Implications:  With so many other key reports postponed by the partial government shutdown – retail sales, international trade, housing starts – we are paying even more attention to the other data we do get, like today's report on industrial production, which showed the manufacturing sector soaring at the finish of 2018.  Industrial production rose a solid 0.3% in December, narrowly beating consensus expectations, and is up a robust 3.9% in the past year.  But the details of today's report were much stronger than the headline gain.  Manufacturing grew 1.1% in December, the second fastest pace in 2018.  Part of the gain in manufacturing was related to a surge in auto production, which rose 4.8%.  However, even excluding the volatile auto sector, manufacturing was still up 0.8% for the month.  In the past year, the various capital goods indices continue to show healthy growth with business equipment up 5.0%, machinery up 4.9%, and high-tech equipment up 5.6%.  Comparing this with the slower year-over-year growth of 1.6% for nondurable goods, or 3.3% for manufacturing as a whole demonstrates that capital goods production remains a valuable source of strength in the sector.  In turn, more capital goods should help push productivity growth higher, making it easier for the economy to grow in spite of a tight labor market.  Mining also continued its rebound in December, rising 1.5%.  The advance was due to gains in oil and gas extraction and nonmetallic mineral mining.  Mining is now up 13.4% in the past year.  The only notable decline in December came from utilities which fell 6.3%, as unseasonably warm weather in much of the country in the early part of the month reduced demand for heating.  In recent employment news, initial jobless claims fell 3,000 last week to 213,000. Meanwhile, continuing claims rose 18,000 to 1.74 million. These figures are consistent with continued robust job gains in January, at least in the private sector.  However, the prolonged nature of the government shutdown will mean workers on furlough are treated as unemployed for the month, boosting the unemployment rate for the month and potentially sending the payroll number (temporarily) into negative territory.  In other recent news, import prices declined 1.0% in December, while export prices fell 0.6%. In the past year, import prices are now down 0.6%, while export prices are up 1.1%.  Finally, on the housing front, the NAHB index, which measures homebuilder sentiment, rose unexpectedly to 58 in January after hitting a three year low of 56 in December. The rebound was primarily attributed to mortgage rates, which have fallen significantly since the November peak, and have helped allay builders' concerns about affordability for buyers.

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Implications:  Producer prices declined for just the second month in 2018, ending the year tied for the largest annual increase in prices since 2011.  Strip out the ever-volatile energy category - which fell 5.4% in December and has declined 2.7% in the past year – and producer prices saw the largest annual increase since the switch to the new calculation method back in late 2009.  Keep that in mind when the pouting pundits inevitably latch on to the December decline for an argument that the Fed should pause rate hikes.  With prices up 2.5% in the past year (and a faster 2.7% "core", which excludes food and energy prices), the Fed certainly has the data to support further hikes in the year ahead and will raise rates so long as interest rates provide room.  While energy was the primary reason for the December decline, the drop in prices was broad based.  In addition to energy, prices for trade services (think wholesaler margins) fell 0.3% in December, and transportation & warehousing services fell 0.2%, offsetting a 2.6% jump in food prices.  That said, the trend remains in place for inflation of around 2.5% in the year ahead, which would exactly match the readings for both 2017 and 2018.   Higher inflation remains in the pipeline, with processed and unprocessed goods prices up 3.0% and 9.1% respectively over the past twelve months.  And both the ISM Manufacturing and Non-Manufacturing indices remain comfortably in expansion territory, while the increasingly-tight labor market for qualified labor to both produce and transport goods should push wages - and general prices - higher in the year ahead.  Note that private capital equipment prices rose 3.3% in 2018, an acceleration from the 2% gain in 2017 and faster than any calendar year since this data series started in 2011.  This gain signals more business investment, which should help sustain economic growth at higher levels than   the consensus expects.  On the manufacturing front, the Empire State Index, which measures factory sentiment in the New York region, fell to 3.9 in January from 11.5 in December.  Despite the drop, the index remains in expansionary territory, and the forward-looking components continue to show optimism for the year ahead.  Those upset about the drop need to know that the index is now the lowest since May 2017.  Remember a recession in mid-2017?  Of course not.  And there won't be one in 2019, either.

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For the more than three decades we have been involved in analysis of the economy, one nagging constant has been pessimistic prognostications over the U.S. debt.  Now once again, debt is the news de jour.  Consumer, business, and government debt are all at record highs, and, therefore, the theory goes, the economy is tempting fate.

We have some very basic problems with this theory.  Debt has been rising for decades, as it usually has since the US was founded more than 200 years ago.  But just like debt, assets, incomes and profits have hit record highs too.  While it's true that debt is usually at a record high when a recession starts, debt itself doesn't cause recessions.  And debt itself doesn't cause growth either.  If it did, then Puerto Rico and Greece would be economic powerhouses; instead, they're basket-cases.

Debt is a transfer of assets from someone who wants to spend less than they earn today, to someone who wants to spend more.  When this debt fuels investment in entrepreneurial ventures that boost growth, then debt helps lift the economy.  But if spendthrift consumers or governments borrow money for non-productive activities, then debt goes up while production stagnates.  That's a problem, as there are no extra goods and services to offset the cost of larger debt payments as they come due.

The other thing about debt is that it can sometimes spur on more production.  Imagine you wake up tomorrow and are $10,000 more in debt.  Are you going to work more hours or fewer to pay that off?        

In other words, investors should neither be "debtophobes" or "debtophiles."   Instead, investors should be agnostic about debt, looking into the underlying reasons for the debt as well as its sustainability relative to asset levels and income.   

Take, for example, the national debt of Japan, which is about 235% of GDP.  That's a lot of debt!  But Japan's interest rates have been hovering around 0% for years, which means the carrying cost of the enormous debt is minimal (for now).    

Another example is the US consumer.  Household debts are at a record high of $15.9 trillion, beating even the $14.7 trillion record set in early 2008 before the financial crisis and Great Recession.  This includes mortgages, home equity loans, student loans, auto loans, credit card debt,...etc.  So, the thinking goes, if we had a crisis after the last record high and now we're even higher, there must be a new crisis lurking around the corner.

The problem with this theory is that it ignores asset values.  Back at the old peak in household debt in 2008, debts were 19% of assets; now they're 12.7% of assets, the lowest share since the mid-1980s.  Meanwhile, households' debt service is the lowest share of after-tax income since at least the 1980s.  Corporate debt, too, is low relative to assets in historical comparisons, and interest costs as a percent of profits are well within the normal range.         

Faster growth in recent years may have coincided with higher debts in some areas, but it wasn't caused by higher debts.  Growth has picked up thanks to a mix of better policies and entrepreneurship.  Bottom line is we don't see anything about the current level of debt that's going to cause a recession anytime soon.  Let the pouting pundits kick and scream but focus your attention on more important things.

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Feel free to completely ignore the headline decline in consumer prices in December, as a sharp decline in gas prices masked inflation in nearly every other category.  Sure, some pouting pundits will grasp on to the first decline in nine months or the fact that consumer prices dipped below the Fed's 2% inflation target on a twelve-month basis for the first time in over a year, but the Fed won't be fooled; the expectation among some market participants of a rate cut in 2019 is way off-base.  Recent months are a textbook example of how volatility distorts the headline reading. Energy prices rose 2.4% in October before falling 2.2% in November and 3.5% in December.  Meanwhile, "core" inflation (which excludes the typically volatile food and energy categories) has risen a steady 0.2% in each of those months.  Over the past three months, overall inflation has risen at a modest 1.2% annualized, while "core" prices are up at a 2.5% annual rate.  In other words, the Fed (which understands the short-term volatility coming from the energy sectors) will feel there is ample data to support a path of continued rate hikes if – and this is important – we see longer term interest rates begin to rise.  The Fed does not want to force a yield curve inversion, but we believe continued solid economic growth and further resolution of trade tensions will bring confidence back to the markets and a return to a more "risk on" environment will put upward pressure on interest rates.  As we stated in our annual forecasts release, we expect the 10-year Treasury to end the year at 3.4%, giving the Fed room for two, maybe three hikes in 2019.  Looking at the details of the November report shows housing and medical care led the rise in "core" prices, up 0.4% and 0.3%, respectively.  Arguably the best news in today's report was that real average hourly earnings rose 0.5% in December – meaning wages rose 0.5% faster than inflation.  These real wages are up just 1.1% in the past year but have been accelerating, with wages up 2.2% at an annual rate over the past three months and up 2.1% at an annual rate in the past six-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 this looks like it could be the long-awaited start to rising wage pressures that have been stubbornly slow over recent years.  The labor market remains strong and companies continue to report that finding available qualified labor remains a top headwind to even faster growth.  In recent employment news, initial jobless claims fell 17,000 last week to 216,000.  Meanwhile, continuing claims declined 28,000 to 1.72 million. These figures are consistent with continued robust job gains in January, though expect a slowdown from December's blistering jobs report and the lack of a resolution in the partial government shutdown may temporarily roil the January jobs report.  Put it all together, and the data show pretty much exactly what you would expect from an economy growing at a healthy clip, and we expect more of the same in 2019.

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Source: St. Louis Federal Reserve FRED Database

Implications:  The pace of growth in the service sector slowed in December, but despite the year-end dip, 2018 averaged the highest reading for the index since the series began in the late 1990s.  And while the pouting pundits may put up a huff over the monthly decline (any slowdown in economic data has brought out the doomsayers), the December reading of 57.6 was higher than the annual reading for any year since 2005, except for 2018 itself.  In other words, hardly reason for concern.  A look at the details of today's report shows that growth was broad-based, with sixteen of eighteen industries reporting growth in December while just one, mining, reported a decline (one industry reported no change).  In addition to the breadth of growth, the two most forward-looking indices – new orders and business activity – remain comfortably in growth territory, even with the 5.3-point decline in the business activity index.  The employment index, in a somewhat paradoxical move given last Friday's booming jobs report - declined to 56.3 from 58.4 in November.  Survey respondents continue to note that the tightening labor market has made hiring (and retaining) employees more difficult, and this in turn has been pushing wages higher.  Finally, the supplier deliveries index once again declined in December, signaling that delays related to labor shortages, component shortages, and freight issues (due to a lack of truck drivers), are easing somewhat.  These delays, paired with the strength in new orders, are putting upward pressure on prices – which continued to rise in December though at a slower pace than in November.  While we don't expect prices will soar any time soon, this suggests inflation will continue to run near-or-above the Fed's 2% target, keeping the Fed on track for continued rate hikes in 2019 if long term interest rates move up as we expect.  As a whole, 2018 was a strong year for both the services and manufacturing sectors, and the tailwinds that sped growth look set to continue in the new year.  

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Talk about destroying a narrative.  On Friday, the Labor Department reported 312,000 new jobs in December, with an additional 58,000 from upward revisions to prior months.  Recession talk got crushed. 

The Pouting Pundits of Pessimism claim jobs are a lagging indicator, but the pace of payroll growth starts declining well before a recession starts.  In the twelve months ending in June 1989 nonfarm payrolls increased a robust 225,000 per month.  In the next twelve months payrolls rose a softer 153,000 per month and then a recession officially started in July 1990. 

A similar pattern happened before the next two recessions, as well.  In the twelve months ending in February 2000, payrolls rose 250,000 per month before decelerating to 137,000 per month in the next twelve months.  A recession started in March 2001.

In the twelve months ending in November 2006, payrolls rose 173,000 per month and then slipped to 101,000 per month in the following twelve months.  After the financial crisis started, the National Bureau of Economic Research dated the start of the Great Recession to December 2007.

By contrast, nonfarm payrolls are up an average of 220,000 in the past twelve months versus a gain of 182,000 per month in the twelve months before that.  On a quarterly basis, from Q2-2017 to Q4-2018, job growth has been 473,000, 553,00, 556,000, 632,000, 634,000, 623,000 and 670,000.  In other words, no sign of the kind of slowdown in job creation that normally precedes a recession; instead, job creation appears to be accelerating. 

Yes, the unemployment rate did rise to 3.9% in December from 3.7% in November, but that's because the growth of the labor force was a healthy 419,000.  A slower decline in the unemployment rate combined with faster economic growth signals that potential GDP growth has increased, exactly the response we would expect with lower marginal tax rates and deregulation.

If the partial government shutdown continues into the employment survey week, the unemployment rate may rise in January, but that'll be temporary, unwinding when the political showdown ends.

Perhaps the best part of Friday's report was that workers' wages are accelerating.  Average hourly earnings rose 0.4% in December and are up 3.2% from a year ago.  And that's excluding extra earnings from irregular bonuses and commissions like those paid out after the tax cut was passed.

Another piece of hard data and good news last week also undermines the recession theory: automakers reported that Americans bought cars and light trucks at a 17.55 million annual rate in December, the fastest pace since November 2017, when sales were still surging in the aftermath of Hurricanes Harvey and Irma.  We don't expect auto sales to stay this strong, but recent strength shows consumers are not under stress.

Yes, the ISM Manufacturing report for December fell short of consensus expectations, but since this is a survey, it's easier to pick up temporary noise, as human emotion can be a factor over the short term.   Still, even at 54.1, it still shows healthy expansion and is well above recession territory.  The last three recessions started with the ISM at 46.6 (July 1990), 43.1 (March 2001), and 50.1 (December 2007).  In the past year manufacturing jobs are up 24,000 per month, as opposed to the contraction in these jobs usually seen before a recession starts.

Monetary policy is not tight and is unlikely to be anytime soon.  Companies are still adapting to lower tax rates, full expensing, and less regulation.  Consumers will be surprised with their larger than anticipated tax refunds.  A trade deal has been struck with Mexico and Canada and negotiations with Europe and Japan should result in lower tariffs on US exports.  The sore spot is China, but the US has lots of leverage given the large trade deficit.

At some point the US will have a recession.  But none of the data we're looking at suggests a recession will start anytime in the near future.  In turn, we think profits will continue to grow and that even at the current level of profits, US equities remain cheap.

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

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