CPI and PMI Releases Show Strength; Paint Complex 2017 Picture

Thursday, 15 December 2016, saw a plethora of significant economic data releases before the markets opened in the US.  These releases came fast on the heels of the FOMC decision to increase interest rates for only the second time in a decade while also signalling a more hawkish monetary policy that may require an accelerated pace of future rate hikes.  Two of the major releases yesterday, the US Manufacturing PMI and the US Consumer Price Index (CPI) lend credence to the inflationary forecasts set forth by Fed Chair Janet Yellen in her Wednesday press conference. 

Manufacturing experienced a strong surge, hitting a 21-month high.  This surge, however, is still well below peaks set in the post-recession era, indicating there may be plenty of room for growth in the months ahead.

Markit US Manufacturing PMI (seasonally adjusted) Source: IHS Market

US manufacturers reported business conditions improving at the fastest rate since March 2015 with manufacturing output expanding for the seventh consecutive month.  The growth in output was attributed to an increase in sales demand, coupled with a need to replenish inventories. 

One major note of caution was signaled in the report, however.  While new work orders received by manufacturers experienced a rapid rise, the report also stated, "This was overwhelmingly attributed to improving domestic demand conditions.  Meanwhile, export sales were close to stagnation, which contrasted with the modest growth seen on average in the second half of 2016."

The stagnation of export sales as cited is most likely the result of the strong US dollar coupled with extremely weak economic conditions in Europe.  Both will likely have a negative impact on the performance of US stocks with heavy overseas exposure.  This will be exacerbated by rising interest rates in the US, further strengthening the dollar against foreign currencies already experiencing downward pressure.

There are strong signs, however, that inflation may increase at a more rapid pace than currently being forecast by the Fed.  An example of this upward price pressure is seen in the PMI report: Input price inflation accelerated for the third time in the past four months during December. Moreover, the latest increase in average cost burdens was the largest since October 2014. Manufacturers cited higher steel prices in particular, alongside generally rising raw material costs, including oil.

That oil prices will increase in 2017 is a near-given.  Following agreements on oil production cuts from the major exporters, we can anticipate oil price stabilization at least in the high 50s, and possibly into the 60s.  The only downward pressure at the moment is the rising strength of the dollar.  An increase in oil prices will automatically have an inflationary impact on virtually all segments of the economy.  Likewise, as Europe begins to recover, increased demand on US exports will add upward price pressure. What remains to be seen, however, are the potential impacts of any trade-policy changes coming out of the new administration.  Tightened trade policies will likely have a medium-to-long term inflationary impact as well.

This steady growth in price inflation is similarly reflected in yesterday's CPI-U release.  Seasonably adjusted, November saw a 0.2% increase month over month, and the index rose 1.7% for the year.  That's barely below the 2% figure set by FOMC as their inflation target.  The greatest contributor to this rise continues to be the shelter and gasoline indexes.  Shelter rose by 0.3% in November, however the gasoline index rose 2.7%.  That will continue to rise as oil prices normalize in 2017.  The energy index as a whole rose 1.7%.

12-month CPI Not Seasonably Adjusted   Source: Bureau of Labor Statistics

In her post-announcement press conference on Wednesday, Ms. Yellen reaffirmed their inflationary target of 2%, however the way she addressed that was a bit interesting.  She indicated rather emphatically that while the committee was concerned about inflationary levels that are below 2%, they were also very concerned about inflation exceeding 2%.  The implication in her statement was that steps would be taken to prevent any sustained rise above that level.  At present, all signs indicate the economy is moving towards just such a rise.

What I take from all this is that the projection for three rate increases in 2017 may either be an underestimate or one of those increases may see more than the 0.25% target increase to which we have become accustomed.  The pressures on price at the moment feel a bit like a coiled spring, and if any of those downward pressures are removed, the Fed may feel compelled to react swiftly to prevent an uncontrolled rise in inflation.  This will be especially true as the "all items" level rises and returns to a normal level above the "all items less food and energy" line. 

The wildcard for 2017 remains the incoming Congress and Administration.  Consumer confidence is surging at the moment, and when consumers are confident, they buy.  There is anticipation that 2017 will see significant reforms both in regulations and in tax structures.  (I'm less optimistic that such reforms will materialize, however that's a topic for another day.)  That pro-business anticipation is adding to corporate confidence, and just like consumers, when corporations are confident, they also increase spending. 

As we head into the new year, it would be prudent to pay close attention to the various public appearances made by the fed governors.  If inflation is showing signs of increasing beyond the pace they have forecast, our first indications will be in changes in tone from the various FOMC members.  We will also pay close attention to the forward guidance offered in key 1Q17 earnings releases.  An increase in optimism in that guidance will be another signal that higher inflation is on the horizon, and another signal that the Fed may be forced to adopt an even more hawkish policy than they signaled on Wednesday. 

Happy Trading

A Neutral Fed Announcement Spooks Markets

The Federal Open Markets Committee (FOMC) issued a statement today that sent the US markets into a nose-dive.  With earnings across most sectors disappointing the markets throughout January, and with economic data being a further disappointment, speculation on the street was pushing estimates of interest rate hikes out into the September time-frame.  The Fed dispelled those notions this afternoon, and the Dow tumbled 190 points in response.

In today's release, FOMC stated, "Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy."  This is being interpreted as indicating a rate increase announcement no earlier than June, however it's not the dovish indicator the markets were hoping for.

It doesn't help that the FOMC's assessment of current economic conditions appears to be a bit rosier than those being seen by investors and traders.  Consider the following statements:

FOMC stated, "Labor market conditions have improved further, with strong job gains and a lower unemployment rate."  While it's true that unemployment has declined to about the 5.6% level, the Participation Index - a much more accurate measure of the workforce - has declined to its lowest level (62.7%) since 1978 and it continues to decline.  This would indicate that the number of eligible workers that are unemployed is increasing, not decreasing.  As to job gains, if you take Texas, Washington DC, Arkansas, and Utah out of the mix, the nation is actually shedding jobs at a rapid rate.  Almost all of the net national gains are coming just from the state of Texas.

Job Gains vs Unemployment

Here's the raw data just for Texas: Joint Economic Committee - Texas Economic Data

Next, the FOMC stated, "Household spending is rising moderately."  That's an interesting view, considering the Retail Sales number recently released was the largest decline experienced in 11 months.  If household spending is rising, one must question where they are spending it since it clearly wasn't in retail stores last month. 

They stated, "Recent declines in energy prices have boosted household purchasing power."  There's certainly more money in the consumer's pockets resulting from a decline in gas prices, however, as has been discussed several times over the past couple of weeks, there is no evidence that the consumer is spending that money.  In fact, there's evidence mounting that the decline in energy prices is about to have an extreme negative impact in the oil producing states that have driven the overall job growth since the recession.  With oil rigs closing, and oil companies starting massive layoffs, the conditions in states like Texas, Oklahoma, California, and North Dakota, among others, will quickly deteriorate.

Finally, FOMC stated, "Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable."  The problem with this statement is that both CPI and Core CPI are down.  This means that, even excluding food and energy, inflation is down. It makes sense, since wages are not increasing.  (Average in the latest release was a mere 1.7%.)  In other words, inflation is dropping, not because of energy prices, but because of a gradual softening of the economy as a whole.

What may have spooked the market the most is this phrase in their press release: "In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation." It's that "and expected" part that is disturbing.  Since their assessment of inflation to date is not accurate, the thought that they will react based on what they expect to happen implies a rate hike that will be premature in an economy that cannot tolerate it.

The only truly encouraging statement in the release is in the very last sentence: "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."  This is, from what we can determine, the only acknowledgement that there are global economic forces that are providing extreme headwinds to US economic growth.  The strength of the dollar, a crumbling European economy, the renewed threat of a Greek Crisis, and the evaporation of Russia's economy are enough to give even the most bullish investor pause.  Add to that a reduction in the rate of growth in China and India, and there's the prospect of a US economy barely able to sustain forward momentum.

We're nearing the end of this quarter's earnings season.  There are definitely very strong sectors that will provide excellent trading opportunities in this uncertain market.  Aerospace, Auto Parts, and Utilities are all looking pretty good right now.  Keep an eye on the remaining announcements, and trade into strength (or short into weakness, if that's to your liking.)  For now, though, expect volatility to remain high given the uncertainty around when the Fed will decide to move on rates.