Implications:  Don't be fooled by the weak headline number this morning; the details of today's report continue to demonstrate resiliency from the industrial sector.  Nearly all the month's weakness was from to utilities, which fell 3.6% due to milder-than-usual temperatures in June that reduced the demand for air conditioning.  (It was the coolest June for the contiguous 48 states since 2009.)  Aside from that series, gains were broad-based.  Auto manufacturing rose 2.9% in June following a similarly strong gain of 2.2% in May.  Meanwhile, manufacturing outside the auto sector (which represents the majority of activity) rose 0.2%.  Putting the two series together shows overall manufacturing rose 0.4% in June.  Even though non-auto manufacturing is only up a tepid 0.2% in the past year, the various capital goods production indices continue to outperform the broader index.  For example, over the past twelve months business equipment is up 1.8%, high-tech equipment is up 5.1%, and durable goods more generally are up 1.4%.  By contrast non-durable goods production is down 0.5%, demonstrating that the ongoing weakness in non-auto manufacturing growth isn't being driven by the death of business investment.  It's also important to keep in mind that manufacturing is only responsible for about 11% of GDP and is much more sensitive to global demand than other sectors of the economy.  Finally, mining activity posted a 0.2% increase in June, hitting a new record high.  In the past year mining is up 8.7%, showing the fastest year-over-year growth of any major category.  In other recent news from the manufacturing sector, the Empire State Index, which measures factory sentiment in the New York region, jumped back into positive territory by rising to +4.3 in July from -8.6 in June.  Expect similar rebounds from the various other regional manufacturing surveys in the month ahead.  On the housing front, the NAHB index, which measures homebuilder sentiment, rose to 65 in July from 64 in June. The higher optimism was driven by expectations of stronger sales activity and buyer foot traffic.

Click here for PDF version

Implications: Tell us again why the Fed is thinking of cutting rates.  Add today's retail sales report to the litany of positive news since the Federal Reserve's last meeting in June.  As we wrote in our Monday Morning Outlook out yesterday, a truly "data dependent" Fed would not cut rates at the end of the month, like it has signaled and as the financial markets still anticipate.  Today's retail sales report affirms the consumer is doing very well.  Sales increased 0.4% in June, beating consensus expectations, and are up 3.4% from a year ago.  Eleven of the thirteen major categories had higher sales, led by non-store retailers (think internet & mail order), autos, and restaurants & bars.  Non-store sales are up 13.4% from a year ago, sit at record highs, and now make up 12.5% of overall retail sales, also a record.  The only significant decline in today's report was for gas station sales, but that was due to a drop in gas prices.  "Core" sales, which exclude autos, building materials, and gas stations (the most volatile sectors) were up 0.7% in June, up 1.1% including revisions to prior months, and are up 4.4% from a year ago.  These sales were also up at a strong 8.0% annual rate in Q2 versus the Q1 average.  As a result, it now looks like real GDP growth in the second quarter will come in closer to the higher end of the 1.5 – 2.0% range we were previously estimating, with real consumer spending up at about a 4.0% annual rate and real GDP growth held down temporarily by a slowdown in the pace of inventory accumulation.  Volatility is perfectly normal from quarter-to-quarter, and the trend in growth remains healthy.  Jobs and wages are moving up, companies and consumers continue to benefit from tax cuts, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs.  For these reasons, expect continued solid gains in retail sales over the coming months.  In other news today, on the inflation front, import prices fell 0.9% and export prices declined 0.7% in May.  In the past year, import prices are down 2.0%, while export prices are down 1.6%.  We expect these inflation figures to head north in the coming months.  
  

Click here for PDF version        

Until recently, Fed Chair Jerome Powell sounded a consistent theme: the Fed is data dependent and will stay that way, unswayed by noise or pressure from politicians. 

When the FOMC released its rate decision last month, it got as dovish as it could without actually cutting short-term rates.  It downgraded its assessment of economic growth from "solid" to "moderate" while noting that "market-based measures of inflation compensation" have declined.

However, the Fed added that "uncertainties...have increased" and it will "closely monitor" incoming information and "act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent (inflation) objective." It removed the reference in prior statements to being "patient" about changes in policy.

This statement, as well as comments made by Powell at the press conference after the meeting, suggested a 25 basis point rate cut was all but in the bag for the next meeting at the end of July.  But with six weeks between June and July's meetings, and a full economic data cycle, what we have seen so far shows that - if the Fed really is data dependent - they shouldn't cut rates.  And if they do, they should lose credibility.

Personal income and spending numbers came in strong for May.  Income grew 0.5% while spending grew 0.4% (and was revised higher for April).  Nonfarm payrolls increased 224,000 in June, well above expectations, and initial unemployment claims remain near historically low levels. And then auto sales also beat consensus, coming in at a 17.3 million annual rate in June.

Its true consumer prices were up 1.6% for the twelve months ending in June, while producer prices were up 1.7%, both below the Fed's 2% target.  But "core" consumer prices – which strip out the volatile food and energy categories to give a better picture of trend inflation - are up 2.1% from a year ago while "core" producer prices are up 2.3%.  There is no sign of aggressive disinflation, and certainly not deflation.  So now in addition to their dual mandate of "employment and inflation," the Fed has added "uncertainties" about weakness in foreign economies to its list of actionable items.

There are still several important data points due out before the Fed's decision on July 31.  These include retail sales and industrial production, both released Tuesday morning.  Next week, look for a report on second quarter real GDP growth in the 1.5 – 2.0% range, held down temporarily by a slowdown in the pace of inventory accumulation.  And then more personal income and spending numbers for the month of June to cap things off. 

Combined, this data will not show any significant slowdown in the U.S. economy.  But the Fed seems obsessed by developments abroad, including slower growth in China and Europe.  This is neither "data dependent" nor logical.

China is a communist country, and communism has never worked at creating wealth in the long run.  China grew rapidly for decades by importing foreign technologies, exporting to the West, and lately, stealing intellectual property from abroad.  These shortcuts have now run their course. 

If anyone thinks monetary policy in the U.S. can solve China's problems, they're dreaming.  Given the size of China's economy, is US contagion a concern?  Hardly.  The last time the second largest economy in the world collapsed (Japan in 1990), the U.S. boomed.  How about Europe?  Do you really think the Fed can fix slow economic growth caused by the socialist policies across the sea?  High taxes, regulations, and spending can't be fixed by the ECB's negative rates, so how the Fed thinks it can help is a mystery.

The Fed is not tight, there are still $1.4 trillion in excess reserves in the banking system.  Most importantly, "data dependence" seems to be out the window.

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

Click here for PDF version

Source: St. Louis Federal Reserve FRED Database

Implications:  As with yesterday's report on consumer prices, today's reading on inflation from the producer side came in higher than the consensus estimate and shows "core" inflation – which excludes the volatile food and energy sectors and is a better measure of trend inflation – running above the Fed's 2% inflation target.  You may think that these reports (plus the strong June employment report) would mean the Fed will hold off on a much hinted at plan to cut rates at the end of this month, and we would agree that a rate cut isn't needed.  But without resolution on the China trade disputes, we expect the Fed will cite "uncertainties" and implement a cut, most likely of only 25 basis points.  Digging into the details of today's report shows producer prices are up 1.7% in the past year (not far off the Fed's 2% inflation target) and, as mentioned above, "core" prices are up 2.3% in the past year, already above the Fed's target.  The rise in June was led by prices for services, where the 0.4% increase from May represents the largest increase since last October.  The jump in prices for services offset a 0.4% decline in the prices for goods (largely accounted for by the 3.1% drop in energy prices).   This continues a trend seen over the past year, during which service prices are up 2.5% while goods prices are flat.  But strip out just energy, and goods prices are up 1.6% in the past year.  In other words, inflation has been broadly moving higher, with concentrated pockets holding back readings from reaching the Fed's target.  It's also notable that private capital equipment prices, a signal of demand for business investment, are up a healthy 2.4% in the past year.  Given these readings, a 3.7% unemployment rate, and an average 192,000 jobs added per month over the past year, the data are clearly not flashing signals of tight monetary policy. 

Click here  for PDF version

Implications:  Consumer prices rose 0.1% in June and are up 1.6% in the past year, while "core" prices – a more reliable gauge of inflation that strips out the typically volatile food and energy components – rose 0.3% in June and are up 2.1% in the past twelve months. In fact, the 0.3% rise in core inflation is the largest monthly move since January of 2018, while the 2.1% increase over the past twelve months makes sixteen straight readings of 2%+ inflation on a year-over-year basis.  Given the Fed's 2% inflation target, that should be a signal that everything is looking A-OK. Not too fast, not too slow, just right. But the Fed seems determined to cut rates at their meeting later this month, and we don't expect today's report – or last week's consensus beating employment report – to change their minds.  A look at the details of today's report makes the fear of low inflation even more confusing.  Headline inflation is up 1.6% in the past year, but up at a 2.1% annualized rate over the past six months, and a 1.8% annualized rate in the past three months.  In other words, broad-based inflation isn't far from 2% and it's rising.  In addition, the Cleveland Fed's median CPI series, which adjusts for both upside and downside outliers, shows inflation up 2.8% in the past year. No matter how you cut it, inflation is in-line with Fed targets, and shows no signs of the economic paralysis that bond markets are pricing in.  Housing, used cars, and apparel led prices higher in June, more than offsetting a 2.3% decline in energy costs.  We believe these data, as well as strength in trend inflation (which is far more important than single month readings) don't support the case for rate cuts.  Moreover, unemployment is 3.7%, initial claims are near historic lows and there are 1.4 million more job openings than unemployed people.  The data, if anything, suggests higher rates would be the more appropriate path based on economic fundamentals alone.  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 longer-term interest rates.  Among the best news in today's report was that real average hourly earnings rose 0.2% in June and are up 1.5% in the past year.  With the strength in the labor market noted above, we believe that the trend higher will continue in the months ahead.  Healthy consumer balance sheets, a strong job market, inflation in-line with Fed targets, and the continued tail winds from improved tax and regulatory policy, all reinforce our belief that the economy is on strong ground.  In other news this morning, new claims for unemployment insurance fell 13,000 last week to 209,000. Initial claims have now been at or below 250,000 for a record ninety-two consecutive weeks.  Continuing claims increased 27,000 to 1.723 million.  These claims figures are both at very low levels, suggesting solid payroll growth continues in July.  

Click here for PDF version

The S&P 500 is up 27% from its Christmas Eve low, and 19.3% this calendar year through the close on Friday – not including dividends.  Last December, our forecast for 2019 was 3,100.  We're just 3.7% away.

As a result, and in combination with our continued bullishness, we are raising our year-end 2019 S&P 500 target to 3,250 from 3,100, with the Dow Jones Industrials Average now estimated to finish the year at 29,250.

Our starting point for setting a stock market target is always our Capitalized Profits Model, which continues to scream BUY. 

The model takes the government's measure of profits from the GDP reports divided by interest rates to measure fair value for stocks.  It looks at every quarter dating back to the early 1950s and we let each of those quarters tell us where the stock market would be today if equities had increased as much as the ratio of profits to the 10-year Treasury yield.  We then take the median of all those predictions (each historical quarter generating its own prediction) to estimate fair value today.

Using a 10-year Treasury yield of 2.03% combined with corporate profits from the first quarter suggests a fair value on the S&P 500 of 5,080!!!  This is absurd, and the market will not price it in because it knows the Fed is holding interest rates artificially low.

In fact, the stock market has been significantly below our model's estimate of "fair value" for a decade because everyone knows that interest rates are artificially low.  In other words, our model says that the analysts who argue that asset values are in a bubble because of the Fed are wrong.  If the market fully incorporated these low rates it would be significantly higher.

Another way to think about this is to ask what interest rate would put the market at fair value with current corporate profits.  The answer is a 10-year yield of 3.45%, which is an interest rate we haven't seen since early 2011 and doesn't look likely anytime in the near future.

The interest rate that would make 3,250 fair value is 3.175%, which is also higher than yields are likely to hit.  Moreover, corporate profits are likely to rise in the quarters ahead, which suggests room for equities to rise above our 2019 target in 2020 and beyond. 

If, on the other hand, corporate profits were to drop by 15% and the 10-year yield rose to 2.7%, fair value would be 3,250, which shows how robust our stock market target is to changes in the economic and financial outlook.  

Another reason to be bullish about equities is that the Federal Reserve has made it clear it will cut short-term rates if the economy falters or if inflation stays low.  We think cutting short-term rates is unnecessary, but we have to factor-in what the Fed is likely to do, not what it should do.  Even just talk about or expectations of future rate cuts will help hold down the 10-year Treasury yield relative to where it should be based on economic fundamentals.     

And last, we think the next several months are more likely to lead to trade deals than an expansion of tariffs, as the election in 2020 approaches.

Some analysts and investors are concerned about the stock market because they can't see corporate profits going much higher.  We think that's mistaken; the growth rate of corporate profits will be slower in 2019 than in 2018, but the level of profits has further to go up as businesses continue to adapt to a much lower tax rate on corporations and continued improvements in productivity.

Raising our target doesn't mean there can't be a correction at some point, perhaps even in the near future.  Corrections come and go and we're not in the business of trying to predict the monthly or quarterly variation in equities, nor do we think anyone else can do it on a systematic basis.  What it means is that we think equities are headed much higher and that the S&P 500 is more likely to blow through 3,250 by the end of the year than it is to fall short.

We know people call us perma-bulls.  We've been bullish since March 2009.  But this bullishness is based on our Capitalized Profits Model and our outlook for profits and economic growth.  Call us what you want, but the fundamentals still point to rising stock prices.   Tally ho!

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

Click here for PDF version

Source: St. Louis Federal Reserve FRED Database