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.
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| 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%.
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| 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
