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Economy Chugging Along,
Even as Trade Concerns Intensify

Judging by the angst surrounding recent data releases, you could be forgiven for forgetting that the U.S. economy is coming off its strongest GDP quarter since 2014. Recent data has been generally solid, but investors have quibbled at any signs of a data series sliding down from a prior peak reading, notes Jim Kelleher, Director of Research with Argus Research, a leading independent research firm.

That level of anxiety is both hindering and, paradoxically, helping the stock market. Bulls need to climb a wall of worry, Wall Street widely believes. Worry keeps a good number of investors on the sideline and eventually results in interim sell-offs. When the selling seems overdone, the sideline crowd makes their bids, typically pushing stocks to levels just above the prior high. From there, the process starts over again and repeats, pushing the market steadily higher – assuming healthy worry is not displaced by truly dire news. Too much complacency and not enough worry, by contrast, leaves the sidelines bare when a bid is needed.

In this environment, stocks are alternating up and down sessions, with the a little more gusto in the up sessions. The practice of buying the dip, etched in investors’ reflexes after a decade-long bull run, has sustained the pattern of rising highs and higher lows on the S&P 500. Amid anxiety and second-guessing, investors have “worried the market higher” such that, on 8/8/18, the S&P 500 closed within 14 points, or about half a percentage point, of its all-time high from the end of January 2018.

Tariffs and trade constitute the market’s current set of worry beads. So far, real damage to the economy appears modest. While global corporations privately bemoan trade barriers, not everyone feels that way. Small business owners continue to support tariffs, and their optimism is near record highs. In the current environment, trade is not the biggest danger to stocks; that distinction belongs to inflation.

*The Data *

August started with mixed news on jobs. July non-farm payrolls increased by 157,000, missing the 193K consensus forecast. May and June revisions added another 59,000 payroll jobs to two already strong months. Hourly wages for July grew 2.7% year over year, matching expectations, while the unemployment rate ticked down to 3.9% from the prior month’s 4.0%.

Jobs growth is steady, if not as rapid as earlier in the expansion. Business owners appear to be shrugging off trade worries, at least when it comes to filling needed positions. While the strong May and June revisions helped the six-month average, payrolls growth has come in below 200K in five of past eight months. An August nonfarm payrolls reading below 150,000 would be the clearest sign yet of mounting anxiety over trade and tariffs.

With costs for food and housing accelerating, 2.7% annual wage growth is struggling to stay ahead of inflation. Remember, 2.7% is nominal growth. Economists would like to see nominal annual wage growth of at least 3% into year-end, which would push real wage growth ahead of inflation.

The ISM non-manufacturing index came in at 55.7% for July, falling from 59.1% in June while missing the 58.1% consensus. This measure of the service economy, which accounts for four-fifths of the U.S. economy, signaled the slowest growth in 11 months. The decline should not be that big a surprise, as some slowing was anticipated from the torrid second-quarter pace. The ISM’s manufacturing survey hit a three-month low in July, also reflecting a post-2Q pause. Both manufacturing and services’ purchasing managers echoed similar concerns about tariffs and retaliatory measures from trading partners.

ISM manufacturing and non-manufacturing purchasing managers are not yet too worried about inflation, according to survey data. But the higher rates the Fed is using to combat inflation are impacting the mortgage refinancing market. The Mortgage Bankers Association (MBA) refinancing index for the first week of August showed the lowest level of refinancing activity since December 2000.

Mortgage originations are more sizable than refinancings. Originations, too, are well off peak as housing activity has slowed. According to MBA, all mortgage applications for the week ended 8/3/18 fell 3%, marking a fourth consecutive weekly decline. In a vicious cycle, aging boomers looking to downsize are locked into existing too-big homes by scarce supply and high prices, further worsening the supply situation. While more new homes could help break the logjam, builder optimism has tanked because of tariff-impacted price spikes for lumber and other materials.

In a bit of relief for those fearing inflation, the Producer Price Index slowed to a crawl in July. The decline in energy prices held the headline all-items index flat month over month; the 0.0% reading compared with a 0.3% jump in June and came in under the 0.2% consensus.

Core PPI, less food and fuel, was also well-behaved with just a 0.1% gain versus a 0.2% consensus forecast. The 2.7% annual change in core PPI also lagged the 2.8% consensus call. July core PPI advanced at the tamest pace for any month in 2018, reflecting a dip in prices paid for services. Notably, wholesalers and retailers are finding it harder to pass through their higher costs to consumers.

Consumer prices as expected are running cooler than wholesale prices, while still rising. Stripping out energy and food, the core Consumer Price Index for July advanced at a 0.2% monthly pace and a 2.4% annual pace. The all-items CPI rose 0.2% month over month in July and 2.9% year over year. The mid-summer decline in energy prices has helped to hold down CPI; growth in food prices also slowed.

Although core CPI is running below core PPI, the 2.4% annual increase in core CPI represents the fastest consumer cost growth since 2008. Non-farm wage growth is measured in nominal, not real terms. A recent Labor Department report showed inflation-adjusted wages unchanged in July from June 2018 and actually down 0.2% from July 2017. Consumers are employed, confident, and spending. But if tariffs and inflation raise the cost of consumer goods at a pace exceeding wage growth, both spending and confidence will suffer.

The National Federation of Independent Businesses (NFIB) index reached 107.9 in July. That put U.S. small business optimism just 0.1 below its all-time high reading from July 1983. Small business owners are generally supportive of tariffs, given that both their suppliers and customers tend to be domestic. They are also benefiting from lower tax rates. While large global corporations are growing cautious, about one-third of small business owners think now is a good time to expand operations.

In an ominous indicator that tariffs and counter-tariffs are starting to bite, agricultural export prices dropped 5.3% in July from June levels, led by a 14.1% plunge in soybean prices. In July, China announced 25% tariffs on U.S. soybeans and varying tariffs on other U.S. agricultural products. Export prices for all major food categories, including corn, wheat, fruit and nuts, were down month over month in July.

Pulled down by ag export prices, overall export prices were down 0.5% in July. On the flipside, import prices were flat month over month but rose 4.7% year over year. While that is the biggest gain since 2002, rising fuel prices rather than tariffs were the main contributors to higher import prices.

Conclusion

With summer winding down, already understaffed trading desks will thin out further in the final weeks of August. Traders and investors returning from vacation in September will step right into the hurly-burly of pre-election campaigning. While the economy looms large in any election cycle, Argus expects an unusually intense and partisan mid-term election season.

While the drop in farm export prices is painfully real, most businesses and consumers have felt little impact from the budding trade war. Positive sentiment can go south in a hurry, however. Business confidence has suffered some erosion, and confidence is a necessary ingredient in growth. Should both business confidence and economic data degrade more meaningfully, we think the GOP – fearing consequences in the fast-approaching mid-term elections – would at least try to temper President Trump’s unflinching stance on trade.

Trying to find the signal amid the increasingly loud noise from both sides, we go back to the data again. While economic indicators are no longer at peak levels, they are at high levels. The commercial and industrial economy is strong, and consumers are employed and spending. The stock market in 2018, for all its turbulence, is tracking slightly ahead of its average annual performance through August for all years since 1980. We continue to expect strong earnings growth into year end, as well as further stock-market appreciation into year end.


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