There were three significant economic events in the past couple of weeks: the GDP report, the Fed meeting, and the Unemployment report. Each time, the market took away only what fit its narrative (i.e., the “soft patch” has passed and there is no danger in investing in equities). The truth is low interest rates have enabled corporate buy-backs and there is now a disconnect between the equity markets and the reality of an economy at near stall speed. Still, markets appear vulnerable to economic disappointments.
The Q1 real GDP growth rate (3.2% annualized) surprised nearly everyone to the upside. And, of course, Wall Street characterized the headline number as proof that the “soft patch” had passed. Never mind the details. Of the 3.2% growth, nearly .7 percentage points came from inventory growth (likely stockpiling ahead of the tariff threats). If the trade deals are ever done (we were led to believe that the deal with China was imminent, only to have cold water thrown on those hopes), destocking will occur, which will be a negative for GDP. The latest Industrial Production data already show lower production levels.
Another 1 percentage point of the 3.2% growth came from net exports. Exports rose by $23 billion, a number not likely to be repeated given the shape of the world’s economies. Worse, there was a fall in imports (-$33 billion), an indication of weakness in the U.S. consumer. Finally, government added another .4 percentage points to the growth. These three (inventory, net exports, and government) are not likely to be repeated in the near term. Taking them out of the growth leaves a paltry 1.1% real underlying growth rate, still positive, but showing the economy is really nearing stall speed.
Other critical measures were also anemic: Consumer spending growth was 1.2% (with big ticket items falling -5.3%, the worst showing since Q4/09), residential and non-residential construction both were lower (-2.8% and -0.8% respectively), and capex was a flimsy +0.2%. These add up to +0.9% on a weighted basis. Looking at the recent past three quarters, that +0.9% compares unfavorably with +2.3%, +3.0%, and +4.0% for the preceding three quarters (Q4/18, Q3/18 and Q2/18). Note also the falling trend in those numbers.
Looking at cyclically sensitive items like consumer durables, clothing, and sensitive services like restaurants, recreation, and transportation, we again observe significant deceleration over the past year: Q1/19: -2.1%, Q4/18: +1.5%, Q3/18: +2.5%, Q2/18: +5.9%. Finally, the GDP price deflator is going the wrong way for the Fed. Again, observe the trend: Q1/19: +0.9%, Q4/18: +1.7%, Q3/18: +1.8%, Q2/18: +3.0%. After this GDP report, markets were convinced that the Fed would have to cut interest rates because their 2% inflation goal was rapidly receding.
Enter the Fed
The Fed held its normal meeting on April 30th and May 1st. There is half an hour between the Fed’s official statement and Powell’s press conference. The actual statement was dovish enough to cause the yield curve to fall several basis points right after its release, as the statement acknowledged, for the first time, that core inflation is below the Fed’s 2% target. From the statement alone and that admission, market participants concluded that the Fed’s next move would be a rate cut, perhaps soon. And, rates immediately moved lower across the yield curve. But, then, in the press conference, Powell said he thought that the low inflation data was “transitory,” meaning rates would revert toward the Fed’s 2% target without further Fed action. (This was clearly his personal view.) That dashed the initial market interpretation, and interest rates reversed course with yields along the curve ending the day higher than they began. Perhaps this was a faux pas, similar to his utterings back in November that caused the December market meltdown. Remember, he walked back his November statements in January, and the equity market recovered. Perhaps, he will walk back this “transitory” remark too, especially if the equity market shows enough pain.
In September, 2017, then Fed Chair Janet Yellen also indicated at that time that she thought that low levels of inflation were “transitory.” Actual events proved this notion incorrect, as core inflation has continued below the Fed’s 2% goal. We know that Yellen relied heavily on the Dallas Fed’s “Trimmed Mean” inflation gauge. And now we can assume that Powell has the same view.
Three-times in the past five years, the Core PCE Inflation Index has significantly deviated (lower) from the Dallas Fed’s “Trimmed Mean” indicator, only to rise back toward it. Today, that Dallas Fed metric sits just below 2% while the Core PCE Index is closer to 1.5%. Powell’s “transitory” remark must come from his belief that inflation will “snap back” toward the Dallas Fed’s 2% level. I should note that, from the data, it appears that the Dallas metric actually follows the Core PCE measure with a lag. So, it could very well be that the Dallas measure will begin to sink. If that is the case, then, like his predecessor, Yellen, Powell’s “transitory” view will be a mistaken one.
Within the Fed, itself, there is another measure of inflation, produced by the NY Fed, that appears to say something quite different. That measure of inflation has fallen for five months in a row. And the preponderance of the economic data seem to indicate that deflation is winning the tug of war.
In addition, there is work being done at BLS regarding how their price indexes are calculated. Some of their current methodology goes back to the 1940s. According to the May 1 issue of the WSJ (“U.S. Economists Shift to Big Data”, A2, D. Harrison), researchers are finding that official measures don’t always capture the benefits consumers receive when the quality of the products they buy improves more than the price. That work is leading to the conclusion that deflationary pressures are more rampant than previously thought.
Employment Numbers: Looking Beneath the Headline
The headline number in the Establishment Survey (ES) (also known as the Payroll Report) looked quite strong at 263k. Realize that 93k of this was a “plug” number from the BLS’s “birth/death” algorithm, a mathematical formula that simply plugs in about 100k/month because the ES does not contact any small businesses. So, the measured number was closer to 170k. Still, not too shabby. What wasn’t widely reported was that the workweek contracted 0.3% in April, and, has fallen in three of the past four months. In terms of income, the shorter workweek is equivalent to a loss of about -375k jobs. But, because that inconvenient fact doesn’t fit the Wall Street narrative, it was not discussed in the media.
What about the fall in the unemployment rate to 3.6%? Isn’t that the quintessential sign of great economy? The “other” employment report, the Household Survey (HS) done concurrently with the ES, produces the unemployment rate. That HS showed a decline of -103k jobs in April, the fourth month in a row that the two surveys have been at 180-degree odds. The fall in the unemployment rate from 3.8% to 3.6% was heralded by Wall Street as further proof that the economy remains on “solid” footings. The media failed to mention that the only reason the unemployment rate fell was because the labor force shrank by -490k (which followed a -224k drop in March and a -770k drop since last December). If not for the drop in the labor force, the unemployment rate would be somewhere north of 4%. When the labor force itself falls (rises), that generally means that job seekers have been discouraged (encouraged) by labor market conditions.
What is Driving Stock Prices?
The economic data indicate that the economy is a lot weaker than Wall Street wants you to believe. Historically, the stock market has been a good indicator of the health of the economy, and, sooner or later, stock prices always reflected economic fundamentals. Wall Street still believes this as gleaned from their constant narrative that the economy is “solid.” As this cycle winds down, however, that bond between the health of the economy and the health of the equity market appears to have been broken, at least temporarily.
Over the past 12 months, S&P 500 companies spent more money on stock buy-backs than they did on capex. That is, they opted to use their cash to reduce their share count rather than to spend it on new projects and organically expand. No wonder growth is so anemic! Buy-backs were up 22% in Q1 vs. a year earlier to $270 billion. Over the past year, S&P 500 companies gave their shareholders $1.25 trillion in the form of buy-backs and dividends, much of this with newly borrowed money. According to the May 3rd issue of the Financial Times, that $1.25 trillion is nearly equivalent to today’s value of all the gold ever mined in the world.
The stock market doesn’t appear to be paying any attention to the underlying fundamental economy. If markets were truly attuned, the stock indexes wouldn’t be anywhere near today’s levels. Instead, the market is banking on the hope that the Fed has its back. And each of the world’s major central banks have told equity markets that very story.
Looked at from a different perspective, a weak economy, or at least a slow growth one, guarantees low interest rates. That, in turn, allows publicly traded companies a venue for low cost borrowings which are used to buy-back shares. Without changing any operations, hiring or firing, with a single phone call to an investment banker, earnings per share are increased (earnings remain the same but there are fewer shares). Rising EPS may occur even in the case where sales and profits are falling. A recent example is Apple. While its Q1/19 revenues were lower than its Q1/18 revenues, its stock price spiked because it announced a huge $75 billion new buy-back program. Several months ago, I argued that, as companies expend their cash to buy-back shares, their PE ratio should fall, because, without that cash, or for those that borrow to do so, with more leverage, the companies are inherently riskier. Few other commentators pointed that out. That concept has yet to take hold. It appears that Wall Street assigns the same PE ratio, or even a higher one, to companies buying shares back.
Conclusion – The Fed as Deus Ex Machina
The stock market has simply stopped being a barometer of the economy. Under the false guise of a strong economy (because Wall Street itself hasn’t yet figured out why stock prices are rising), Wall Street pushes the narrative that equities are safe. The truth is that the equity prices are rising due to scarce supply, and not due to great economic fundamentals. The economic data scream of a high potential for recession, or, at best, stall speed economic growth. The real “transitory” items, those that drove GDP growth in Q1, are unlikely to be repeated in going forward. Because Wall Street still talks like the equity market is driven by the underlying economy (i.e., the “narrative” that the economy is doing well), it could be that a recognition of stall speed growth, or other growth inhibiting issues (like trade talk breakdowns) will put a “scare” into the market. But, then, if markets show enough pain, Jay Powell may very well walk back his “transitory” remark, and the Fed, once again, may play the role of the deus ex machina, when, just in time, it steps in to save the markets.