They say a picture is worth a thousand words….Well I don’t know if the above picture is worth that many, but it’s certainly worth more than these six “however, net exports have been soft.” That quote was from the FOMC statement released on 9/17/15 when the Fed decided to leave rates unchanged. “Soft” exports, falling market based measures of inflation and “global economic and financial developments” were all cited as reasons to remain with ZIRP. While exports and clearly inflation fall within the dual mandates of the Fed, I’m a bit hesitant to go along with the global concern aspect. So let’s take a look at data the Fed had to use for its statement and some that has come out since.
Taking the most recent revised GDP data, we have exports at 12.73% of GDP. To put this in perspective, I’ve compiled some historical export to GDP ratios as seen below:
Looking at that history, it’s tough to say that exports are weak and the strong dollar is a problem when the highest print was 13.74% on 7/1/11. An important aspect of our core exports is that we are the best, and in some cases, the only game in town for certain goods like aircraft, industrial supplies and various types of engines. This competitive advantage alleviates currency pressure on domestic suppliers and dispels the hype that the strong dollar destroys exports. However, I don’t doubt that the strong dollar is an issue for the 47.82% of S&P 500 sales generated overseas in 2014 (assuming roughly the same for this year). In the big picture, domestic demand and consumption dominate exports in terms of U.S. economic importance and take some relevance away from data points like the soft durables print we just got.
Let’s move on to inflation and its also misunderstood brother, deflation. Inflation debates really make a great example as to how markets get made…There’s always two sides. On one side, we have people making blanket statements that there is no inflation or that we are in danger of a deflationary period. Then on the other side, we have people like myself and others saying that there is clearly inflation in housing, services and certain goods. I think this wide range in views is in part a function of the different inflation metrics available and how people view what is core or not core inflation.
The two widely accepted inflation metrics are CPI and PCE. Both are produced by different government agencies, but are based on the same hard data. Notice in the table below in the last column what the basis is for the PCE component in line 7. The list goes on down through the rest of PCE components.
That being said, it’s strange for people to cite PCE as if it’s independent from CPI and a superior metric just because the Fed prefers it. All PCE really is, is a watered down version of CPI. Since PCE includes additional categories for third party payments, allocations to other components are reduced:
“PCE also includes expenditures financed by third-party payers on behalf of households, such as employer-paid health insurance and medical care financed through government programs…” – BEA
The difference in allocation of components is felt most in the difference for housing expenses:
Just looking at this, we can see that there would be an immediate rise in core PCE should the same weighting for housing costs be used. If we compare the weighting to the average person’s actual expenses, 32% is still on the low side. Recently, there have been numerous articles on the rapid rise in rents and the increased portion of income that rent is consuming. This is partially a function of ZIRP but also not necessarily curable by raising rates since demand is so strong. Statistics are also understating actual rent/income ratios because they are taking a real expense and comparing it to a gross (pre-tax) income number. An apples to apples comparison would drive the ratios roughly 40% higher (reducing income by 30% taxes). While it is typical to use gross income data for comparison purposes, the reality is that rising rents impact consumers more than the statistics show. Therefore, to place such emphasis on an index like PCE which has such a low weighting on a major expense like housing is completely inappropriate. PCE really just makes reported inflation and QE a more manageable situation for the Fed.
For a more detailed explanation of the differences between CPI and PCE, please see here.
Meanwhile in the real world, on 9/24, Nike reported a very strong quarter and had some interesting comments regarding inflation:
“Gross margin expanded 90 basis points to 47.5 percent. The increase was primarily attributable to higher average selling prices and continued growth in the higher margin Direct to Consumer (DTC) business, partially offset by higher product input and warehousing costs. ”
This is the second quarter in a row for Nike with comments regarding increased selling prices and input costs. When a global manufacturer like Nike is experiencing a rise in input costs, rest assured others are as well.
Here are some other inflation tidbits…So many in fact, it took a bit of effort to get them all into an easily readable format. These are items with greater than 2% YoY growth in the latest CPI report. To be fair, there are still other durable and energy related items with price declines. Point being, there is inflation.
Now when people start talking about deflation is where the train really goes off the tracks. As I’ve written previously, declining prices are not inherently bad. Deflation, when coupled with stable jobs and income, only feeds the innate human desire to consume. In the U.S., we have a fantastic situation where consumers are benefiting from low energy prices and drops in prices of certain goods (e.g. home electronics) and, as a result, consumption is up. Unfortunately, many in financial media and economic circles depict deflation as always being this downward spiral of decreased economic activity when it’s really not. Case in point, the NY Post just put out this article which stated:
“But the one thing the US can’t afford to import now is deflation.”
This statement is made without any economic reasoning other than deflation is just bad. The author fails to state how consumers benefit from these lower import prices. So now we have millions of readers who have been biased against deflation without even understanding it. The fact is, there is a fundamental difference between supply side driven price declines and lack of demand price declines. Fracking and other technological advances have structurally shifted prices in favor of consumers. With that, I don’t know about you, but I enjoy coming across goods that I like being on sale and I typically buy more.
Since the Fed meeting, we’ve gotten a few more data points that highlight the underlying strength of the economy. The backbone of everything is employment. We continue to see a grind lower in weekly initial and continuing unemployment claims. This picture really does speak for itself:
What’s particularly interesting in the weekly claims data are the internals. I like to look at the state level gains and losses. Here is the most recent week:
This is a great section to look at when gauging energy related job losses, or the lack thereof.
For housing, we got three big data points last week. Existing home sales (EHS), FHFA price index (HPI) and New home sales (NHS). EHS came in below expectations and is being thrown into economic surprise indices as a miss when in fact it was a solid print. EHS transactions are being hindered by low inventory and high prices. There’s nothing weak about that. Strong pricing is being seen in the HPI which now sits just 1.1% below its March 2007 all time high. This actually gives the Fed a bit of leeway in terms of having to raise rates. At first I thought we were looking at a potential housing bubble, but after a second look, we really have a sustainable market. The NHS data which printed well above expectations also shows how strong demand is. Taking NHS in the context of EHS and low inventories, we can see the true underlying strength of the market.
Strong housing demand coupled with today’s strict lending standards is driving a healthy sustainable market. The high quality / lower transaction defined market we have today is a far more desirable situation than that of the 2004-2007 bubble years.
On Friday, we got the Markit Services PMI. The flash index came in at a healthy 55.6 just barely down from August’s 56.1. If you just read the comments in the report and ignored the actual index levels, you would think the index came in at 45 with how bearish the commentary was. Again, fear sells….That said, looking at the GDP chart on the top of this post, you get an understanding of how important services are to this economy and why a healthy services PMI is so important.
So with employment, housing and services / consumption data all humming along nicely, that leaves us with the rest of the world’s worries…The good news is that the recent Markit Eurozone Composite PMI is well in expansionary territory at 53.9 and showing stability. Barron’s also featured an article this week regarding an uptick in the Chinese real estate market. As for the rest of EM, no amount of QE will ever get certain governments to straighten their houses out. Regardless, the Fed has essentially created a third mandate of global stability which seems to be tying U.S. policy to the unknown plans of foreign governments. Although I suspect that given market reactions since the Fed meeting, I think the FOMC will be more inclined to raise rates come October. The Fed needs to step up and take control of the situation and show markets that they are in control.