Implications:  Existing home sales continued to moderate in April, slipping 0.4% to post back-to-back declines after a sharp surge in activity in February.  Despite the negative headline number in April, the ingredients are present for an upward trend in sales in 2019.   First, even though median prices have risen for eighty-six months in a row on a year-over-year basis, the rate of growth has been slowing, with April showing a modest increase of 3.6%.  This means wages are now growing nearly as fast as prices. On top of this, mortgage rates have fallen roughly eighty basis points since their November peak, which further boosts affordability.  The primary culprit behind the tempered existing housing market in 2018 was lack of supply, but here too there's been progress.  Inventories have turned a corner, rising on a year-over-year basis (the best measure for inventories given the seasonality of the data) for the ninth month in a row.  It looks like sellers really are changing their behavior, and a reversal in the steady decline of listings from mid-2015 through mid-2018 is a welcome reprieve for buyers, boosting supply and sales, while keeping a lid on price growth.  We have already seen some positive effects on sales activity from these factors, with Q1 as a whole posting a 1.2% gain over the Q4 2018 average, the first quarterly gain after four consecutive declines.  That said, some headwinds for sales remain.  First, potential homebuyers in high-tax states are likely still reeling from the $10,000 cap on state and local tax deductions.  Second, the months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – was only 4.2 months in April and has now stood below 5.0 (the level the National Association of Realtors considers tight) since late 2015.  With demand so strong that 53% of homes sold in April were on the market for less than a month, continued gains in inventories will remain crucial to sales activity going forward.  It won't be a straight line higher for sales in 2019 but fears the housing recovery has ended are overblown.

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At the close of activity on Friday the futures market in federal funds was projecting a 75% chance of at least one rate cut this year.  From now through the end of 2020, the market is projecting two rate cuts. 

We thought markets stopped believing in Santa Claus a long time ago, but unfortunately it doesn't appear so.

The US economy is nowhere even close to needing one rate cut much less two.  Nominal GDP – real GDP plus inflation – was up at a 3.8% annual rate in the first quarter, is up 5.1% from a year ago, and is up at a 4.8% annual rate in the past two years, all well above the federal funds rate of 2.375%. 

Yes, the yield on the 2-year Treasury security is only 2.21% – meaning the very short end of the yield curve is inverted – but that's because many investors anticipate rate cuts.  Hypothetically, if the Federal Reserve were to cut rates once this December and once in December 2020, then the average federal funds rate over the next two years would be very close to 2.1%, which is what's holding down the 2-year yield in the first place.

But we don't think the Fed is anywhere close to cutting rates, as we suspect the minutes from the last meeting (on April 30 and May 1) will show.  Those minutes will be released this Wednesday, two days from now.

The last time the Fed issued one of its "dot plots" was on March 20.  At the time, there were six Fed policymakers who thought the Fed would raise rates at least once later this year, while eleven thought the Fed would remain steady.  As far as 2020 was concerned, not one policymaker saw rates lower at the end of that year than they are today.

Think of the environment in which the Fed made those projections.  The S&P 500 was lower than the Friday close while the 10-year Treasury yield was higher.  In other words, some analysts at the Fed should be thinking that current financial conditions are already more accommodative than they were on March 20. 

It's also important to recognize that on March 20 the Atlanta Fed's GDP model was projecting a 0.6% real GDP growth rate for the first quarter while the New York Fed's model was forecasting a growth rate of 1.4%.  As it turns out, real GDP grew at a 3.2% annual rate in Q1, although this figure may be revised down slightly next week.   
 
In spite of all this, some on the Fed seem to be listening to the White House and are angling for a looser stance for monetary policy in the future.  This includes Minneapolis Fed Chief Neel Kashkari and Fed Governor Lael Brainard, both of whom seem comfortable with letting measured inflation run consistently above 2.0% for several years. 

We think that would be ill-advised but might end up happening anyhow.  Monetary policy has been loose for a long time and, given the lags between Fed policy and inflation, will most likely result in inflation exceeding the Fed's 2% target.

To us, it looks increasingly likely that the Fed isn't going to raise rates this year.  However, we do expect that tight labor markets, rising wages, continued 3% real GDP growth and a boost in inflation will increase pressure for a rate hike and change the mind of any Fed doves.  If the Fed hasn't lifted rates by mid-year 2020, then don't expect one until December.  The Fed has meetings scheduled for November 4-5th, 2020, right after the presidential election, and then mid December 2020. Raising rates days after the election would make the Fed appear very political.

We think that's unfortunate because the economy could easily withstand a rate hike, and such a move would help stabilize the economy over the longer term by preventing an upward move in inflation in the future.

In the meantime, postponing short-term rate hikes probably means longer term interest rates stay relatively low, as well.  While we think this is a mistake, low long-term rates are a positive for equities in the meantime. 

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Housing starts surprised to the upside in April, hitting a 1.235 million annual rate, signaling signs of life in home building early in the second quarter.  In addition, housing starts were revised higher for March.  And a pickup in construction activity looks set for the months ahead.  There has been a rapidly growing backlog in planned housing projects (the number of units authorized but not yet started), which are up 19% in the past year and remain very close to the post-recession high set in January.  Builders have responded with a surge in completions, which should help free up badly needed workers to start development on new projects.  The increasingly tight labor market has made hiring difficult across industries, and construction has felt an especially tight pinch.  The National Association of Home Builders recently released their survey of top challenges for builders in 2019, and concerns related to the cost and availability of labor were the most prevalent, with 82% of developers surveyed citing them as their biggest challenge in the year ahead.  Despite the headwinds from labor, fundamentals for potential buyers have improved markedly over the past several months.  Mortgage rates have dropped roughly 80 basis points since the peak late last year, and wages are now growing faster than new home prices, boosting affordability.  Although housing starts are down 2.5% from a year ago, this is largely due to the effects of the unusually strong hurricane season in late 2017, which spurred a surge in building in early 2018.  In other words, it's not surprising – or worrying - that recent starts data looks weak in year-ago comparisons.  The forward-looking data in today's report show that permits for new construction rose 0.6% in April, the first increase of 2019.  That said, the gain was entirely due to multi-unit permits; single-family permits have failed to gain any ground so far this year.  Overall, our outlook on housing hasn't changed: we 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.  In employment news this morning, initial jobless claims declined 16,000 last week to 212,000.  Continuing claims fell 28,000 to 1.660 million.  These readings suggest another solid month of job creation in May.  On the manufacturing front, the Philly Fed Index, a measure of East Coast factory sentiment, jumped to +16.6 in May from +8.5 in April, signaling continued growth.  Recent positive releases of regional manufacturing surveys suggest yesterday's negative report on production in the manufacturing sector in April was an outlier.

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Source: St. Louis Federal Reserve FRED Database

Implications:  Industrial production disappointed in April, falling short of expectations and posting its third decline in four months.  And the details of today's report weren't much better, with nearly all major categories posting declines.  However, this doesn't mean the end of the economic recovery, or even close.  We've experienced sluggish periods in industrial production before, like in 2015-2016, and the economy continued to grow overall.  Expect the same this time around, as well.  Moreover, the production data are inconsistent with ISM indices and manufacturing employment.  The biggest source of weakness in April came from manufacturing outside the auto sector (which represents the majority of activity), where activity fell 0.4%.  Adding the 2.6% drop in the volatile auto sector on top of this generated a decline in overall manufacturing of 0.5% in April.  The manufacturing headline series also ticked negative on a year-over-year basis in April, the first such negative reading since late 2016.  In the past year auto production is down 4.4%, while manufacturing outside the auto sector is still up 0.1%, demonstrating the ongoing divergence in activity between the two sectors.  Year-over-year growth rates peaked for both manufacturing and headline industrial production in September 2018 and have since declined rapidly, as the above chart shows. Some will suggest that the Trump administration's tariffs on an additional $200 billion in Chinese goods are responsible, and this is something to think about, but as we noted above, other indicators disagree. Manufacturing is only responsible for about 11% of GDP, and is especially sensitive to global demand, but the industrial production data are only one measure.  The bright spot in today's report came from mining, which rose 1.6% due to an increase in oil and gas extraction and coal mining.  The mining series remains near a record high and at 10.4%, is showing the fastest year-over-year growth of any major category.  In other recent news, the Empire State Index, which measures factory sentiment in the New York region, rose to 17.8 in May from 10.1 in April. This signals a continued rebound in optimism after the index touched a recent low in March. On the housing front, the NAHB index, which measures homebuilder sentiment, increased to 66 in May from 63 in April.  The V-shaped recovery in builders' optimism continues to have momentum after the index hit a three-year low of 56 in December. Yes, production data were weak, but they appear to be missing something.

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Implications: Retail sales sagged slightly in April after the largest monthly gain in more than a year in March.  Retail sales declined 0.2% in April, falling short of the consensus expected 0.2% gain.  Some may worry this means the consumer is weakening, but one month does not make a trend. In fact, putting together the last few months, we are seeing an acceleration in sales after the Q4 slump last year. In the past three months, retail sales are up at a 4.9% annual rate versus a 3.1% gain in the past year. These numbers are nowhere close to recessionary.  In fact, the consumer is doing very well and that should continue.  For April itself, six of the thirteen major categories showed a drop in April, led by declines in autos and building materials which fell by 1.1% and 1.9% respectively.  Gasoline stations showed the largest dollar gain rising 1.8% as prices at the pump rose in April.  "Core" sales, which exclude autos, building materials, and gas stations (the most volatile sectors) were unchanged in April, are up at a 3.6% annual rate over the past three months, and are up 3.4% from a year ago.  Even if these sales are completely unchanged in May and June, they'll be up at a 2.8% annual rate in Q2 versus the Q1 average.  Given the tailwinds from deregulation and tax cuts, we still expect an average real GDP growth rate of close to 3% in 2019, just like we saw in 2018.  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 near a record high, as well.  Relative to assets, household debt levels are hovering near the lowest in more than 30 years.  For these reasons, expect solid gains in retail sales over the coming months.  On the inflation front, both import and export prices rose 0.2% in March. In the past year, import prices are down 0.2%, while export prices are up 0.3%.  Expect higher year-ago comparisons later in 2019 due to the rebound in energy prices.

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Since hitting new all-time highs two weeks ago, the S&P 500 has fallen about 2.2% as trade negotiations with China hit a snag.  Last week, the US announced new tariffs on Chinese imports.  This morning, China announced new tariffs on some US goods. Many fear a widening trade war.

Don't get us wrong.  We want free trade, and we understand the dangers of trade wars and tariffs (which are just taxes on consumers).  At the same time, we think trade deficits themselves are not a reason for trade wars.  We all run personal trade deficits with the local grocery store and benefit from that.  Even if the entire world went to zero tariffs, the US would almost certainly still run trade deficits, even with China.

But today, the trade deficit with China is partly due to the fact that China has higher tariffs on imports than the US does – working to eliminate these lopsided tariffs is worthwhile.

In 1980, China was an impoverished nation.  Then it began adopting tools of capitalism – property rights, markets, free prices and wages.  Chinese businesses started to import the West's technology, and growth accelerated.

Initially, China didn't have to worry about intellectual property.  When you replace oxen with a tractor, all you have to do is buy the tractor, not reinvent the internal combustion engine.  But China has now picked, and benefited from, the lowest hanging fruit.  So, China decided to steal the R&D of firms located abroad.  Some estimates of this collective theft run into the hundreds of billions of dollars.

That's why normal free market and free trade principles don't neatly apply to China. 

Remember President Reagan's old story supporting free trade?  "We're in the same boat with our trading partners," Reagan said.  "If one partner shoots a hole in the boat, does it make sense for the other one to shoot another hole in the boat?"  The obvious answer is that it doesn't, and so our own protectionism would hurt us.

But China hasn't just shot a hole in the boat, they've become pirates.  If Tony Soprano and his cronies robbed your house, would free market principles require you to trade with them to buy those items back?  Of course not! 

It's true tariff increases will not help the US economy.  But $100 billion of tariffs spread over $14 trillion of consumer spending is not a recession inducing drag.  It's true some business, like soybean farmers, are hurt.  But the status quo means accepting hundreds of billions in theft from companies that are at the leading edge of future growth.

Either way, if tariffs nick our economy, China's gets hammered.  Last year we exported $180 billion in goods and services to China, which is 0.9% of our GDP.  Meanwhile, China exported $559 billion to the US, which is 4.6% of their economy.  We have enormous economic leverage that they simply can't match.

An extended US-China trade battle means US companies will shift supply chains out of China and toward places like Singapore, Vietnam, Mexico, or "Made in the USA."  If that happens, the Chinese economy is hurt for decades.                       

Anyone can invent a scenario where some sort of Smoot-Hawley-like global trade war happens.  Realistically, though, that appears very unlikely.  We're not the only advanced country China's piracy has victimized, and China may realize it's more isolated than it thought.  In the end, China wants to trade with the West, not North Korea, Russia, and Venezuela.  China needs the West.  And all these trade war hysterics just aren't warranted.     

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

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Implications:  We wouldn't fault investors for thinking that inflation has been little more than an energy story of late, as gas prices in particular seems to grab the headlines when the CPI reports come out.  But a look at the details shows inflation is broad-based.  Strip out food (down 0.1% in April) and energy (which rose 2.9%), and "core" prices rose 0.1% in April.  More important is that these core prices are up 2.1% in the past year, faster than the 2.0% prices have risen when you include food and energy.  In other words, no matter how you cut it, inflation is broadly in-line with Fed targets, and shows no signs of the economic paralysis that bond markets are pricing in.  Housing and medical care costs – both up 0.3% in April - continue to be the primary drivers pushing "core" prices higher, more than offsetting a 1.3% decline in prices for used cars and trucks.  We believe these data, as well as continued strength in employment and the Q1 GDP data, support the case for higher rates, but don't expect much of a change from the Fed when they release updated forecasts – the "dot plots" – at their June meeting.  Their last set of projections released back in March showed eleven FOMC members expected rates to remain unchanged through year end, while six expected one or more hikes and not a single member forecast a cut.  That stands in sharp contrast to the markets, which are pricing in a 62.5% chance of at least one rate cut this year, and zero chance of a hike.  That's nuts.  The fundamentals support higher rates, and the only factor currently restraining the Fed from raising rates is the low level of the yield on the 10-year Treasury Note, which simply isn't reflecting the underlying strength of the economy.  As the year progresses and worst-case scenarios aren't realized, possibly catalyzed by resolution of trade tensions, we expect a return of confidence to the financial markets and a shift back towards a more "risk on" environment, putting upward pressure on interest rates.  The worst news in today's report was that real average hourly earnings fell 0.1% in April following a 0.3% decline in March.  However, they remain up 1.2% in the past year and, with the strength in the labor market noted above, we believe that the trend higher will return in the months ahead.  Add in the 1.6% increase in hours worked over the past year, and employees are continuing to see more cash in their pockets.  And remember, 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.  Healthy consumers balance sheets, continued strong employment growth, inflation in-line with Fed targets, and GDP growth that came in well above the dismal forecasts some pundits were promoting earlier this year, all reinforce our belief that the economy is on very solid ground, and the Fed will keep their eyes on the big picture.  

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Implications:  After surging 0.6% in March, Producer prices increased at a more normal 0.2% pace in April.  But just like the previous two months, the main driver of rising prices in April were energy prices, which rose 1.8% for the month.  Energy prices are now up 43.3% annualized over the past three months, while overall producer prices have risen at a 3.5% rate.  Meanwhile "core" prices, which exclude food and energy, rose 0.1% in April.  In the past year, producer prices are up 2.2%, while core prices are up 2.4%.  In other words, regardless of which measure you prefer, inflation is running modestly above the Fed's 2% inflation target.  And this is a trend, not the result of short-term volatility. "Core" prices have now exceeded the 2% target for twenty-one consecutive months.  Outside of energy, the April increase in producer prices was led by portfolio management services, which jumped 5.3%.  Hospital outpatient care, machinery, equipment, and parts services also moved higher.  In contrast, trade services was the only major category to show a decline in April, falling 0.5%.  Notably, private capital equipment prices are up 2.9% in the past year, the fastest year-over-year growth of any major category, possibly signaling rising demand for business investment which will provide a boost to economic activity in the year ahead.  Given these readings, we think many investors are severely mistaken in their belief that the Fed will cut rates before the end of the year. The data – for employment, inflation, and GDP growth – suggest further rate hikes, not rate cuts, are more likely. 

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