuries.
We're comfortable with both markets right now. Some caution in order on the equity side but not enough to sell.
1. Are we about to hit a recession? No. Oh, come on, you know where we are with this. There are many recession indicators. Some so early as to be unhelpful (yield curve inversion). Others too late to do anything (credit spreads) and plenty in the middle (consumer confidence).
The common definition of recession is two consecutive quarters of declining real GDP. Fair enough. That’s enough to worry about. But it tells you little about depth or duration. The 1990 recession, for example, lasted 8 months peak to trough and unemployment went from 5.1% to 7.0%. The 2008 recession lasted 18 months and unemployment shot from 4.5% to over 10%.
The folk who determine if we’re in a recession are at the National Bureau of Economic Research and their definition of recession is quite long and complicated (see here). And it turns out, the two quarters of GDP measure is woefully inaccurate. The 2001 recession never had two quarters of declining GDP but many of the other measures (sales, employment, real income etc.) were turning south quickly. The 2008 recession was halfway done when it first showed two quarters of declining GDP.
And the NBER doesn't try to predict. Far from it. They announced the 1980 recession one month before it ended. And the 2008 recession 11 months after it started.
So we’re always looking for a good recession indicator. And we found one courtesy of Brookings, which says if the 3-month moving average unemployment rate is 0.5% above its recent 12-month low, then you're in a recession. That makes sense. It doesn't really matter if unemployment is 3% or 5%. If it starts to move quickly upwards, the chances are employers are getting nervous and laying people off. We've headed into recessions with 6% unemployment and we’ve had recoveries with 9% unemployment. It’s the rate of change that matters. The moving average just removes one-offs like, oh I dunno, government shutdowns, tariffs.
There’s a whole book on it and we’re probably doing a disservice in our summary but the 0.5% rule has a very high success rate. And it makes intuitive sense as well.
So where are we now?
The recent 12-month low in unemployment is 3.6% and the recent 3-month moving average is 3.67%. Add 0.5% to the low and we get 4.1%, the black dotted line. So if we see unemployment increase closer 4.1% in the next few months, we’re in trouble.
But not yet.
2. Any sign of inflation? No. In fact it’s heading down. The latest CPI showed broad inflation falling to 1.8% from 2.0%. Core inflation was at 2.0% but has been running at an annualized rate of 1.2% since February. The PCE inflation, the one the Fed follows, is below even those at 1.57% and has also been trending down for the last 3 months.
Now you would be quite forgiven if you said to yourself that the official CPI doesn’t resemble anything like what you pay. And that’s down to some adjustments that the BLS makes when calculating inflation. Here's a graph of TV prices over the last 20 years.
They've fallen 97% in the last 20 years. And it’s true that it's never been cheaper to buy a good 40” high end TV loaded for $229.. Back in the mid-1990s a top of the line 32” TV would have cost around $1,000. But according to that graph it would have been around $7,700. That’s where the folk from the BLS say,
“Yes, we know it’s not a 97% price decline but today’s TV has better sound, a 4K display, is internet ready, built-in Wi-Fi, HDMI ports, is lighter, flatter, bigger and just overall awesome, so we’re going to make a price adjustment for that”.
And that’s fine. It’s called hedonic adjustment and no one thinks it’s a government plot to suppress inflation (well some do but they’re fringe). But it's one reason why there is a downward bias to inflation reporting. Think of all the things that are cheaper or the same price than a few years ago but of much higher quality. Autos, phones, houses….all big-ticket items.
It’s one of the reasons that we’re looking at lower inflation for a while and although the Fed claimed back in April that
“At least part of the recent softness in inflation could be attributed to idiosyncratic factors that seemed likely to have only transitory effects on inflation…”
…it’s very possible they're not transitory at all. We'll know more with the Fed meeting next week where they might signal a rate cut for the July meeting (h/t Tim Duy).
Either way, things are slowing down and the Fed will probably act in the face of weak inflation.
3. How’s the budget deficit going? Oh, you know….bad. Depending on your point of view tax cuts i) pay for themselves ii) increase capex and iii) employment and wages or iv) are a decidedly dodgy way to play with the country’s finances.
Anyway, the latest Treasury Statement shows that a year ago, the deficit was at $532bn for eight months of the fiscal year (government years run from October) and is now $738bn…or, wait for it, the same as the total for fiscal 2018.
Tax receipts are flat while expenditures are up 9%. Corporate taxes are way down, which was the plan, but interestingly custom duties, which are around 1% of tax revenue, are up…a lot.
That's a 66% increase and the government is pulling in around $100bn (annualized) from custom duties…which we all know as tariffs. It’s not enough to choke off consumer confidence yet but it cancels out the personal tax cuts. So, well done everybody.
Bottom Line: Plenty of concerns in the market right now but prospect of a Fed cut is front and center. Oil is not moving because of high inventories and low demand.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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4th Time Around