Yield Curve Inversion

Posted on Updated on

July 16th, 2018

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

The yield spread between the 2-year and 10-year Treasury Note has narrowed to 25 basis points, its smallest spread since 2007. This has many investors worried the narrowing spread will lead to an inversion of the yield curve (when short-term rates exceed long-term rates) – which throughout history has often occurred prior to a recession.

In reality, an inverted yield curve simply means long-term investors expect short-term rates to fall in the future. A 2-year bond is just two 1-year bonds, one after another. So if the 2- year yield is below the 1-year yield, then investors are saying the yield on the 1-year bond, one year from now, is expected to be lower.

For the record, an inverted yield curve does not cause a recession. Typically, the yield curve inverts because the Fed drives short-term interest rates too high and over-tightens monetary policy. It’s this tight monetary policy that causes the recession, the inversion is a symptom of the bigger issue. Investors, realizing the Fed is too tight, push long-term rates down because they expect the Fed to reduce short-term rates in the future. It’s the overly-tight Fed that causes both the recession and the inverted yield curve.

This is why we do not believe the current narrowing yield spread signals looming recession. The Fed is far from being tight. Short-term rates remain well below the pace of nominal GDP growth, and even below many measures of inflation. As a result, rates are likely to rise in the future, not fall. If anything, the 10-year Treasury note appears overvalued – possibly in a bubble (meaning yields on the 10-year Treasury are far too low).

But just like most overvalued markets, investors seek ways to justify it. In 1999, despite weak – or no – earnings growth, the US stock market became massively overvalued. By our measures, over 60% above fair value.

This has now apparently happened to the Treasury market. Justification for low yields include low foreign yields, an imminent recession, and a belief the Fed is (or will soon become) too tight.

Nominal GDP (real growth plus inflation) grew 4.7% in the four quarters ending in March, and looks to have grown even faster in the four quarters ending in June. At 2.83%, the 10-year Treasury note yield is 187 basis points below nominal GDP growth. For comparison, over the past 20 years (1997- 2017) – the 10-year Note yield averaged just 43 basis points less than nominal GDP growth. In other words, today’s spread is substantially – and we think unsustainably – larger than its 20-year average.

Nominal GDP growth is a good proxy for a “natural or neutral” rate of interest because it’s the average rate of growth in the economy – a reasonable proxy for investment returns. Some companies grow much faster than GDP, some grow much slower.

If interest rates are well below nominal GDP, then companies growing less than average are encouraged to borrow. But this makes no economic sense. It’s “malinvestment”…investment that hurts growth and slows the creation of wealth. In other words, interest rates today are well below levels justified by fundamentals.

More importantly, the economy is accelerating, and the Fed is chasing both rising real growth and rising inflation. Even if the Fed lifts rates to 3.5% by the end of 2019 (which would require six more rate hikes at the current pace), the Fed will still not be tight relative to nominal GDP growth. So, the odds of a recession in the next few years remain very low even if we get a technical inversion.

That said, we don’t expect the yield curve to invert in the near future. It may. But if it does, it just means that the bubble in long-term rates still exists. At some point that will cease. It won’t be pretty for long-term bond holders, but at least it should end the inversion-recession fears.

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

7-16 / 7:30 am

Retail Sales – Jun

+0.5%

+0.6%

+0.5%

+1.3%

7:30 am

Retail Sales Ex-Auto – Jun

+0.3%

+0.4%

+0.4%

+1.4%

7:30 am

Empire State Mfg Survey – Jul

21.0

19.0

22.6

25.0

9:00 am

Business Inventories – May

+0.4%

+0.4%

+0.4%

+0.3%

7-17 / 8:15 am

Industrial Production – Jun

+0.5%

+0.6%

-0.1%

8:15 am

Capacity Utilization – Jun

78.2%

78.3%

77.9%

7-18 / 7:30 am

Housing Starts – Jun

1.320 Mil

1.307 Mil

1.350 Mil

7-19 / 7:30 am

Initial Claims Jul 15

221K

220K

214K

7:30 am

Philly Fed Survey – Jul

21.5

24.5

19.9

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/2018/7/16/yield-curve-inversion

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Job Market: From Strength to Strength

Posted on Updated on

July 9th, 2018

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

The US labor market is going from strength to strength. Like with corporate earnings, June jobs data beat consensus estimates – up 213,000 – pushing the average monthly gain for the past year to 198,000 per month.

Meanwhile the unemployment rate jumped from 3.8% to 4.0%. Why? Because the civilian labor force grew by 601,000.We hate blowing one month’s data point out of proportion, butthere is enough concurrent evidence out there to conclude that this gain in the labor force is a bullish sign for the economy. It signals that fewer people are counting on the government for support.

There are two ways to shrink the welfare state. One way is to directly cut welfare benefits. That’s a structural change that encourages work no matter where the economy is in the business cycle. The other method is indirect: adopt policies that help the economy grow faster and let private sector opportunity pull people out of the government’s welfare system and back into the labor market. Right now, that second method is taking hold.

The number of people getting Food Stamps (SNAP benefits, which stands for the Supplemental Nutrition Assistance Program) fell to 39.6 million in April, down 4.7% from a year ago and the lowest level since about 2010. This isn’t because it’s harder to get food stamps, it’s because the rewards for work are rising.

In the second quarter of 2018, applications for Social Security disability benefits (SSDI) were down 2.3% from the same period a year ago. That’s on top of a 6% decline for full- year 2017 from 2016. And last year also saw 1.3% fewer workers collecting disability benefits than in 2016, the biggest annual decline since 1983. This year, that number has continued to decline. In other words, the job market is plenty strong enough to pull workers back into the private sector.

Although average hourly earnings are up a respectable, but not stellar, 2.7% from a year ago, hundreds of companies are paying “one-time” bonuses to their workers, either based on tax reform or as a way for companies to attract workers without raising their long-term costs, particularly in the trucking sector. These bonuses are helping push down both the median duration of unemployment, and already low unemployment rates across education levels, sexes and races.

While unemployment rates by racial/ethnic categories are volatile from month-to-month (and why we prefer to focus on the trend), the black unemployment rate increased from a near record low in June, but the Hispanic jobless rate fell to 4.6%, the lowest for any month since the government started tracking the data in the early 1970s. And for the past 12 months, the average unemployment rate for both blacks and Hispanics fell to the lowest levels ever recorded, dating back to the early 1970s.

None of this means the labor market is perfect. It never is. Back in the late 1990s, the participation rate among prime- age workers (age 25-54) reached a peak of 84.6%. Right now, their participation rate is 82%. But this is a double-edged sword…where some see imperfection, others see room for further growth. Where some see a labor market that can’t get any better, others see opportunity.

We fall in the second camp. Extremely low unemployment rates and rising earnings mean that private sector employment is becoming increasingly more attractive than static government programs. And with more workers moving into the private sector, it’s not hard to see better times for workers ahead. The tax cut happened just over six months ago. Deregulation is encouraging more business investment. Corporate earnings continue to exceed expectations. The job market looks set for even more strength.

 

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

7-9 / 2:00 pm

Consumer Credit– May

$12.0 Bil

$15.5 Bil

$9.3 Bil

7-11 / 7:30 am

PPI – Jun

+0.2%

+0.2%

+0.5%

7:30 am

“Core” PPI – Jun

+0.2%

+0.3%

+0.3%

7-12 / 7:30 am

Initial Claims – July 7

225K

226K

231K

7:30 am

CPI – Jun

+0.2%

+0.2%

+0.2%

7:30 am

“Core” CPI – Jun

+0.2%

+0.2%

+0.2%

7-13 / 7:30 am

Import Prices – Jun

+0.1%

+0.2%

+0.6%

7:30 am

Export Prices – Jun

+0.2%

+0.2%

+0.6%

9:00 am

U. Mich Consumer Sentiment- Jul

98.2

98.7

98.2

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/2018/7/9/job-market-from-strength-to-strength

Election Outlook

Posted on Updated on

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

At least three reasons suggest the Democrats should be optimistic about taking control of the House this November.

First, the party controlling the White House typically loses seats in mid-terms. These include “tidal waves” against the president’s party like in 1994 and 2010, when newly-elected presidents Bill Clinton and Barack Obama watched their parties lose 54 and 63 seats, respectively. Yes, 2002 was an exception, when the GOP gained 8 seats under President Bush. But that was after 9/11 when the nation was focused on national security, where the GOP had a significant advantage.

The second is the number of House Republicans who have announced retirements since the last election – 40+ at last count. Some read this as a sign of low confidence in retaining control.

The third reason is that in special congressional elections in 2017-18, Democrats have typically outperformed by about 16 percentage points compared to what they normally do.

Yet the President’s job approval rating has improved thisyear. Last December, his approval was at an all-time low of 37%; now it’s above 43%.

The last time the Democrats won the House from the GOP was in 2006. Back then, in early July, they were winning in the“generic ballot” (the poll that asks which party you’d rather control the House) by 12 points; now they’re winning by about6 points. In other words, 2006 this is not, at least not yet.

It still looks like the Democrats are going to pick up some seats in the House, but it also looks like the Blue Wave crested early, so a tidal wave is unlikely. Instead, it looks like it will go down to the wire, and will give the Republicans a very slight edge, although we wouldn’t be shocked by a narrow Democratic victory, either. It’s even possible the GOP loses but a handful of seats.

Meanwhile, Republicans are in good shape in the Senate. Currently, the GOP has a slight 51-49 edge over the Democrats. But, of the 35 Senate seats contested in November, the Democrats already occupy 26, while Republicans have only 9, giving the Democrats few opportunities to make gains.

Even worse for the Democrats is having five incumbents running in states Trump easily won by double-digit margins. By contrast, the only vulnerable Republican seats are in Nevada, which Trump lost by just 2 points, Arizona, where he won by 3.5 points, and Tennessee, where he won by 26 points. As a result, we think the Republicans will probably gain two seats in the Senate this year.

If we’re right, with one party narrowly controlling theHouse and the GOP enlarging their majority in the Senate, it will be a tougher legislative environment for the president. But the Senate controls appointments to the Courts and agencies and, as long as the president can keep his own party in-line, he will have broad discretion to pick who he wants.

This means the deregulatory agenda stays on track, which will be a tailwind for equity investors and the economy in the next two years. At the same time, tax cuts won’t be repealed and there is little change to the outlook for spending, either pro or con. The political environment is changing, but the investing environment remains positive.

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

7-2 / 9:00 am ISM Index – Jun 58.5 58.8 60.2 58.7

9:00 am Construction Spending – May +0.5% +0.4% +0.4% +0.9%

7-3 / 9:00 am Factory Orders – May 0.0% +0.2% -0.8%

Afternoon Total Car/Truck Sales – Jun 17.0 Mil 16.9 Mil 16.8 Mil

Afternoon Domestic Car/Truck Sales – Jun 13.0 Mil 12.9 Mil 12.8 Mil

7-5 / 7:30 am Initial Claims – Jun 30 225K 223K 227K

9:00 am ISM Non Mfg Index – Jun 58.3 58.3 58.6

7-6 / 7:30 am Non-Farm Payrolls – Jun 195K 191K 223K

7:30 am Private Payrolls – Jun 190K 188K 218K

7:30 am Manufacturing Payrolls – Jun 15K 15K 18K

7:30 am Unemployment Rate – Jun 3.8% 3.8% 3.8%

7:30 am Average Hourly Earnings – Jun +0.3% +0.2% +0.3%

7:30 am Average Weekly Hours – Jun 34.5 34.5 34.5

7:30 am Int’l Trade Balance – May -$43.6 Bil -$42.9 Bil -$46.2 Bil

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:

Bonds Misjudge The Future

Posted on Updated on

June 18th, 2018

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

We’ve always been skeptical that bond yields carry deep meaning about the future. Low Treasury bond yields in recent years were said to be a signal of slower growth, or possibly a recession, ahead. And the bond world said stocks were over- valued.

Clearly, the forecasted recession never came. Not only is the economy accelerating, but the recovery is likely to become the longest on record. And stocks have handily outperformed bonds.

Now, low bond yields are supposed to signal the Fed is getting close to being too tight. Either too many rate hikes will cause a recession, or the Fed will hike rates only twice next year as the economy slows. And, of course, the bond world says this too is bad for stocks.

We see at least two mistaken beliefs that are influencing bond bulls these days. The first mistake is that the Fed will lift rates only once or twice in 2019. We believe four rate hikes are more likely, with more to follow in 2020. The reason is simple. Nominal GDP is accelerating, and likely to grow at a rate of 5%+ over the next few years.

But four rate hikes of 0.25% in 2019, after two more in 2018, will only push the federal funds rate near 3.5%. History (in 1969, 1973, early 1980s, late 1980s, 2000, and 2007) shows that, in order for the Fed to create a recession, it needs to push the federal funds rate above nominal GDP growth. Right now, the Fed is chasing growth, and bond markets are underestimating how much rates must rise before policy becomes “tight.”

This, we believe, has pushed the long-term bond market into what appears to be a bubble. At a 2.92% yield, the implied Price-Earnings (PE) ratio for the 10-year Treasury Note is 34.2, with zero chance of an increase in earnings in the next 10 years.

That doesn’t sound like a very good investment to us.Real GDP is likely to grow at a 3% rate this year, while consumer prices should rise 2.5%. In other words, nominal GDP – total spending in the US economy – will rise by 5.5% in 2018, which means revenue at the “average” company will grow at that pace, as well – double the yield on a 10-year Note.

Corporate profits are growing even faster than GDP –most likely 20%+ this year – and hundreds of companies have raised dividends in the past year. The PE ratio of the S&P 500 is 21 based on trailing twelve months’ earnings, and less than 17 on forward earnings.

Yet, even with all that data in front of them, many bond investors are convinced the 10-year yield is likely to decline in the next year, making long-term bonds a slightly more palatable investment.

Instead, it looks like the bond market is acting like the stock market in 1999, when our capitalized profits model said stocks were 62% overvalued. But, like all bubbles, a vast majority of investors still believed stocks could go higher. Obviously, they were wrong.

The second mistake animating the bond market is the belief that the narrowing spread between the federal funds rate and the IOER (Interest Rate on Excess Reserves) signals a developing shortage of reserves – a sign of tight Fed policy.

Yet, there are still $1.9 trillion in excess reserves in the banking system – which contradicts any belief that Fed policy is remotely close to being tight. There are very few banks that actually trade federal funds, because they simply don’t need them.

Meanwhile, the Fed has been doing reverse repos with institutions (like Fannie Mae and Freddie Mac) because it is not allowed to pay them interest on reserves. What has happened is that those reserves (the Fannie/Freddie kind) have now been mostly drained from the system, which means the difference between these short-term rates is narrowing. This is not a sign of a lack of bank reserves, just that excess liquidity outside of the banking system is getting tighter and more competitive.

As a result, the IOER is becoming the most important short-term rate in the monetary system. Today, at 1.95%, it is still too low. The key question is whether the Fed can pay banks enough not to lend out that money, even as accelerating growth creates more profitable opportunities to lend. If the Fed can do that – pay banks not to lend – then excess reserves are not a sign of easy money. But, lending rates are still much higher than IOER, and banks have excess capital as well.

In other words, the Fed is nowhere near “tight,” and themarket is mis-pricing both growth and inflation risks to bond yields. Rates look far more likely to rise than fall.

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

6-19 / 7:30 am

Housing Starts – May

1.314 Mil

1.289 Mil

1.287 Mil

6-20 / 9:00 am

Existing Home Sales – May

5.530 Mil

5.460 Mil

5.460 Mil

6-21 / 7:30 am

Initial Claims – Jun 17

220K

222K

218K

7:30 am

Philly Fed Survey – Jun

29.0

33.1

34.4

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/2018/6/18/bonds-misjudge-the-future

Is 2020 the Year for Recession?

Posted on Updated on

June 11th, 2018

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

According to former Fed Chair Ben Bernanke, the U.S. economy will get a Wile E Coyote surprise in 2020. You know, just when everyone thinks he caught the Roadrunner, Wile notices he has run straight off a cliff, plummets seemingly forever before hitting the bottom in a cloud of dust, and then, just for spite, an anvil lands on his head.

In other words, Bernanke sees a 2020 recession looming. Other analysts are saying it, too. And whenever they do, they get their name in the headlines. Scaremongering attracts attention.

But there is good news here: The Pouting Pundits of Pessimism don’t think the crisis starts tomorrow. No longer does some exogenous crisis event – say, Brexit, or Grexit, student loan defaults, etc., – threaten imminent collapse. Now, the recession doesn’t happen for another two years.

Another interesting detail: the new problem is that the economy is growing too fast. Remember when analysts used tosay, “since the economy is growing less than 2% annually, itmeans a recession is coming”? Now, Bernanke says the U.S.applied stimulus (in the form of a tax cut) “at the very wrong moment,” with the economy already at full employment. In other words, real GDP growth is too strong, so the Fed will over-tighten and a recession is inevitable.

Now we agree that a recession is coming – someday. Recessions are a fact of life, like death and taxes. But predicting one in 2020 – and being right about it – is likereading tea leaves, it’s pure chance. No one, and we mean no one, can honestly see that far in the future – not with the clarity expressed by these dated forecasts.

No one knows exactly what the Fed will do, not even the Fed. Let’s say they follow their forecasts, raising fed funds to 3.5% in 2019. That alone doesn’t tell us if policy is “tight.”

While most recessions are caused by an excessively tight Fed, we don’t think the Fed is too tight until it drives the federal funds rate close to, or above, the rate of growth in nominal GDP. Over the past five years, nominal GDP has averaged about 3.9%. Which means if the Fed were to raise the funds rate by 0.25% three more times in 2018 and four times in 2019 (reaching 3.5%), and if nominal growth slowed to 3.5%, the Fed would be tight at that point. A recession would be possible.

However in the past year, nominal GDP growth has accelerated to 4.7%, and next year it could be as high as 6%. That means a 3.5% federal funds rate would not be restrictive. The Fed would have to raise rates faster and farther than any forecast we have seen in order to be “tight” going into 2020. At the same time, there are still at least $1.9 trillion in excess bank reserves. Until those reserves are eliminated, no one knows if raising rates can actually cause a recession.

We do have one major worry. Government spending is rising rapidly, and the deficits this spending creates will put pressure on politicians. If they were to raise tax rates, this could cause potential problems for U.S. growth.

But the bottom-line remains: the U.S. is not facing animminent threat. That’s why doom and gloomers have shiftedto forecasting future recessions, not looming crises. But wethink it’s not going to be the economy that gets an anvil on itshead in 2020. More likely, it’ll be investors who believe in the recession forecast.

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

6-12 / 7:30 am CPI – May +0.2% +0.2% +0.2%

7:30 am “Core” CPI – May +0.2% +0.2% +0.1%

6-13 / 7:30 am PPI – May +0.3% +0.3% +0.1%

7:30 am “Core” PPI – May +0.2% +0.2% +0.2%

6-14 / 7:30 am Initial Claims – June 10 224K 224K 222K

7:30 am Retail Sales – May +0.4% +0.6% +0.2%

7:30 am Retail Sales Ex-Auto – May +0.5% +0.5% +0.3%

7:30 am Import Prices – May +0.5% +0.6% +0.3%

7:30 am Export Prices – May +0.3% +0.4% +0.6%

9:00 am Business Inventories – Apr +0.3% +0.3% 0.0%

6-15 / 7:30 am Empire State Mfg Survey – Jun 19.0 19.1 20.1

8:15 am Industrial Production – May +0.2% -0.1% +0.7%

8:15 am Capacity Utilization – May 78.1% 77.9% 78.0%

9:00 am U. Mich Consumer Sentiment- Jun 98.5 98.5 98.0

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:

Why Not 50?

Posted on Updated on

May 21st, 2018

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

Asking if the Federal Reserve will lift the federal funds rate on June 13 is like asking if Las Vegas Golden Knights goalie Marc-Andre Fleury, who has stopped 94.7% of the shots against him in the 2018 Stanley Cup playoffs, will stop the next one. It’s a virtual lock.

And everyone knows the rate hike is almost guaranteed to be the very same 25 basis point (bp) increment the Fed has used six times in the current rate hiking cycle, starting in December2015. In fact, that’s the same 25 bp increment the Fed used consistently between June 2004 and June 2006, totaling seventeen drip-drip-drip rate hikes in all. That campaign lifted rate 425 bps total, every one of which was telegraphed. Rates moved from a starting point of 1% to a peak of 5.25%.

We need to go all the way back to May 2000 to find a meeting at which the Fed raised rates by 50 bps – the final rate hike of that cycle – after a series of 25 bp hikes that started in mid-1999. In other words, the Fed has become comfortable and predictable with 25 bp moves, which seems to be all about not getting blamed for any kind of short-term market turmoil.

So why not raise by 50 bps?

Everyone knows the Fed will lift rates by at least another 50 bps this cycle. The federal funds futures market puts the odds of the Fed raising rates by less than 50 bps this year at 6.6%. We’re sure the odds would be even lower if we included2019. That’s as close to a sure thing as Marc-Andre Fleury.

So, if the Fed is going there anyhow, why not get there sooner? Why not get to a neutral monetary policy more quickly? Why be so predictable?

Raising rates by 50 bps this early in the cycle isn’t goingto make monetary policy tight. Right now, nominal GDP (real GDP growth plus inflation) is up 4.8% in the past year and up at a 4.4% annual rate in the past two years, well above the current federal funds target of 1.625%. The 10-year Treasury yield is about 145 bps above the funds rate. Meanwhile, the banking system is chock full of excess reserves and a record amount of capital. Congress and executive agencies are moving to undo some of the excess regulations on the banking system, there are no major bubbles in the financial system, and corporate balance sheets are in fantastic shape.

Add in an unemployment rate of 3.9%, well below theFed’s consensus view that its long-term average will be 4.5%. Plus, the PCE deflator, the Fed’s favorite inflation measure, is already up 2% from a year ago and, given the recent rise in oil prices, should hover persistently above 2% for the rest of the year.

One of the key problems with “forward guidance” andgradually lifting interest rates on a predictable schedule is thatit’s too predictable. It’s like clockwork. At present, everyone thinks they can predict the movement of future short-term rates with little to no risk. Which is exactly what happened in the previous decade. By telegraphing every move, the financial system could use simple spreadsheets to build a strategy for taking advantage of 25 bp moves at every meeting. This led to a complacency and a willingness by many players to take on excessive risk. In many ways, this is the same thing President Trump complained about with our military – always telling the world exactly what we would do and when we would do it.

To be precise, we’d like to see the Fed raise rates by 50bps in June. Then, using its dot plot and press conference, the Fed could signal more rate hikes to come while also, by going 50 bps at this meeting, signal that timing is always on the table. In other words, the Fed would probably raise rates by a total of 100 bp this year, but the average level of short-term rates in 2018 would be slightly higher than if it moved only 25 bps at a time. This would move long-term rates higher sooner as well.

Surprising the market would not be the end of the world. Back in September, the Bank of Canada surprised with a rate hike and lived to tell the tale. Canadian equities are up since then. And the Canadian dollar is up, as well.

Once again: we’re not holding our breath waiting for theFed to surprise the market. The most likely outcome on June 13 is yet another 25 bp rate hike. But if the Fed really wants to prevent the kinds of imbalances that built up before the last recession, it should consider introducing some upside uncertainty into the path of short term rates.

630-517-7756 • http://www.ftportfolios.com

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

5-23 / 9:00 am

New Home Sales – Apr

0.679 Mil

0.666 Mil

0.694 Mil

5-24 / 7:30 am

Initial Claims May 19

220K

217K

222K

9:00 am

Existing Home Sales – Apr

5.550 Mil

5.480 Mil

5.600 Mil

5-25 / 7:30 am

Durable Goods – Apr

-1.3%

-1.2%

+2.6%

7:30 am

Durable Goods (Ex-Trans) – Apr

+0.5%

+0.7%

+0.1%

9:00 am

U. Mich Consumer Sentiment- May

98.8

98.8

98.8

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.

Don’t Compare Stocks to GDP

Posted on Updated on

May 7th, 2018

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

The bull market in U.S. stocks, which started on March 9, 2009, gets little respect. Those who have been bullish, and right,are mocked as “perma-bulls,” while “perma-bears,” who have been repeatedly wrong, are quoted endlessly.

We don’t have enough fingers and toes to count the number of times a recession has been predicted. Brexit, Grexit, adjustable rate mortgages, student loans, the election of Donald Trump, tapering, rate hikes, a 3% ten-year Treasury yield, Hindenberg Omens, Death Crosses, and two fiscal cliffs are just a few of the seemingly endless list of things that were going to end the bull market. (And the pouting pundits of pessimism are never held accountable for erroneously spreading fear.)

One staple of the bearish argument, and the one we want to discuss today, is that corporate profits have grown faster thanGDP. This, the bears have claimed for years, can’t last. Theargument is that there will be a reversion to the mean, profit growth will slow sharply and an overvalued market will be exposed. A close cousin to this argument is that stock market capitalization has climbed above GDP, signaling over-valuation.

Both of these arguments make fundamental mistakes: first, about the relationship between GDP and profits; second, about the correct measurement of GDP.

The economy is a combination of the public sector and the private sector. Most people think direct government purchases of goods and services, which were 17.2% of GDP last quarter, represents the full impact of government on the economy. But total Federal, State and Local spending (which adds in entitlement spending, welfare, and government salaries), as well as the cost of complying with government regulations, raises the number to 45% of GDP. And because the private sector pays for every penny of government spending, resources directed by the government are significantly larger than just purchases.

There is little doubt that the growth rate of productivity in the private sector is much stronger than in the public sector. In fact, it is probably true that productivity growth in the public sector is negative – directly, and indirectly – through the burden of regulatory costs. If 55% of the economy (private spending) experiences strong productivity, but 45% of the economy (the public sector) experiences negative productivity, overall GDP and productivity statistics are dragged down.

In other words, secular stagnation is a figment of the average – government has grown too big and is a drain on the economy. Yes, private sector growth (and profits) can growfaster than GDP. It’s not a bubble, it only looks like a bubble when looking up from the hole government has created.

The second important point is that GDP is a flawed measure of economic activity. It tracks final sales, but not “total”economic activity. A new car may cost $42,000, but the total amount of economic activity to build and sell that car (the total of all the checks written between businesses and consumers) is significantly more than the final cost of the car. Much business- to-business activity is not captured directly in GDP.

Mark Skousen has pushed for years for the Bureau of Economic Analysis to publish “Gross Output (GO),” whichincludes all economic activity. And in Q4-2017 GO was $34.5 trillion, nearly double the $19.7 trillion reading for GDP.

If you really want to compare the market cap of U.S. corporations to the correct measure of economic output, it is much more logical to compare it to Gross Output, not GDP. By that measure the market cap of the U.S. stock market is still well below overall economic activity.

The real issue here is that investors should care little about GDP. No one buys shares of GDP. Investors buy shares of companies, and profits are proof that productivity is strong in the private sector. Government distorts the picture, showing both asecular stagnation and “bubble” that don’t really exist.

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

5-7 / 2:00 pm

Consumer Credit – Mar

$15.2 Bil

$19.1 Bil

$10.6 Bil

5-9 / 7:30 am

PPI – Apr

+0.2%

+0.3%

+0.3%

7:30 am

“Core” PPI – Apr

+0.2%

+0.3%

+0.3%

5-10 / 7:30 am

Initial Claims – May 5

219K

221K

211K

7:30 am

CPI – Apr

+0.3%

+0.3%

-0.1%

7:30 am

“Core” CPI – Apr

+0.2%

+0.2%

+0.2%

5-11 / 7:30 am

Import Prices – Apr

+0.5%

+0.3%

0.0%

7:30 am

Export Prices – Apr

+0.4%

+0.3%

+0.3%

9:00 am

U. Mich Consumer Sentiment- May

98.3

99.3

98.8

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.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/5/7/dont-compare-stocks-to-gdp

3% – Why It Doesn’t Matter

Posted on Updated on

April 30th, 2018

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

Just a few weeks ago, the Pouting Pundits of Pessimism were freaked out over the potential for the yield curve to invert. They’ve now completely reversed course and are freaked out over a 3% 10-year Treasury note yield.

All this gnashing of teeth is driven by a belief that low interest rates and QE have “distorted” markets, created a“mirage,” a “sugar high” – a “bubble.”

These fears are overblown. Faster growth and inflation are pushing long-term yields up – a good sign. And, yes, the Fed is normalizing its extraordinarily easy monetary policy, but that policy never distorted markets as much as many people suspect. Quantitative Easing created excess reserves in the banking system but never caused a true acceleration in themoney supply. That’s why hyper-inflation never happened and both real GDP and inflation remained subdued. Profits, not QE, lifted stocks.

And our models show that low interest rates were never priced into equity values, either. We measure the fair value of equities by using a capitalized profits model. Simply put, we divide economy-wide corporate profits by the 10-year Treasuryyield and compare these “capitalized profits” to stock pricesover time. In other words, we compare profits, interest rates, and equity values and determine fair value given historical relationships. The lower the 10-year yield, the higher the model pushes the fair value of stocks.

Because the Fed held short-term rates so low, and gave forward guidance that they would stay low, they pulled long- term rates down, too. As a result, over the past nine years, artificially low 10-year yields have caused our model to show that stocks were, on average, 55% undervalued.

In other words, stocks never priced in artificially low interest rates. If they had, stock prices would have been significantly higher, and in danger of falling when interest rates went up.

But we have consistently adjusted our model by using a 3.5% 10-year yield. Using that yield today, along with profits from the fourth quarter, we show the stock market 15% undervalued. In other words, we’ve anticipated yields risingand still believe stocks are undervalued. A 3% 10-year yield does not change our belief that stocks can rise further this year, especially with our expectation that profits will rise by 15-20% in 2018.

The yield curve will not invert until the Fed becomes too tight and that won’t happen until the funds rate is above the growth rate of nominal GDP growth. Stay bullish.

 

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

4-30 / 7:30 am Personal Income – Mar +0.4% +0.4% +0.3% +0.3%

7:30 am Personal Spending – Mar +0.4% +0.4% +0.4% 0.0%

8:45 am Chicago PMI – Apr 58.0 57.8 57.6 57.4

5-1 / 9:00 am ISM Index – Apr 58.4 58.3 59.3

9:00 am Construction Spending – Mar +0.5% +0.3% +0.1%

afternoon Total Car/Truck Sales – Apr 17.1 Mil 16.9 Mil 17.4 Mil

afternoon Domestic Car/Truck Sales – Apr 13.4 Mil 13.0 Mil 13.4 Mil

5-3 / 7:30 am Initial Claims – April 28 224K 229K 209K

7:30 am Q1 Non-Farm Productivity +0.9% +0.9% 0.0%

7:30 am Q1 Unit Labor Costs +3.0% +3.0% +2.5%

7:30 am Int’l Trade Balance – Mar -$50.0 Bil -$50.3 Bil -$57.6 Bil

9:00 am ISM Non Mfg Index – Apr 58.0 58.1 58.8

9:00 am Factory Orders – Mar +1.4% +1.3% +1.2%

5-4 / 7:30 am Non-Farm Payrolls – Apr 191K 184K 103K

7:30 am Private Payrolls – Apr 190K 184K 102k

7:30 am Manufacturing Payrolls – Apr 20K 22K 22K

7:30 am Unemployment Rate – Apr 4.0% 4.0% 4.1%

7:30 am Average Hourly Earnings – Apr +0.2% +0.2% +0.3%

7:30 am Average Weekly Hours – Apr 34.5 34.5 34.5

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:

Modest Growth in Q1

Posted on Updated on

April 23, 2018

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

From mid-2009 through early 2017, the US economy grew at a real average annual rate of 2.1%. Not a recession, but not robust growth either, which is why we called it a Plow Horse Economy.

For the first quarter of 2018, we expect growth of 1.9% at an annualized rate, right in-line with a Plow Horse.

But that doesn’t mean the economy is still a Plow Horse.It isn’t. Growth has picked up, even if last quarter doesn’tshow it. Even with a 1.9% growth rate in Q1, real GDP is still up 2.7% from a year ago, and we anticipate an average growth rate of around 3% this year and next year with higher odds of growth exceeding that pace rather than falling short.

Taxes and regulations have been cut and monetary policy remains loose. Look for a significant acceleration in growth in the quarters ahead.

Here’s how we get to 1.9% for Q1. But, keep in mind that we get reports on shipments of capital goods on Thursday as well as early data on trade and inventories, so we could end up tweaking this forecast slightly later this week.

Consumption: Automakers reported car and light truck sales fell at a 12.4% annual rate in Q1, in large part due to a return to trend after the surge in sales late last year following Hurricanes Harvey and Irma. Meanwhile, “real” (inflation- adjusted) retail sales outside the auto sector declined at a 0.8% annual rate. However most consumer spending is on services, and growth in services was moderate. Our models suggest real personal consumption of goods and services, combined, grew at a 1.2% annual rate in Q1, contributing 0.8 points to the real GDP growth rate (1.2 times the consumption share of GDP, which is 69%, equals 0.8).

Business Investment: It looks like another quarter of solid growth, with investment in equipment growing at about a 5% annual rate, and investment in intellectual property growing

at a trend rate of 5%, as well. Meanwhile, commercial construction looks unchanged. Combined, it looks like business investment grew at a 4% rate, which should add 0.5 points to real GDP growth. (4.0 times the 13% business investment share of GDP equals 0.5).

Home Building: It looks like residential construction grew at a 5% annual rate in Q1, roughly the same pace as the average over the past five years. This should add 0.2 points to the real GDP growth rate. (5.0 times the home building share of GDP, which is 4%, equals 0.2).

Government: Public construction projects were up in Q1, but military spending declined. Looks like overall real government purchases rose at a 0.6% annual rate in Q1, which would add 0.1 points to the real GDP growth rate. (0.6 times the government purchase share of GDP, which is 17%, equals 0.1).

Trade: At this point, we only have trade data through February. Based on what we’ve seen so far, it looks like netexports should subtract 0.7 points from the real GDP growth rate in Q1.

Inventories: Like with trade, we’re also working withincomplete figures on inventories. But what we do have suggests companies were accumulating inventories more rapidly in the first quarter than at any time in 2017. This should add a full 1.0 point to the real GDP growth rate.

Add it all up, and we get a 1.9% growth rate. More data will come, and we could adjust, but hopes of a blow-out quarter have dimmed in recent months. Nonetheless, the year-over- year growth rate has accelerated, and this slower quarter is just a temporary pause. Corporate sales, incomes, jobs growth, investments, and construction are all accelerating. So will GDP .

630-517-7756 • http://www.ftportfolios.com

Modest Growth in Q1

Brian S. Wesbury – Chief EconomistRobert Stein, CFA – Dep. Chief EconomistStrider Elass – Senior Economist

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

4-23 / 9:00 am

Existing Home Sales – Mar

5.550 Mil

5.480 Mil

5.600 Mil

5.540 Mil

4-24 / 9:00 am

New Home Sales – Mar

0.630 Mil

0.617 Mil

0.618 Mil

4-26 / 7:30 am

Initial Claims – Apr 21

230K

231K

232K

7:30 am

Durable Goods – Mar

+1.5%

+2.6%

+3.0%

7:30 am

Durable Goods (Ex-Trans) – Mar

+0.4%

+0.7%

+1.0%

4-27 / 7:30 am

Q1 GDP Advance Report

2.0%

1.9%

2.9%

7:30 am

Q1 GDP Chain Price Index

2.2%

2.1%

2.3%

9:00 am

U. Mich Consumer Sentiment- Apr

98.0

97.8

97.8

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.

First Trust Monday Morning Outlook:

https://www.ftportfolios.com/Commentary/EconomicResearch/2018/4/23/modest-growth-in-q1

A Generation of Interest Rate Illiterates

Posted on Updated on

April 9th, 2018

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

An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they’re determined.

Lots of this confusion has to do with the role of central banks. Many think central banks, like the Fed, control allinterest rates. This isn’t true. They can only control short-term rates. It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time. If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future.

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation. Credit risk –the chance a loan will not be repaid – is also part of any interest rate. And, of course, those who earn interest owe taxes on that income. After taxes, investors deserve a positive return. In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they? In July 2012, the 10-year Treasury yield averaged just 1.53%. But since then, the consumer price index alone is up 1.5% per year. An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes. In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off. The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing. The theory is that when the Fed buys bonds, yields fall. It’s simply supply and demand. But this is a mistake. Bonds aren’t like commodities, where if

someone buys up all the steel, the price will move higher. A bond is a bond, no matter how many exist. Just because Apple has more bonds outstanding than a small cap company doesn’tmean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)? It’s the same issuer, same inflation rate,same tax rate, same credit risk, and the same maturity and coupon. It should have the same yield. It didn’t become a collector’s item; it still faces competition from a wide array of other investments. It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future. If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero. And since the 10- year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well. The Fed’s zero percent interest rate policy artificiallyheld down longer-term Treasury yields, not QuantitativeEasing. That’s why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise. Why? Because the Fed has held short-term rates too low for too long. Interest rates are below inflation and well below nominal GDP growth. The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow. Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher. It’s true the Fed is unwinding QE, but that’s not why rates are going up. They’re going up because the economy is telling savers that they should demand higher rates.

 

A Generation of Interest Rate Illiterates

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

Date/Time (CST)

U.S. Economic Data

Consensus

First Trust

Actual

Previous

4-10 / 7:30 am

PPI – Mar

+0.1%

+0.1%

+0.2%

7:30 am

“Core” PPI – Mar

+0.2%

+0.2%

+0.2%

4-11 / 7:30 am

CPI – Mar

0.0%

0.0%

+0.2%

7:30 am

“Core” CPI – Mar

+0.2%

+0.2%

+0.2%

4-12 / 7:30 am

Initial Claims – Apr 7

230K

229K

242K

7:30 am

Import Prices – Mar

+0.1%

-0.1%

+0.4%

7:30 am

Export Prices – Mar

+0.1%

0.0%

+0.2%

4-13 / 9:00 am

U. Mich Consumer Sentiment- Apr

100.4

101.4

101.4

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.