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Saturday, January 27, 2018

The Business Week In Review

"Modest-to-moderate" was the Federal Reserve's unvarying verdict of the economy all through last year and even in the last Beige Book posted earlier this month. But don't be too surprised if FOMC policy makers begin to upgrade their assessment given the building strength of incoming data centered in the consumer. In this week's report we'll breakdown fourth-quarter GDP, take a look at the housing sector, and even offer updates on the dollar and the lift underway for oil.


The economy
GDP came in at 2.6 percent annualized growth in the fourth quarter which is solidly above the FOMC's long-range median of 1.8 percent and also well above the long-range 2.2 percent high estimate. GDP has been gradually trending upward over the course of the expansion including the last 3 years and especially during 2017, a year that included the 3.1 percent and 3.2 percent results of the second and third quarters.


But the hidden highlight of 2017 may very well be the fourth quarter's results. Consumer spending, which makes up more than 2/3 of GDP, rose at a very strong 3.8 percent rate. This is among the very strongest results of the expansion and, importantly, is centered in durable goods which surged at a 14.2 percent rate. Buying a new car or a new appliance speaks to the confidence and strength of the consumer and stands in contrast perhaps to less discretionary spending on essential services like medical care or electric bills or spending on nondurable goods such as groceries or household supplies. The 14.2 percent showing for durables is the strongest in more than 9 years, a time when results were being lifted by easy comparisons coming out of the Great Recession.


What really limited the fourth quarter were net exports, at an annualized deficit of $652.6 billion. This comes out to more than 54 billion inflation-adjusted dollars leaving this country each month! Imports of oil are always an issue for the deficit but less so in recent years given increases in the output of domestic oil. What is a persistent sore point is the import of consumer goods, and looking at the details (here in nominal dollars) shows an average monthly deficit of nearly $53 billion. Imports of capital goods are even slightly higher but these goods help improve business output and worker productivity. Consumer goods, whether discretionary or non-discretionary, don't provide the same benefits. These increasing levels of consumer imports are masking what is in fact a healthy rate of export growth led especially by foreign demand for capital goods which is one of this nation's greatest strengths, such as aircraft and machinery. Cross-border trade is in fact very active though the U.S. consumer's preference for foreign consumer products continues to inflate the deficit and in turn hold down U.S. GDP.


Inventories also held down fourth-quarter GDP, rising $9.2 billion in the quarter vs the prior quarter's $38.5 billion increase which is a negative in the GDP calculation. But here, like the rising totals for exports which are being masked by the greater totals for imports, the slowing inventory build is coming at a time of strengthening demand which is actually very positive for the economy. The lack of fourth-quarter build points to the need for a greater first-quarter build and that means rising production and rising employment. When excluding the effects of net exports and inventories, GDP actually rose 4.3 percent in the fourth quarter which is the best showing in 3-1/2 years and the second best in nearly 9 years.


A major plus for the economy over the past year has been solid rates of business expansion which is measured in the GDP report by nonresidential fixed investment. This rose at a 6.8 percent rate in the fourth quarter and follows similar rates in the prior 3 quarters. Strength here is no surprise given the exceptional rise in business confidence and flow of investment funds into the stock market. But there is a note of caution in the week's data and that comes from the core capital goods component of the durable goods report. This reading, which excludes defense products and also aircraft, shows a 0.3 percent December decline in orders. The monthly weakness in core orders, which includes a second straight sharp decline for communications equipment, points to a future slump in capital goods shipments and poses an obstacle to first-quarter growth in business investment.


We close fourth-quarter GDP with a look at residential investment, which is another consumer-related component and which rose at a very impressive 11.6 percent rate. This is the best showing in nearly 2 years and reflects the rising strength of the new home market and rising demand for home improvements. And similar to the strength in nonresidential investment, it reflects the general strength of confidence in the economy and especially the fundamental strength of the labor market.


Residential investment makes up a deceptively small percentage of GDP, less than 5 percent, yet the effect of housing on the economy as a whole can be very significant. Home sales were another feature of the week's news and the results were mostly solid. Month-to-month sales data can be extremely volatile which makes 3-month averages a necessity. Sales of new single-family homes (blue line of graph) have been very strong, up 12 percent for the 3-month average over the past year and up 9 percent during the fourth quarter to a 638,000 annualized rate. But sales of existing single-family homes (green line) are another story, up only 1 percent during 2017 though they did show life at year-end with a 4 percent quarterly gain to a 4.973 million rate. Yet with employment as strong as it is and with the stock market taking off, why haven't more Americans been moving up to better homes?


The Federal Reserve's explanation is lack of housing inventory which limits buyer choices. On the new home side, completions have been rising with 6 percent more homes, at 295,000 in December, on the market than in September. But existing homes are going the other way, at only 1.480 million for a quarterly decline of 20 percent. Why aren't more homeowners putting their homes on the market? It's not because prices are low. They've been rising at an annual 6 percent pace by the various measures which, outside the stock market right now, is a strong rate of return in a low interest rate economy. Perhaps part of the answer lies in the labor market, specifically the JOLTS report where the monthly separation rate has been subdued at just under 4 percent. With people staying put, that is employers holding onto their employees very closely and vice versa, there may be less relocation going on and with this less need to swap homes. Whatever the factors, lack of supply in the resale market looks to be one of the few early obstacles for the 2018 economy.


Markets: The dollar and worn out jawbones
The dollar fell sharply at midweek after Treasury Secretary Mnuchin cited the positive effects of its decline on "trade and opportunities", comments that ECB President Draghi the next day warned are the language of a currency war. The dollar index fell 1-1/2 percent in reaction to Mnuchin to hit a 3-year low below 89 before President Trump voiced his support for a strong dollar which sent the greenback higher. This is a back-and-forth replay of the dollar-yen strategy early in the Clinton administration when some advisors, seeking to reduce the nation's trade imbalance with Japan, were calling for a stronger yen while others were warning against it, most memorably Larry Summers who, as then Treasury Undersecretary, spoke his famous line "you cannot devalue yourself into prosperity." But devaluation was definitely the outcome back then as the dollar fell 1/3 against the yen during the first 3 years of Clinton's first term. And what did this mean for the deficit? Devaluation certainly didn't reduce it as the goods deficit with Japan widened from $49.6 billion in 1992 to $59.1 billion in 1995. Note that the dollar index is down 3.4 percent so far this year following last year's very sizable decline of 9.7 percent.


One effect of a weaker currency, if not improvement in the deficit, is a higher cost for imported foreign goods and services. This means getting less for more which is the definition of inflation and which actually would be welcome by Fed policy makers who have been trying hard to reflate the economy. Another source of inflation is also now coming from oil. Here supply is the key as OPEC is talking about sustained production cuts at the same time that U.S. inventories, as tracked in the columns of the graph, continue to fall. Dollar weakness and oil strength, not to mention a very low 4.1 percent unemployment rate and the risk of wage inflation, could fire up inflation quickly -- and, in what would be an irony, perhaps more quickly than the Fed could contain.


Markets at a Glance Year-End Week Ended Week Ended Year-To-Date Weekly

2017 19-Jan-18 26-Jan-18 Change Change
DJIA 24,719.22 26,071.72 26,616.71 7.7% 2.1%
S&P 500 2,673.61 2,810.30 2,872.87 7.5% 2.2%
Nasdaq Composite 6,903.39 7,336.38 7,505.77 8.7% 2.3%

     

Crude Oil, WTI ($/barrel) $60.15 $63.50 $66.14 10.0% 4.2%
Gold (COMEX) ($/ounce) $1,305.50 $1,334.40 $1,354.20 3.7% 1.5%






Fed Funds Target 1.25 to 1.50% 1.25 to 1.50% 1.25 to 1.50% 0 bp 0 bp
2-Year Treasury Yield 1.89% 2.06% 2.11% 22 bp 5 bp
10-Year Treasury Yield 2.41% 2.66% 2.66% 25 bp 0 bp
Dollar Index 92.29 90.64 89.12 -3.4% -1.7%


The bottom line
There's a lot of activity in the U.S. economy right now and FOMC policy makers may not have the luxury of downplaying the strength. Yes, inflation has been very limited but there are many advanced indications of greater pressure ahead: strong consumer demand, strong business demand, a falling dollar, rising oil prices -- not to mention a tax cut and full employment.

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