The big picture….


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:

GDPvsEXP 9.26.15

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.

PCE Def 9.26.15

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:

PCE CPI Weights 9.21.15

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.

CPI Table 9.19.15

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:

claims 9.26.15

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:

claims internal 9.26.15

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.

HPI redo 9.26.15

Data from FRED

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.

I fell for it again….

So the Fed left rates unchanged and gave us dovish forward guidance. The Fed statement also downplayed the strength of the U.S. economy and instead worried about foreign market volatility. This is very troublesome. By ignoring their mandates and playing into foreign market volatility the Fed has tied our fortunes to the truly unknown. The way that U.S. equities are reacting right now is as if people have gotten fed up with the Fed. I think the Fed finally went to the well one too many times and its finally run dry. The good news is that domestic equities (companies with little international exposure) are going to fare well going forward. The fact of the matter is that domestic consumption is strong. Employment data is strong. Services business data is strong. Today will definitely be a rough ride though.

Now, just scratching the surface of yesterdays current account data shows the U.S. economy is becoming more and more insulated from foreign volatility. This only makes the Feds current stance that much more perilous for the U.S. Anyways, I’ll have much more to say later on these facts and more as I recover from being suckered by the Fed for the last time.

When breaking up is good…

There comes a time in some relationships when the best thing for both people is to just go their separate ways. It seems that the Fed and ZIRP have reached that point with the economy. And in this case, just like in a relationship, both parties are afraid of the unknown but know deep down inside that a change must be made. On Friday we got some labor data that has been portrayed as not so great in financial media, shocking I know, but in reality was actually a solid report. The August employment situation report has given the Fed enough of a reason to finally end ZIRP in September. The non farm payroll (NFP) headline number came in at  173,000 along with average hourly earnings (AHE) growth of 2.2% (YoY). While the headline 173,000 was below street expectations, it is still a strong print when looked at in the context of the considerable job creation we have had over the past 4 years. More importantly, the creation was in all the right places for  a services based economy like the US. Lets take a look at the numbers:

TE 9.8.15

The table above gives us a great picture as to where the earnings power of the labor force is and where it’s not (note how small mining and logging are). Professional and business services (PBS) and Education and health services (EHS) account for 40% of labor force earnings. Leisure and hospitality which includes food service and drinking places only accounts for 6% of labor force earnings. Every NFP report, financial media likes to place the emphasis in a derogatory way on food services when they should be more focused on the significance of PBS and EHS. Next, I’d like to look at the growth rates of different industries within the NFP report. The table below decomposes the PBS line item and compares it against other major categories.

Growth Rates 9.8.15

CSR PBS Decomp 9.8.15**click for links to job category descriptions

**All data in both tables are from and FRED.

The table is sorted by the YTD growth % column. We can see that the top earning positions also have some of the best growth. Looking at the temporary help category, its interesting to note that its growth peaked right after the crisis and has now come down to normal levels as the workforce has normalized. A point quite often neglected in financial media which also lends itself well to the economy being towards full employment.

Temp help 9.9.15More importantly, the labor data meshes perfectly with recent ISM and Markit Services data releases. ISM and Markit had diffusion index readings well north of the expansion line (50) at 59 and 56.1 respectively. The headline of the Markit report read “Sharpest increase in service sector output for three months in August.” Barron’s called the ISM print “in the stratosphere.” What we are seeing is corroborating evidence from multiple sources that the service sectors are growing the economy.

Just for laughs..Here is data for as far back as FRED went for most categories..

Growth Rates SI 9.8.15

The point that I am making here is that the economy is growing in all the right places and business is strong where it counts. For the 2010-2014 period, the World Bank had services counting for nearly 80% of US GDP!!! As services continue at their strong pace, I would expect to see Q3 GDP around 4% conservatively. ISM has GDP tracking at 5%.

Average hourly earnings for August came in at a solid 2.2% YoY gain. This is especially solid when factoring in the demographic trend of older higher paid workers being replaced by younger lower paid workers. (Thanks to Ed Bradford on Twitter @fullcarry for first bringing that change to my attention months ago). Hours worked also ticked up .1 to 34.6. Hours worked improving is significant given the number of employers that have scaled back employee hours in order to avoid Obamacare mandates. Clearly there has to be demand to be driving job and hours growth. Overall, we have a labor market that has been resilient to some significant headwinds and has continued to grow.

Listen to yourself, not your friends…

As we get closer to Fed tightening, markets have become even more volatile. Namely China and the rest of EM. We have a few different things going on here. One of which is the idea that China is on the brink of disaster and has weakened its currency in hopes of spurring the economy. The fact is, China is moving away from an export based economy to a sustainable and more independent consumption based economy like the US. This transition will be tough, but is necessary for the long-term health of the Chinese economy. Back in March this year, we have Zhang Gaoli, a member of the Politburo (China’s ruling political cabinet), saying “The growth model featuring high input, high energy consumption and over dependence on external demand is no longer sustainable.”Translation: China will no longer be the workhorse for the global economy. Keep in mind, this policy change was introduced just after the financial crisis as a response to the impact that the crisis had on China’s heavily dependent export economyWhat’s interesting, is that if all the EM economies followed suit and took steps to straighten their own houses out, they wouldn’t be EM anymore. Yet, time and time again, EM governments make poor financial choices that will impede their economies for years to come. Given that mismanagement, we still have the IMF, World Bank and a cacophony of financial media pundits saying the Fed needs to hold off on rate hikes until EM is ok. When is EM ever going to be ok? What problem should the Fed pick from the pile to use as its metric that EM is ok? If the Fed is to consider potential effects upon EM, then there may never be a time to raise rates. Sticking to ZIRP in hopes that EM will be ok would be like staying in a destructive  relationship because your friends like to use your partners beach house. The FED has mandates for a reason. No one even knows what may or may not happen upon liftoff. However, what we do know is that in the US we are literally blowing another real estate bubble that the Fed does not want to be responsible for. We do know that pensions and savers have been penalized long enough. We do know that our economy has no business being on emergency monetary polices when there is no longer an emergency. I believe the Fed will use this time we have right now to begin to normalize rates so that if a sudden shock does come soon, they have some ammunition left to fight it. One thing is for sure, the next week is going be a bumpy ride and hopefully in the end, the Fed will stick to its mandates and do what is right is for the US economy.


Beige Book , Services data and the Big Kahuna…

Well yesterday was another crazy day for markets, but finished with a happy ending. We got one of my personal favorite reports, the Beige Book. Like I was saying yesterday on Twitter and on CSR, the Beige Book is a very useful but underrated report. I think after yesterdays reaction from people and the sell off in bonds it drove, it’ll be upgraded across the street. The comments in the report were the most bullish that I’ve read in a long time. Plenty of references to rising wages, tight labor markets and even improved manufacturing. However, there is one line in the report that will grab the Feds attention the most:

“Commercial real estate lenders in Chicago continued to be concerned that valuations were too high, leading some to put limits on the size of loans they make for financing new purchases.”

This statement poses two of the worst possible threats to the Fed. First, it invokes thoughts of yet another real estate bubble. Second, it shows lenders being afraid to lend. Valuations being too high are a result of demand and low financing rates. We know there is plenty of commercial demand across the regions from all the comments in the report. So that leaves how can the Fed fix this issue ? That’s right folks….Raise rates.  Raising rates will typically have the affect of bringing down the value of a levered asset (unless demand overpowers that) and will also give lenders more incentive to lend. We’ve seen plenty of other evidence that shows real estate is very strong, and the Fed is not going to stand by while another real estate bubble forms. (In this case, EM is irrelevant to the situation.)

Today we get a couple services reports from ISM and Markit. The last ISM NMI report was through the roof with a 60.3 print. If we stay anywhere above 55 (which is still strong), I’ll be happy. The job creation and wage components in the reports will give  good insight into tomorrow’s NFP report. These service reports are critical in gauging the health of the economy, as the US is a services / consumption based economy. There was a good article on Bloomberg yesterday talking about renewed demand for lawyers, which could play right into a jump in the Professional and Business Services (PBS) line item in the NFP report. PBS employs the most people of all sectors listed in NFP.

Once again, we are headed into the big kahuna of economic reports: non farm payrolls (NFP), which will be released tomorrow morning at 8:30 am. Tomorrows NFP will be the most significant report of the year as it’s right in front of the September Fed meeting. I’m hearing stats about how August data tends to underperform only to be revised up later. We’ll see if that’s a factor tomorrow. One thing is for sure, this report is capable of surprising wildly to the up or down side. We’ll have more about NFP tonight.

Have a great day..its almost the last official summer weekend…booooooooo!!!

Stay focused on the data….

So US equity markets took a tumble yesterday for no good reason. Many people will assign the blame to the Chinese slowdown and associated EM risks. While this is understandable, it is still a spurious reason. Yesterday we got a couple decent readings on the manufacturing sector from Markit and ISM. Both prints were in expansionary territory. Given the headwinds that manufacturing has from the strong dollar and the fact that we are consumption / services based economy, I’m happy with this data. The dollar troubles will revert to the mean and we might get a slight uptick from here. This is par for the course manufacturing data at this point in the cycle.

It was the strong construction print along with healthy revisions that got my attention yesterday. It also got the attention of a few weak handed sell-side economists who revised their GDP estimates up after having had such little faith in the economy up to this point. The moral of the story continues to be that the economic facts in the US show a healthy and growing economy. Below is a section from Table 1 from the report on construction spending. This, taken along with the strong housing data paints a rather robust construction picture.

construction 9.2.15

Again, the focus in this kind of market environment needs to be on the actual data and not what may or may not be happening overseas. The US economy is more insulted today from overseas shocks than ever before. Especially when it comes to banking. As someone who has been on the sell-side through the entire crisis, I can say that banks (through regulation) have learned their lesson.

So yesterday we saw another collapse in oil and equities which really had investors spooked. Treasuries, however, did not have much of a rally at all. We know there were some sovereigns selling off the run bonds which certainly kept the rally subdued. Fixed income PM’s may also finally be seeing the writing on the wall that rates are going up and may not have such an appetite as before. A 2.20% 10yr in a 3% GDP economy just doesn’t work…We’ll have to wait for the bond math to catch up on that one.

We get a few economic prints today with the two main ones being ADP and the Beige Book. The Beige Book is probably the most underrated data point out there. If you have the time and read at least the summary sections, it’ll be worth your effort. The BB gives you excellent color (no, no pun intended @UBTrader,@InterestArb lol) as to what is really going on around the country. You can read previous BB reports and see the data show up in other subsequent economic data points.

With that, today is already shaping up to be another crazy one. At least the spooz are bid up so far this am. Oil is doing what it does best by going down and treasuries have a slight bid. Lets see what ADP brings us at 8:15…Good luck!!

PCE and the misconception on deflation….The week ahead

Last Friday, 8/28, we got July PCE data. As usual people ran wild with the easy to read headline prints which showed small month over month gains in the broad indices. However, when one takes a look at the many tables that the BEA provides, we can see that there are significant gains across many line items. It’s really become quite scary how so many people in financial media do almost no research on the data. These numbers don’t lie. Yet we still have people saying there is no inflation and that the US is in danger of deflation. People just like a catchy, easy to use headline to drive clicks I guess. What we can derive from this latest PCE report is that consumption is up and price levels are rising. Period. *Data below is taken from NIPA Table 2.3.1

PCE 8.29.15

Bottom line..PCE, CPI and employment data all give the Fed the green light to go in September. Comments from VC Fischer this weekend confirmed the fact that while the Fed recognizes foreign economies, those situations will not dictate Fed policy.

We can thank the rise in consumption to :

1. Jobs

2. Low energy prices.

Going back to one of my underlying arguments for consumption and why deflation is not a threat is basic human tendency to consume. When people have job security and money, we buy things. When items that we to like buy have gone down in price, we tend to buy more. I posed this question recently to my girlfriend on how she reacts to items she likes being on sale…She unequivocally buys more. While all this is really just common sense, it still for some reason eludes many economists. I can only conclude that It must be the common sense component.

Here we are on Tuesday morning with equity markets in turmoil again. This time last week we were staring into the abyss again and look how that turned out. A face ripping equity rally. To help things, we just got an encouraging labor report out of Europe that has unemployment falling to a 3.5 year low..Only problem is, the aggregate level is still double digits. In the US, we do have significant manufacturing and services data coming out this week along with the holy grail of economic reports: August non-farm payrolls. Weekly claims data would have us headed for another 200K+ print, but I’m reserving my prediction to see what the employment components are of our PMI and ISM reports. So get ready for another volatile week…