Implications:  Existing home sales continued to suffer in September, falling for the sixth consecutive month to the slowest pace in nearly three years. It looks like Hurricane Florence may have played a major role in the September decline, with sales in the South (where the storm made landfall) dropping 5.4%, the largest monthly decline since a federal rule change artificially delayed closings back a month in 2015.  That region alone drove 2/3rds of the overall decline in September.  Keep in mind that Hurricane Michael will probably cause further distortions in next month's report, though we expect a rebound in sales after the initial negative effects work their way through the data.   All that said, the biggest problem for existing home sales has been a lack of supply.  The months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – was 4.4 months in September and has been below 5.0 since late 2015 - the level the National Association of Realtors (NAR) considers tight.  The good news is that inventories look like they may finally be turning a corner, rising on a year-over-year basis for the second month in a row after 38 straight months of stagnation and declines.  If sellers really are changing their behavior, a reversal in the steady decline of listings we've seen since mid-2015 would be a welcome reprieve for buyers, boosting supply and sales, as well.  Even with the current lack of choices, the demand for existing homes has remained remarkably strong, with 47% of homes sold in September remaining on the market for less than a month.  Higher demand and a shift in the "mix" of homes sold toward more expensive properties has also driven up the median sales price, which is up 4.2% from a year ago.  Many analysts are suggesting rising mortgage rates are signaling the end for the housing market recovery.  However, continued strength in the job market, rising wages, and some gains in housing inventory should provide the right cocktail to allow potential buyers to offset higher financing costs going forward.  In other recent news, initial jobless claims fell 5,000 last week to 210,000.  Meanwhile, continuing claims fell 13,000 to 1.64 million.  These figures suggest a rebound in the pace of job growth in October after the temporary lull in September due to Hurricane Florence.  On the manufacturing front, the Philly Fed Index, a measure of East Coast factory sentiment, fell slightly to a still strong +22.2 in October from +22.9 in September, signaling continued optimism among manufacturers. 

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Implications:  Hurricane Florence took a big toll on housing starts in September. Starts in the South - where the storm made landfall and held back activity - fell 13.7%, while starts in the rest of the country (The West, Northeast, and Midwest) rose 3.8%.  Most of the recent volatility in overall starts has been due to multi-family starts, which fell 15.2% in September, the third double-digit percentage swing in four months.  Meanwhile, single-family housing starts fell 0.9% in September after a 2.1% gain in August. Normally, we would highlight comparisons to the same month a year ago, but September was when Hurricane Irma hit Florida last year.  Further, with Hurricane Michael hitting Florida this October, next month's report and year-ago comparisons will be almost useless, as well.  Instead of year-ago comparisons involving a single month, for the time being the trend is best described by the first nine months of the year compared to the same nine months in 2017.  And that shows single-family starts up 5.7% while overall starts are up 6.2%, demonstrating that the broader trend in construction growth remains intact.  The worst news in today's report is that permits for new construction fell slightly, dropping 0.6% despite expectations of a rebound.  That said, overall permits are still up 3.3% in the first nine months of 2018 compared to the same period last year.  Expect a rebound in the months ahead, as permits are less influenced by weather.  We still anticipate a rising trend in home building in the next few years.  Based on fundamentals – population growth and scrappage – the US needs about 1.5 million new housing units per year but hasn't built at that pace since 2006.  The problem is that there continue to be some headwinds that may temper growth in home building.  The National Association of Home Builders said 84% of developers cited labor shortages and the rising cost of building materials as their biggest problems in 2018.  And both these issues look set to continue as an increasingly tight labor market keeps the number of job openings in construction elevated and tariffs on lumber, steel, and aluminum drive up input costs.  Cost concerns were echoed in yesterday's NAHB Index, but seem to be stabilizing, as lumber prices have fallen nearly 50% since reaching a record high in May.

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Implications:  Industrial production continued to climb higher in September, posting a fourth consecutive month of growth to hit a new record high.  And a look at growth in the past year shows industrial production – which counts "units" of output and is therefore a proxy for "real" growth – rising at the fastest 12-month pace since late 2010.  It should also be noted that the Federal Reserve reported in today's release that output growth was held down in September due to impacts by Hurricane Florence. In other words, the trend pace of growth is even faster than the headline number suggests.  Looking closer at the details of today's report shows that manufacturing, which makes up the largest part of overall production, rose 0.2% in September.  The typically volatile auto production series led the way in September, up 1.7%.  But even excluding autos, manufacturing production rose a healthy 0.2%.  In the past year manufacturing activity is up 3.5%, while manufacturing ex-autos is up 3.3%, both representing the fastest 12-month increases since 2012 for their respective series.  This demonstrates that the strength in overall manufacturing is broad-based and looks likely to persist, though storm impacts may increase the volatility in the data over the coming months.  Mining, meanwhile, grew for the eighth month in a row and is up 13.4% from a year ago.  Keeps this data in mind through market gyrations as yet another reminder that the fundamentals for continued growth remain in place.  It's heartburn, not a heart attack.  In housing news this morning, the NAHB index, which measures homebuilder sentiment, rose to 68 in October from 67 in September, remaining at a historically elevated level as homebuilders cited an optimistic outlook thanks to both economic and demographic tailwinds.      

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Implications:  It looks like Hurricane Florence hit retail sales hard in September, with restaurant & bar sales down 1.8% for the month, the largest drop for any month since late 2016.  As a result, retail sales grew less than expected in September, but we wouldn't read too much into today's release.  Retail sales still grew 0.1% in September, the eighth consecutive monthly gain.  And excluding restaurants & bars, retail sales were up 0.4%, and the gains in September were broad-based, with ten of thirteen major categories showing rising sales, led by autos and non-store retailers (internet & mail order sales).  Non-store retailers now make up 11.4% of all retail sales, a record high, and are up 11.4% over the past year.  Overall retail sales are up a solid 4.7% from a year ago (and up an even stronger 5.7% excluding auto sales).  After plugging in the retail numbers, "real" (inflation-adjusted) consumer spending in the third quarter looks to have grown at about a 3.0% annual rate, supporting our projection of about 4.0% real GDP growth for Q3.  Given the tailwinds from deregulation and tax cuts, we expect an average real GDP growth rate of 3%+ in both 2018 and 2019, a pace we haven't seen since 2005.  Jobs and wages are moving up, tax cuts have taken effect, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs. Some may point to household debt at a record high as reason to doubt that consumption growth can continue.  But household assets are at a record high, as well.  Relative to assets, household debt levels are the lowest in more than 30 years.  In other words, there's plenty of room for consumer spending – and retail sales – to continue to trend higher in the months to come, but don't be surprised if the series remains choppy in the short-term due to Hurricane Michael.  In other news today, the Empire State index, a measure of factory sentiment in New York, rose to a 21.1 in October from 19.0 in September, signaling continued optimism in the region.  On the inflation front, import prices rose 0.5% in September, while export prices were unchanged.  The large rise in import prices was due to a 4.1% increase in fuel costs. Export prices remained unchanged due to lower prices for farm exports offsetting higher nonagricultural prices.  Import prices are up 3.5% in the past year, while export prices are up 2.7%, both signaling the need for continued rate hikes from the Fed.

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Not long ago, many investors were kicking themselves for not investing more when the stock market was cheaper.  But when stocks fall, like they did last week, many investors have a hard time buying for fear stocks may go lower still.

Who knows, maybe they're right.  We have no idea where stocks will close today, nor at the end of the week.  Corrections (both small and large) happen from time to time.  In hindsight, many claim they knew it was coming, but we don't know anyone who has successfully traded corrections on a consistent basis – we certainly won't try.

We're also skeptical when analysts try to attribute corrections to a particular cause.  It's a basic logical flaw: post hoc ergo propter hoc.  Because the correction happened after a certain event, that event must have been the cause.  But important news and economic events happen all the time.  Sometimes the market goes up afterward, sometimes down, and similar events at different times have no discernible impact.

Now some are blaming the Federal Reserve, and specifically statements from Chairman Powell, for the downdraft in equities.  But, according to futures markets, the outlook for monetary policy has barely changed.  The markets are still pricing in a path of gradual rate hikes and continued reduction in the size of the Fed's balance sheet.

Let's face it, fretting over the Fed is as old as the Fed itself.  In recent years alone, we faced the "Taper Tantrum" and calls for a fourth round of quantitative easing.  And remember when the Fed first raised rates and then announced it would reduce its balance sheet?  Each time, analysts predicted the apocalypse was upon us – that a recession and bear market were right around the corner.  How did those calls pan out?

Exactly, they were wrong, and this time looks no different.  QE never lifted stocks, taking it away won't hurt; and interest rates are still well below neutral.  The biggest pain has been felt by those who followed the false prophets of doom.

The odds of a recession happening anytime soon remain remote, we put them at 10%, or less.  And a recession is what it would take for us to expect a full-blown bear market. In other words, the current downdraft is just heartburn, not a heart attack.

We'll publish a piece next week about our exact forecast for economic growth in Q3, but it looks like real GDP rose at about a 4.0% annual rate.  Profits are hitting record highs and businesses are still adapting to the improved incentives of lower tax rates and full tax expensing for business equipment.  Home building is still well below the pace required to meet population growth and scrappage (roughly 1.5 million units per year).  Household debts are low relative to assets and debt service payments are low relative to income.  These are not the ingredients for a recession.

That's why we love Jerome Powell's response to the recent gyrations in the market.  Many pundits were calling for him to back off his tightening and his "hawkish" language, but he didn't take the bait.  He's focused on monetary policy, and the economy and won't be pushed around by hysterics or market gyrations.  The S&P 500 fell about 6% from its intraday all-time high to Friday's close.  This isn't earth-shattering, and the Fed shouldn't respond.  Investors need to stop obsessing about the Fed.  Instead, they should focus on entrepreneurship and profits.  The fundamentals are what matter.  

Meanwhile, some investors are concerned about President Trump tweeting or speaking out on the Fed and monetary policy.  If this were any other president, we'd be concerned, as well.   But we all know Trump isn't the kind of president to hold his opinions close to the vest on any topic.  If he thinks it, he says it.  Please take his comments on the Fed in that context.  That certainly seems to be what Jerome Powell is doing.

The bull market in equities that started in March 2009 isn't going to last forever.  But we don't see anything that's going to bring it to a screeching halt anytime soon.                         

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Source: St. Louis Federal Reserve FRED Database

Implications:  Consumer prices rose less than expected in September, but the upward trend in inflation remains intact.  Consumer prices rose only 0.1% in September, compared to the 0.2% the consensus expected.  But in the past eight Septembers (2010-2017), consumer prices have risen as much as expected four times, while rising less than expected four times, so September data may be influenced by some seasonal issues.  In other words, investors shouldn't see tepid inflation in September as a shift in the overall upward trend.  Look for a rebound in inflation reported a month from now.  Even with the soft inflation reading for September, consumer prices are up 2.3% from a year ago and have exceeded the Fed's 2% inflation target for thirteen consecutive months.  To put it in a longer-term perspective, consumer prices rose 2.2% for the twelve-months ending September 2017, 1.5% for the twelve-months ending September 2016, and were unchanged for the twelve-months ending September 2015.  So, after running stubbornly below the Fed's inflation target for the first five years of the recovery, the question has shifted from "will the Fed wait on raising rates?" to "can the Fed wait on raising rates?" No, this isn't runaway inflation, but with the federal funds rate well below the pace of nominal GDP growth, the odds of higher inflation – paired with a tight labor market and widespread strength in economic data - should be enough to keep the Fed on track for slow-but steady hikes through at least the end of 2019 (think one more this year, and four next year).  Energy prices fell in September, declining 0.5% on the back of lower prices for electricity and natural gas.  That said, energy prices are still up 4.8% in the past year.  Food prices, meanwhile, were unchanged in September.  "Core" consumer prices – which exclude both food and energy costs – rose a modest 0.1% in September but are up 2.2% in the past year.  Taking a deeper dig into today's report shows the 0.1% increase in core prices was once again led by owners' equivalent rent (the amount an owner would need to pay in order to rent their home on the open market).  Meanwhile, a 3% drop in used car and truck prices – which tied the steepest decline for any month since 1969 – as well as declines in prices for hospital services and prescription drugs held down the overall increase in core prices.  The best news in today's report was that real average hourly earnings rose 0.3% in September.  While these wages are up just 0.5% in the past year, there is clear acceleration, with wages up 1.3% at an annual rate in the past six months, and up at a 1.9% annual rate over the past three months.  And importantly, these earnings do not include irregular bonuses – like the ones paid by companies after the tax cut or to attract new hires – or the value of benefits.  It's an imperfect measure (to say the least), but we still expect a visible pickup in wage pressure in the year ahead.  In employment news this morning, initial jobless claims rose 7,000 last week to 214,000, while continuing claims rose 4,000 to 1.66 million.  Both measures stand near multi-decade lows, reiterating the strength of both the labor market and the economy.  Note that Hurricane Michael will influence claims reports for at least the next couple of weeks and may temporarily limit job gains in the October employment report, as well.        

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Implications:  Following a surprise lull in August (the first decline in eighteen months), producer prices returned to their rising ways in September.  And the 0.2% increase in producer prices in September came in spite of a 0.8% decline in energy prices and a 0.6% decline in food prices.   Strip out these two volatile categories, and "core" producer prices rose 0.2% in September and are up 2.5% in the past year.  A look at the details in September shows the rise was led by increased costs for services, including a 5.5% rise in prices for airline passenger services.  Goods prices, meanwhile, fell 0.1% in September, the first decline for the category since May of 2017.  However, the September decline in goods was entirely due to the food and energy categories. Strip those out, and goods prices increased 0.2% in September.  Also of note in today's report was that trade services prices (think margins to wholesalers and retailers) continues to run below the pace of both headline and "core" inflation.  This could be the result of companies accepting smaller margins in the short-term, rather than raise prices for consumers, as input prices increase.  A look at recent ISM reports suggests strong order activity paired with difficulty finding qualified labor and freight truck drivers is putting price pressure on some industries.  Excluding food, energy, and trade services, producer prices rose 0.4% in September and are up 2.9% in the past year, tied for the highest twelve-month increase since the series began in late 2014.  No matter which way you cut – headline prices up 2.6% in the past year or "core" prices up 2.5% - trend inflation clearly stands above the Fed's 2% target.  Paired with recent comments by Fed Chair Powell and continued strength in economic data, we expect both FOMC members and the markets as a whole to shift towards our long-standing expectation for one more hike this year (for a total of four in 2018) and four more hikes to come in 2019 (the Fed currently forecasts three hikes in 2019, while the markets are pricing in just two).  With nominal GDP growth of 4.6% over the past two years, monetary policy is far from being tight, and a steady pace of rate hikes won't dent the Kevlar economy. 

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Federal Reserve Board Chairman, Jerome Powell, who has been remarkably quiet as he adjusts to his new role at the Fed, finally roiled markets last week.  He made comments on Wednesday, during the Atlantic Festival at a session moderated by Judy Woodruff of the PBS News Hour.

Powell said, "The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore."

He added, "(I)nterest rates are still accommodative, but we're gradually moving to a place where they will be neutral.  We may go past neutral, but we're a long way from neutral at this point."  [Our emphasis added.]

The reaction of the markets was swift and dramatic.  The 10-year Treasury note rose from 3.06% on Tuesday to 3.23% on Friday, its highest yield since 2011.  From their intraday highs on Wednesday to Friday's close, the Dow Jones Industrial Average fell 1.8%, the S&P 500 fell 1.8%, and the NASDAQ Composite fell 3.3%.

To begin with, we agree completely with Mr. Powell.  There are a number of models that purport to measure a "neutral" interest rate – a federal funds rate which does not hurt growth, but also does not lift inflation.  Rates above neutral hurt the economy, rates below neutral lift inflation.

One model is the "Taylor Rule," which is based on setting separate targets for real GDP growth and inflation and then adjusting short-term interest rates when these data deviate from the targets.  For example, if inflation and economic growth are above the target, then the "neutral" rate should move higher.  If the economy or inflation fall, then so should the neutral rate.  There are multiple versions of the Taylor Rule and right now these versions suggest a neutral federal funds rate somewhere between 3% and 5%.

While we very much like a rule-based monetary policy, and think the Taylor Rule is a fine rule, we try to simplify things even more.  We think the growth rate of nominal GDP (real growth plus inflation) is the best target.  Nominal GDP (or total spending in the economy) is a measure of the average growth rate of all business plus government.  When interest rates are below this average growth rate there's an incentive for business to borrow even for projects that return less than average.  This can cause distortions in the market.  When rates are above this average, it can shut down activity.

Our model uses a two-year moving average of nominal GDP growth to avoid the volatility of shorter time frames.  In the past, when the Fed has lifted the federal funds rate above two-year nominal GDP growth, recessions have occurred.  It happened in 1969, 1973-74, twice in the early 1980s, 1990-91, 2000-01, and 2007-08.

Right now, nominal GDP growth over the past two years has been 4.6%.  Looking back, a federal funds rate of roughly 50 to 75 basis points below nominal GDP growth is roughly neutral.  As a result, we currently estimate a neutral rate around 4%. Moreover, we believe real GDP will keep growing at least 3% annually, while inflation continues to rise by 2% or more.  In other words, the "neutral" rate is rising.  And likely moving toward 4.5%.

This is why we agree with Chairman Powell.    At the same time, we think the stock market has over-reacted, while the bond market is finally bowing to the reality that longer-term rates are heading much higher.

We have never believed that long-term rates were being held down by recent slow growth or low foreign rates.  We believe they have been held down by the Fed's policy of low short term rates and the market belief that the Fed would hold them low.  That has now changed.

And, yes, higher interest rates do reduce the fair value of equities.  But even with current earnings, it would take a 3.7% 10-year yield to make current equity values "fair." With earnings likely to grow 20%+ this year and 10%+ next year, the market can handle higher interest rates and continue to rise.  Higher rates are coming, but that doesn't mark the end of the recovery or the bull market. 

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Source: St. Louis Federal Reserve FRED Database