The Long-Term Yield Conundrum

Posted on

December 10, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

Last Friday, the 10-year Treasury Note closed at a yield of 2.85%. That’s up from 2.41% at the end of 2017, but down from the peak of 3.24% on November 8th, and well below where fundamentals suggest yields should be.

In the last two years, nominal GDP growth – real GDP growth plus inflation – has run at a 4.8% annual rate. Normally, we’d expect yields to be close to nominal GDP growth, but Treasury yields have remained stubbornly low.

Some analysts are spooked by the recent movement of 3- year yields above 5-year yields, thinking this “inversion” signals a recession. We think this is sorely mistaken. With a lag, recessions have often (but not always) followed periods when the federal funds rate exceeds the 10-year yield. If anything, that’sthe inversion to look out for; feel free to ignore the rest. But, at present, the 10-year is yielding about 70 basis points above the funds rate, well within the normal range.

One reason that the 10-year yield has remained below where economic fundamentals suggest it should trade is that the Federal Reserve set short-term interest rates near zero. Longer- term bonds, including the 10-year reflect the current level of short-term rates as well as the projected path of those rates in the future. So, back when yields were essentially zero, and the Fed was signaling they could stay there for a long time, this pulled down longer-term yields. The Fed has now lifted short-term interest rates by 200 basis points from where they were, but investors still don’t believe they will go much higher.

Part of the issue is that many think low rates themselves are the only reason the economy came out of the Great Recession. So as the Fed lifts rates, many investors expect the next recession is a small tip of the scale from returning in force.

If you’re buying 10-year Notes under the premise that a recession will happen sometime in the next ten years – and you also expect the next recession to tie (or beat) ’08-’09 for the title of worst recession since the Great Depression – then the yield on the 10-year Treasury makes a lot more sense.

But we whole heartedly disagree with your assessment. We think the bond market is anticipating a far weaker economy over the next ten years than the data justifies.

No matter how many believe it, the bond market is not all- knowing. In November 1971, the 10-year Treasury was yielding 5.81%. Over the next ten years, inflation alone increased at an 8.6% annual rate and nominal GDP grew at a 10.7% annual rate. In other words, 10-year note investors got hammered as yields soared. And notice that back in 1971 we had a Republican president (Richard Nixon) leaning heavily on the Fed to maintain a loose monetary policy. Sound familiar?

The next recession is unlikely to be like the last. Our calculations suggest national average home prices were 40% overvalued at the peak of the housing boom – pumped up by government rules and subsidies artificially favoring home buying. Meanwhile overly stringent mark-to-market accounting rules created a once in a 100-year panic. Mark-to-market rules have now changed to allow cash flow to be used to value assets, plus banks are much better capitalized. In other words, fundamentals suggest another panic is not in the cards.

What’s more likely is that, when the next recession hits – and we don’t see one happening until at least 2021 – it will be softer than usual, more like 1990-91 or 2001, than 1973-75, 1981-82 or 2007-09. As investors realize data trumps the rhetoric, we expect bond yields to rise. In the end, math wins.

Date/Time (CST) U.S. Economic Data Consensus First Trust Actual Previous

12-11 / 7:30 am PPI – Nov 0.0% 0.0% +0.6%

7:30 am “Core” PPI – Nov +0.1% +0.2% +0.5%

12-12 / 7:30 am CPI – Nov 0.0% 0.0% +0.3%

7:30 am “Core” CPI – Nov +0.2% +0.2% +0.2%

12-13 / 7:30 am Initial Claims – Dec 8 227K 228K 231K

7:30 am Import Prices – Nov -1.0% -0.7% +0.5%

7:30 am Export Prices – Nov -0.3% -0.5% +0.4%

12-14 / 7:30 am Retail Sales – Nov +0.1% -0.1% +0.8%

7:30 am Retail Sales Ex-Auto – Nov +0.2% -0.1% +0.7%

8:15 am Industrial Production – Nov +0.3% +0.2% +0.1%

8:15 am Capacity Utilization – Nov 78.6% 78.5% 78.4%

9:00 am Business Inventories – Oct +0.6% +0.6% +0.3%

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:
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Scapegoating Powell

Posted on

December 3, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

New Narrative Alert: Fed Chief Jerome Powell is to blame for the volatility in stocks. Back on October 3rd, with stock markets near their record highs, Powell said “we’re a long way from neutral.” That was not long after the Fed had moved the federal funds rate to a range of 2.00% to 2.25%, so the implication was that the Federal Reserve was going to maintain a pace of rate hikes in 2019 similar to 2018.

Then came the correction – which, by the way, seems to have ended the day after Thanksgiving – just a few trading days before Powell adjusted his language and said short-term interestrates set by the Fed are “just below” neutral.

Conventional wisdom says it’s all about the Fed. This thinking began back in 2008/09 when many pundits, analysts and investors decided it was QE and zero percent interest rates that saved the markets during the Great Recession. Forget about entrepreneurship, forget about profits, forget about tax rates and regulation. Just read the Fed tea leaves or listen to those who read them for you.

Count us skeptical. No matter how bullish we’ve been the past several years, we’ve always told investors that it’s aboutentrepreneurship, profits, and policy, not the Fed. If printing money and low rates were really the answer, European stockmarkets wouldn’t have under-performed the US by so much in the past decade. And no one can consistently predict corrections. Investors could save a lot of headache (and a lot of money) simply by focusing on fundamentals rather than trying to time the market.

After a correction happens, plenty of people come out of the woodwork to tell us what caused it, even though they never predicted the correction in the first place. There’s always someexplanation – after the fact – that seems to fit the limited data available. So, it’s not surprising some analysts are blaming Powell. Heck, the pouting pundits have been predicting near constant doom and gloom since 2009, and they’ll take anychance they can (no matter how temporary) to pop champagne and gloat.

Regardless, neither of Powell’s statements were out ofline. Back in September the “median dot” suggested a neutralrate of 3.0% for federal funds, which is about four rate hikesaway or a “long way from neutral.” But the range for neutral extends from 2.5% to 3.5%, possibly only one or two more ratehikes away, consistent with “just below.”

We think the news that really drove the market higher last week was the report that economy-wide pre-tax corporate profits were up 10.3% from a year ago (and up 19.4% after taxes – thank you tax cuts!). Focus on fundamentals, not post- event explanations. The former tell us the trend, the latter are little more than a distraction.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/12/3/scapegoating-powell

Consumers Stay Strong

Posted on Updated on

November 26, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

It’s that time of the year again. Holiday sales data show surging online sales while foot traffic at brick and mortar storesremains tepid. If you have a sense of déjà vu, it’s because youheard the same stories last year.

Black Friday had a 23.6% increase in online sales this year, according to Adobe Analytics, which tracks sales at 80 of the top 100 internet retailers, with one-third of the sales via mobile devices – that’s up from 29.6% in 2017. Looks like more people are getting comfortable with making buying decisions on the go rather than at a desk.

Online sales on Thanksgiving Day itself were up 28%, while the average online order is up 8.5% this year to $146. So,we’re getting both more orders and orders for bigger-ticket items. Many of those orders are picked up in stores.

Meanwhile, according to ShopperTrak, foot traffic at brick-and-mortar stores was down 1.0% this year on Thanksgiving and Black Friday, combined. However, that’s smaller than the 1.6% decline on the same days last year.

Look, you could spin this data anyway you like, but instead of getting bogged down in the day-to-day figures, we like to focus on fundamentals, and those fundamentals are very strong. Total retail sales are likely to be up 6%+ this year over last year. That’s very strong.

The unemployment rate is 3.7%, the lowest since the NY Jets were reigning Super Bowl champs in 1969, and trending lower. Yes, the participation rate – the share of adults who are either working or looking for work – is hovering at levels lower than in the 1980s, 1990s, or 2000s. But the participation rate is higher than it was in the 1960s, back when many say theeconomy was at “full employment.”

The “U-6” unemployment rate, sometimes referred to as the “true unemployment rate,” which includes discouraged workers and those working part-time who say they want full- time jobs, is 7.4% right now. That rate was lower from late 1999 to early 2001 at the peak of the original internet boom, bottoming at 6.8%. So, by that standard the economy could be doing better. But the gap between 7.4% and 6.8% is relatively small in a data sense, and a huge decline from the peak in 2010 of 17.1%. In other words, the labor market has improved markedly on all fronts. And, remember 6.8% was the lowest level recorded at the peak of the 1990s boom; the current expansion is still intact, with the peak potentially years away.

Another key fundamental pointing towards the positive is the acceleration of wage growth, with average hourly earnings up 3.1% from a year ago, the fastest growth since 2009. Meanwhile the employment cost index, an alternative measure of worker compensation, is up 2.8% from a year ago, also the largest increase since 2009. And don’t let anyone tell you that this just shows the “rich getting richer.” The fastest gains in weekly earnings are being made near the bottom of the income spectrum, not the top.

In addition, gas prices are down. Remember how concerned demand-side economists get whenever gas prices go up? They look at it like a tax hike. But now gas prices have dropped and we notice barely a peep about how this will lift purchasing power for consumers.

As of mid-year, household debts were the lowest relative to household assets since the mid-1980s. Meanwhile, financial obligations – think debt service on consumers’ loans plus recurring payments like rent, car leases, homeowners’ insurance, and property taxes – are still hovering near the lowest share of after-tax income since the early 1980s.

None of this suggests that every consumer is in the best financial position they’ve ever been in. But very many are, others are very close, and we expect this to be reflected in continued robust gains in consumer spending in both November and December as well as the year ahead.

So while, yes, the market is down, in correction territory in fact, it’s just a correction, not a recession. Don’t get sidetracked. The consumer, the producer, the entrepreneur – the economy as a whole – are all moving forward at a very healthy pace.

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Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

11-28 / 7:30 am

Q3 GDP Second Report

3.5%

3.7%

3.5%

7:30 am

Q3 GDP Chain Price Index

1.7%

1.7%

1.7%

9:00 am

New Home Sales – Oct

0.575 Mil

0.585 Mil

0.553 Mil

11-29 / 7:30 am

Initial Claims – Nov 24

220K

215K

224K

7:30 am

Personal Income – Oct

+0.4%

+0.5%

+0.2%

7:30 am

Personal Spending – Oct

+0.4%

+0.5%

+0.4%

11-30 / 8:45 am

Chicago PMI – Nov

58.5

58.5

58.4

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/11/26/consumers-stay-strong

“Fading” Fiscal Stimulus; Really?

Posted on Updated on

November 20, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

Fed Chair Jerome Powell and others have started a new narrative about economic “headwinds.” They think past rate hikes, slower foreign growth, and “fading fiscal stimulus” shouldslow the Fed’s rate hikes. But is fiscal stimulus really fading?

Powell and others think the growth benefits of both the 2018 tax cuts and increased federal spending are winding down.This is pure Keynesian analysis and we think it’s wrong. In our view it reflects a misunderstanding of both how tax cuts work and the actual path of federal spending.

The difference is between demand-side (Keynesian thinking) and supply-side thinking. Keynesians think demand drives growth. In other words tax cuts work by putting more money in people’s pockets, which increases consumption and,therefore, GDP. They say the first year of a tax cut boosts after- tax incomes and demand, but then, stimulus fades as this boost is removed and income falls back to the previous (slower) trend.

Keynesians also believe federal government spending stimulates growth because it, too, is part of demand. In fact, government purchases are a direct part of GDP accounting and so it appears like government spending is a stimulus.

By contrast, supply-siders think incentives for entrepreneurship and investment drive growth. It is the supply of new goods and services that leads to faster economic activity.Say’s Law says “supply creates its own demand.” In otherwords, the tax cut led to better incentives to invest, work, and invent. And, as long as tax rates remain low a “permanent”change in incentives has been initiated, which will boost growth rates permanently. There is no “fade.”

Before the tax cut, the corporate tax rate in the US was approximately a combined 40% (federal, state, and local). In 2017, Canada had a corporate tax rate of 26.5%. So, there was a 13.5% incentive to invest in Canada over the US. And, at the margin, more investment went to Canada (and other countries with lower corporate tax rates) than would have been the case if the US tax rate was not the highest in the developed world.

Now the combined U.S. corporate tax rate is approximately 27%, radically changing incentives. In other words, at the margin, as long as tax rates stay where they are, there is a

permanent incentive to invest more in the US. This does not mean growth will accelerate from where it is now (roughly 3% GDP), but it will not automatically revert back to 2%, where it was from 2010-2017.

The more curious and misguided argument is that fading government spending will slow and reduce GDP. We think this comes from a misunderstanding of the budget deal which was passed last year. Yes, that budget deal increased spending, butso far it hasn’t shown up as a boost to GDP growth.

In Fiscal Year 2018, nominal GDP rose 5.0% over FY2017, while total federal spending went up just 3.2%. Government purchases, which feed directly into GDP, rose just 4.0%. In other words, relative to the private sector, government demand grew more slowly.

On top of this, total federal revenue was up 1% in FY2018. While corporate tax receipts fell 22%, total individual receipts were up 6%. In other words, while it’s true that the federalgovernment collected fewer tax receipts in FY2018 than it budgeted prior to the tax cut, it still collected more revenue than it did in FY2017.

The bottom line is that the entire demand-side basis for the fiscal stimulus argument has no data to support it. Government spending grew slower than GDP and actual tax receipts went up.As a result, any argument that there will be “fading” fiscalstimulus is based on a data that does not exist.

The reason growth has accelerated is because lower tax rates, and less regulation, increase entrepreneurial activity – a supply-side acceleration in growth, not Keynesian. Anyonewaiting for slower economic activity as fiscal stimulus “fades”will be waiting in vain.

The one worry we have is the exact opposite of what Keynesians argue. A new divided government adds to pressure for bipartisan legislation. Bipartisanship often means more government spending. As supply-siders, we view increased government spending as a drag on growth, not a boost.

The more government spends as a share of GDP, thesmaller the private sector. That’s how growth will really fade.

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

11-20 / 7:30 am

Housing Starts – Oct

1.225 Mil

1.267 Mil

1.201 Mil

11-21 / 7:30 am

Initial Claims – Nov 17

215K

215K

216K

7:30 am

Durable Goods – Oct

-2.5%

-2.8%

+0.7%

7:30 am

Durable Goods (Ex-Trans) – Oct

+0.4%

+0.9%

0.0%

9:00 am

Existing Home Sales – Oct

5.200 Mil

5.300 Mil

5.150 Mil

9:00 am

U. Mich Consumer Sentiment- Nov

98.3

98.3

98.3

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/11/19/fading-fiscal-stimulus-really

The Plentiful Job Market

Posted on Updated on

November 5, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

Growth is determined by a perpetual tug-of-war between entrepreneurship and government redistribution. When President Obama was in office, we believed incredible technological innovation would allow for economic growth in spite of Obamacare, greater redistribution, higher taxes and increased regulatory burdens. We thought it would be a Plow Horse Economy, and that things would get better if we did not grow government so much.

From mid-2009 through early 2017, real GDP grew at a 2.2% annual rate, with plodding growth in wages. It certainly wasn’t an economic boom, but it wasn’t recessionary either. For us, this meant we were shunned by both sides of the press.

We consistently repeated that the economy would grow faster with a better set of policies. So we became pariahs: liberal commentators didn’t want to hear about the free market policies we thought would improve economic growth; while conservative commentators didn’t want to hear about the economy being anything other than awful.

Now, thanks to the long-awaited corporate tax cut and deregulation, policies are more pro-growth.

In the past year, non-farm payrolls are up 210,000 per month while civilian employment, an alternative measure that includes small-business starts-ups, is up 200,000 per month. Some say, “Hey, that’s not any faster than recent years” and that’s true, but the longer expansions go, the tougher it is to sustain rapid job growth as the pool of available workers shrinks. In other words, today’s job growth is more of an achievement than it was during earlier stages of the recovery.

More important is the acceleration in workers’ paychecks. Average hourly earnings are up 3.1% from a year ago, the fastest wage growth for any 12-month period dating back to 2009. Factor-in robust gains in the total number of hours worked, and total cash earnings for workers are up 5.5% in the past year (even excluding one-time bonuses and commissions, like those paid after the tax cut was enacted late last year). That’s the fastest growth in cash earnings since recording began in 2006.

Meanwhile, the Employment Cost Index, a different measure of workers’ earnings, has also accelerated. Wages and salaries for private industry workers are up 3.1% from a year ago, the fastest pace since 2008. A year ago, in the third quarter of 2017, this measure of wages was up 2.6%. The ECI holds the weight of each industry and occupation the same over time, so the boost to wage growth is more likely to reflect faster pay increases for workers at the same job, rather than pay increases due to a shift in the mix of jobs towards those already paying higher wages.

Here’s the best part. A survey from the Labor Department on workers’ usual weekly earnings shows the fastest wage growth is for the bottom tenth of earners. Rising wages appear to be drawing more workers back into the labor force, with the number of people either working or looking for work up 162,000 per month in the past year, even as the US continues to face the demographic headwind of an aging Baby Boom generation.

It wasn’t that long ago that some analysts were complaining about too much of the job growth coming from part-time jobs. We never bought into that argument, and the data supporting it was weak. The number of people working part-time for economic reasons peaked at about 9.2 million in 2010 and now it’s down to 4.6 million. In the past eight years, part-time jobs in the economy are down 56,000, while we have added more than 17 million full-time positions.

So, now, some argue that faster job growth is due to multiple job holders. But the data don’t show that, either. Multiple job holders are 5.2% of all workers, which is lower than it was, on average, in both the prior economic expansion (2001-07) and the expansion of the late 1990s.

If someone tortures the data enough, we’re sure they could twist it into some new argument claiming things aren’t as good as they seem. And we stand ready to keep reviewing their claims to see if they make sense. So far, they haven’t. We don’t expect that to change anytime soon.

 

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

11-5 / 9:00 am

ISM Non Mfg Index – Oct

59.0

59.1

60.3

61.6

11-7 / 2:00 pm

Consumer Credit– Oct

$15.0 Bil

$14.9 Bil

$20.1 Bil

11-8 / 7:30 am

Initial Claims – Nov 3

213K

213K

214K

11-9 / 7:30 am

PPI – Oct

+0.2%

+0.3%

+0.2%

7:30 am

“Core” PPI – Oct

+0.2%

+0.2%

+0.2%

9:00 am

U. Mich Consumer Sentiment -Nov

98.0

99.1

98.6

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Review:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/11/5/the-plentiful-job-market

Robust Growth Continues

Posted on Updated on

October 22, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

Economic growth continued at a robust rate in the third quarter, supporting the case for both a continued bull market in stocks and further rate hikes from the Fed.

While we might make minor adjustments when we get Thursday’s data on durable goods, international trade, and inventories, right now our model forecasts real GDP expanded at a 3.6% annual rate in Q3. If so, the real economy grew at a 3.1% pace in the past year, a roughly 50% acceleration from the 2.1% growth rate that defined the Plow Horse Economy from mid-2009 through early 2017. It’s clear that cutting tax rates and slashing red tape have boosted economic growth. And there is room to run. We don’t see a recession coming for atleast the next two years, and potentially much longer.

But that won’t stop the pessimists, who are likely to assert that inventories artificially boosted Q3 growth. Yes, it’s truethat the pace of inventory accumulation was fast, but that simply makes up for the unusually large drop in inventories in the second quarter. A similar story holds true for net exports, which will be an unusually large drag on growth in Q3 after pushing growth higher in Q2. In other words, inventories and trade are just swapping the roles they played in Q2.

Here’s how we get to our 3.6% real growth forecast:

Consumption: Automakers reported car and light truck sales declined at a 4.8% annual rate in Q3. Meanwhile, “real”(inflation-adjusted) retail sales outside the auto sector grew at a 4.4% annual rate. Most consumer spending is on services, however, and real service spending looks like it climbed at about a 3.0% annual rate. Putting it all together, it looks like real personal consumption (goods and services combined), grew at a 3.1% annual rate, contributing 2.1 points to the real GDP growth rate (3.1 times the consumption share of GDP, which is 68%, equals 2.1).

Business Investment: Another quarter of solid growth in business investment, with our estimates showing equipment growing at an 8.5% annual rate, commercial construction

growing at a 3% rate, and intellectual property growing at a 4.5% pace. That would mean total business investment grew at a 6.0% rate in Q3, which should add 0.8 points to real GDP growth. (6.0 times the 14% business investment share of GDP equals 0.8).

Home Building: Residential construction slowed in Q3, although we think the home building recovery that started back in 2011 will revive in the quarters ahead. For now, it looks like real residential construction declined at a 2.6% annual rate in Q3, which would subtract 0.1 point from the real GDP growth rate. (-2.6 times the residential investment share of GDP, which is 4%, equals -0.1).

Government: Public construction projects soared in Q3 while military spending slowed modestly. As a result, it looks like real government purchases rose at a 1.2% annual rate, which would add 0.2 points to the real GDP growth rate. (1.2 times the government purchase share of GDP, which is 17%, equals 0.2).

Trade: At this point, we only have trade data through August. Based on what we’ve seen so far, net exports shouldsubtract 1.8 points from the real GDP growth rate. However, an advance glimpse at September trade figures arrives Thursday, which could shift this key estimate.

Inventories: We’re also working with incomplete figureson inventories. But what we do have suggests companies accumulated inventories at a rapid clip in Q3, making up forlast quarter’s reductions. This should add 2.4 points to the real GDP growth rate.

Add it all up, and we get 3.6% annualized growth. Not every quarter is going to be as fast as the last two – remember, real GDP grew at a 4.2% annual rate in Q2 – but we still expect an average growth rate of 3%+ for both 2018 and 2019. More growth, in turn, means higher profits, which should help send the stock market higher as well.

 

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

10-24 / 9:00 am

New Home Sales – Sep

0.625 Mil

0.627 Mil

0.629 Mil

10-25 / 7:30 am

Initial Claims – Oct 20

213K

210K

210K

7:30 am

Durable Goods – Sep

-1.4%

-0.9%

+4.4%

7:30 am

Durable Goods (Ex-Trans) – Sep

+0.4%

+0.5%

0.0%

10-26 / 7:30 am

Q3 GDP Advance Report

3.4%

3.6%

4.2%

7:30 am

Q3 GDP Chain Price Index

2.1%

1.7%

3.0%

9:00 am

U. Mich Consumer Sentiment- Oct

99.0

99.0

99.0

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/10/22/robust-growth-continues

Heartburn, Not a Heart Attack

Posted on Updated on

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

October 15, 2018

Not long ago, many investors were kicking themselves for not investing more when the stock market was cheaper. But when stocks fall, like they did last week, many investors have a hard time buying for fear stocks may go lower still.

Who knows, maybe they’re right. We have no idea where stocks will close today, nor at the end of the week. Corrections (both small and large) happen from time to time. In hindsight, many claim they knew it was coming, but we don’t know anyone who has successfully traded corrections on a consistent basis – we certainly won’t try.

We’re also skeptical when analysts try to attribute corrections to a particular cause. It’s a basic logical flaw: post hoc ergo propter hoc. Because the correction happened after a certain event, that event must have been the cause. But important news and economic events happen all the time. Sometimes the market goes up afterward, sometimes down, and similar events at different times have no discernible impact.

Now some are blaming the Federal Reserve, and specifically statements from Chairman Powell, for the downdraft in equities. But, according to futures markets, the outlook for monetary policy has barely changed. The markets are still pricing in a path of gradual rate hikes and continued reduction in the size of the Fed’s balance sheet.

Let’s face it, fretting over the Fed is as old as the Fed itself. In recent years alone, we faced the “Taper Tantrum” and calls for a fourth round of quantitative easing. And remember when the Fed first raised rates and then announced it would reduce its balance sheet? Each time, analysts predicted the apocalypse was upon us – that a recession and bear market were right around the corner. How did those calls pan out?

Exactly, they were wrong, and this time looks no different. QE never lifted stocks, taking it away won’t hurt; and interestrates are still well below neutral. The biggest pain has been felt by those who followed the false prophets of doom.

The odds of a recession happening anytime soon remain remote, we put them at 10%, or less. And a recession is what it would take for us to expect a full-blown bear market. In other words, the current drop is just heartburn, not a heart attack.

We’ll publish a piece next week about our exact forecast for economic growth in Q3, but it looks like real GDP rose at about a 4.0% annual rate. Profits are hitting record highs and businesses are still adapting to the improved incentives of lower tax rates and full tax expensing for business equipment. Home building is still well below the pace required to meet population growth and scrap page (roughly 1.5 million units per year). Household debts are low relative to assets and debt service payments are low relative to income. These are not the ingredients for a recession.

That’s why we love Jerome Powell’s response to the recent gyrations in the market. Many pundits were calling for him to back off his tightening and his “hawkish” language, but he didn’t take the bait. He’s focused on monetary policy, and the economy and won’t be pushed around by hysterics or market gyrations. The S&P 500 fell about 6% from its intraday all-time high to Friday’s close. This isn’t earth-shattering, and the Fed shouldn’t respond. Investors need to stop obsessing about the Fed. Instead, they should focus on entrepreneurship and profits. The fundamentals are what matter.

Meanwhile, some investors are concerned about President Trump tweeting or speaking out on the Fed and monetary policy. If this were any other president, we’d be concerned, as well. But we all know Trump isn’t the kind of president to hold his opinions close to the vest on any topic. If he thinks it, he says it. Please take his comments on the Fed in that context. That certainly seems to be what Jerome Powell is doing.

The bull market in equities that started in March 2009 isn’t going to last forever. But we don’t see anything that’s going to bring it to a screeching halt anytime soon.

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

10-15 / 7:30 am

Retail Sales – Sep

+0.6%

+0.6%

+0.1%

+0.1%

7:30 am

Retail Sales Ex-Auto – Sep

+0.4%

+0.3%

-0.1%

+0.2%

7:30 am

Empire State Mfg Survey – Oct

20.0

21.4

21.1

19.0

9:00 am

Business Inventories – Aug

+0.5%

+0.5%

+0.5%

+0.7%

10-16 / 8:15 am

Industrial Production – Sep

+0.2%

+0.1%

+0.4%

8:15 am

Capacity Utilization – Sep

78.2%

78.1%

78.1%

10-17 / 7:30 am

Housing Starts – Sep

1.210 Mil

1.251 Mil

1.282 Mill

10-18 / 7:30 am

Initial Claims – Oct 13

210K

215K

214K

7:30 am

Philly Fed Survey – Oct

20.0

16.2

22.9

10-19 / 9:00 am

Existing Home Sales – Sep

5.290 Mil

5.270 Mil

5.340 Mil

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/10/15/heartburn,-not-a-heart-attack

Powell Moves Markets

Posted on Updated on

October 8, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

Federal Reserve Board Chairman, Jerome Powell, who has been remarkably quiet as he adjusts to his new role at the Fed, finally roiled markets last week. He made comments on Wednesday, during the Atlantic Festival at a session moderated by Judy Woodruff of the PBS News Hour.

Powell said, “The really extremely accommodative lowinterest rates that we needed when the economy was quite weak,we don’t need those anymore.”

He added, “(I)nterest rates are still accommodative, butwe’re gradually moving to a place where they will be neutral.We may go past neutral, but we’re a long way from neutral atthis point.” [Our emphasis added.]

The reaction of the markets was swift and dramatic. The 10-year Treasury note rose from 3.06% on Tuesday to 3.23% on Friday, its highest yield since 2011. From their intraday highs on Wednesday to Friday’s close, the Dow Jones IndustrialAverage fell 1.8%, the S&P 500 fell 1.8%, and the NASDAQ Composite fell 3.3%.

To begin with, we agree completely with Mr. Powell. There are a number of models that purport to measure a “neutral”interest rate – a federal funds rate which does not hurt growth, but also does not lift inflation. Rates above neutral hurt the economy, rates below neutral lift inflation.

One model is the “Taylor Rule,” which is based on setting separate targets for real GDP growth and inflation and then adjusting short-term interest rates when these data deviate from the targets. For example, if inflation and economic growth are above the target, then the “neutral” rate should move higher. If the economy or inflation fall, then so should the neutral rate. There are multiple versions of the Taylor Rule and right now these versions suggest a neutral federal funds rate somewhere between 3% and 5%.

While we very much like a rule-based monetary policy, and think the Taylor Rule is a fine rule, we try to simplify things even more. We think the growth rate of nominal GDP (real growth plus inflation) is the best target. Nominal GDP (or total spending

in the economy) is a measure of the average growth rate of all business plus government. When interest rates are below thisaverage growth rate there’s an incentive for business to borroweven for projects that return less than average. This can cause distortions in the market. When rates are above this average, it can shut down activity.

Our model uses a two-year moving average of nominal GDP growth to avoid the volatility of shorter time frames. In the past, when the Fed has lifted the federal funds rate above two- year nominal GDP growth, recessions have occurred. It happened in 1969, 1973-74, twice in the early 1980s, 1990-91, 2000-01, and 2007-08.

Right now, nominal GDP growth over the past two years has been 4.6%. Looking back, a federal funds rate of roughly 50 to 75 basis points below nominal GDP growth is roughly neutral. As a result, we currently estimate a neutral rate around 4%. Moreover, we believe real GDP will keep growing at least 3% annually, while inflation continues to rise by 2% or more. Inother words, the “neutral” rate is rising. And likely movingtoward 4.5%.

This is why we agree with Chairman Powell. At the same time, we think the stock market has over-reacted, while the bond market is finally bowing to the reality that longer-term rates are heading much higher.

We have never believed that long-term rates were being held down by recent slow growth or low foreign rates. We believe they have been held down by the Fed’s policy of low short term rates and the market belief that the Fed would hold them low. That has now changed.

And, yes, higher interest rates do reduce the fair value of equities. But even with current earnings, it would take a 3.7% 10-year yield to make current equity values “fair.” With earningslikely to grow 20%+ this year and 10%+ next year, the market can handle higher interest rates and continue to rise. Higher rates are coming, but that doesn’t mark the end of the recovery or the bull market.

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

10-10 / 7:30 am

PPI – Sep

+0.2%

+0.2%

-0.1%

7:30 am

“Core” PPI – Sep

+0.2%

+0.2%

-0.1%

10-11 / 7:30 am

Initial Claims – Oct 6

210K

206K

207K

7:30 am

CPI – Sep

+0.2%

+0.2%

+0.2%

7:30 am

“Core” CPI – Sep

+0.2%

+0.2%

+0.1%

10-12 / 7:30 am

Import Prices – Sep

+0.2%

0.0%

-0.6%

7:30 am

Export Prices – Sep

+0.2%

+0.2%

-0.1%

9:00 am

U. Mich Consumer Sentiment- Oct

100.6

100.6

100.1

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/10/8/powell-moves-markets

No Looming Recession

Posted on Updated on

October 1, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist & Strider Elass – Senior Economist

As far as Harvard economist Martin Feldstein is concerned, we’re all doomed. Feldstein says that the low interest rates of the last several years have created a stock market bubble rivaling the housing bubble that precipitated the last crisis. As interest rates keep rising, he says, the stock market bubble will eventually burst, sending the economy into another “long and deep downturn.”But, unlike in the prior recession, with interest rates still relatively low, the Federal Reserve will have less room to respond to a weaker economy.

We have to admit to feeling a little awkward disagreeingso strongly with Feldstein. He’s been a long-time advocate of lower tax rates and less government spending, policy positions near and dear to our hearts.

But, when it comes to forecasting what the economy will do in the next few years, we think he’s laid an egg.

Why? Let’s start by looking back. We like to assess fair value in residential housing by comparing the asset value of owner-occupied homes to the annualized rent these homes could earn. Using historical averages, our calculations suggest home prices were about 40% above fair value at the end of 2005. With US homes valued at about $21 trillion, that meant an overvaluation of about $6 trillion. (Note: When an asset is priced 40% too high, it takes a loss of 28.6% from theovervalued level to bring the price down to fair value.) For perspective, GDP was $13 trillion that year.

By contrast, the stock market is not even close to that kind of overvaluation. At present, the price-to earnings ratio on the S&P 500 is 22.3. The average in the past 40 years is 20.2. So even if you accept the P-E ratio as the gospel (and we don’t), equities only appear about 10% over-valued.

Except the current P-E ratio only reflects two quarters of the tax cut so far. The forward P-E ratio is 16.9, which leaves room for a 20% rally in equities just to get back to the 40-year average of 20.2 (assuming earnings estimates are accurate.) Moreover, the average P-E ratio of 20.2 over the past 40 years was established when the yield on the 10-year Treasury Note was averaging 6.26%, not the 3.06% it’s at today. In other words, bonds were a much more attractive alternative to equities in the past than they are today.

The basic problem with all this is that if you want to sound smart – and if you want media attention – it’s better to be a pessimist. Warn people about impending doom and they hang on every word. And let’s be honest, telling people the bull market has room to roam is not the best way to get published.

We’re sure the economy will eventually face another recession. It may even be a deep one, although our best bet is that the next recession will be mild compared to the last. When it happens, the pessimists will tell you how they got it right all along. But getting it right, briefly, at least a few years from now is not worth losing out on the gains to be made in the meantime. Those who stay long equities will be rewarded.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/10/1/no-looming-recession

Previewing the Fed

Posted on Updated on

September 24, 2018

Brian S. Wesbury – Chief Economist, Robert Stein, CFA – Dep. Chief Economist, & Strider Elass – Senior Economist

The Federal Reserve meets on Wednesday and there’s one thing we know for sure: it’s going to raise rates by another 25 basis points, lifting the federal funds rate to a range from 2.00 to 2.25%.

Why are we so confident? Two reasons. First, the market in federal funds futures is putting the odds of a September rate hike at 99%. For the Fed to let those odds get so high without pushing back forcefully with speeches and leaks to friendly reporters means the Fed is fully on board.

Second, and much more important, it’s the right thing to do. Nominal GDP – real GDP growth plus inflation – is up 5.4% in the past year and up at a 4.6% annual rate in the past two years. An economy growing at that pace calls for higher short-term rates.

But the meeting is not only about changing the level of short-term rates; it’s also about signaling the path of future rate hikes as well as the continued reduction in the size of the Fed’s balance sheet, which became bloated during and after the financial crisis a decade ago.

Back in June, the last time the Fed issued economic projections, it forecast that real GDP would be up 2.8% this year and 2.4% next year. But, given the momentum in the economy, we think the Fed may lift these forecasts. It may also want to reconsider its projections for inflation now that its favorite measure of inflation – the PCE deflator – is already up 2.3% from a year ago

In turn, that should translate into a more aggressive “dot plot,” as well. In June, the consensus at the Fed – the “median dot” – showed a total of four rate hikes this year, with one more hike in September and a last one in December. But almost half of the voters at the Fed had the Fed stopping at the third rate hike this year or maybe even stopping at two in June. That’s going to change substantially on Wednesday and we expect a large majority at the Fed projecting a fourth rate hike in December. Our best guess is that the median dot will still show three rate hikes in 2019, but that may change in December, by which time the Commerce Department will have reported strong real GDP growth for the third quarter.

In the end, we expect four more rate hikes in 2019. That would take the federal funds rate to a range of 3.25 to 3.5%. Right now, that’s not what the market expects. The market is putting the odds of four rate hikes or more next year at 5%. As the economy continues to impress, look for those odds to soar over the next several months. In turn, that means long-term Treasury yields keep trending higher, as well.

 

The Fed may also consider using Wednesday’s meeting to change some wording that’s been in every Fed statement since December 2015, which was the first time the Fed raised rates after the financial crisis. The language is “The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.”

Some at the Fed may think Wednesday’s rate hike means monetary policy is no longer accommodative. That would be a mistake. But others may want to rightly change the wording because inflation already exceeds 2%. As a result, the Fed needs to start considering how tight it may eventually have to get to keep inflation from staying above 2%.

Just remember, though, that nothing the Fed does on Wednesday is worthy of obsession. Just because the financial media dwells on every word from the Fed, doesn’t mean investors should. Instead, focus on profits, which, continue to point to a robust bull market.

 

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

9-26 / 9:00 am

New Home Sales – Aug

0.630 Mil

0.624 Mil

0.627 Mil

9-27 / 7:30 am

Initial Claims – Sep 22

210K

220K

201K

7:30 am

Q2 GDP Final Report

4.2%

4.1%

4.2%

7:30 am

Q2 GDP Chain Price Index

3.0%

3.0%

3.0%

7:30 am

Durable Goods – Aug

+1.9%

+2.1%

-1.7%

7:30 am

Durable Goods (Ex-Trans) – Aug

+0.4%

+0.6%

+0.1%

9-28 / 7:30 am

Personal Income – Aug

+0.4%

+0.4%

+0.3%

7:30 am

Personal Spending – Aug

+0.3%

+0.3%

+0.4%

8:45 am

Chicago PMI

62.0

64.5

63.6

9:00 am

U. Mich Consumer Sentiment- Sep

100.5

100.8

100.8

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.