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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Implications: The trade deficit grew in March to $50.0 billion, basically matching expectations.  More important, there was significant gain in the total volume of trade – imports plus exports – which signals how much businesses and consumers interact across the US border.  Exports rose by $2.1 billion, while imports grew by $2.8 billion.  Total trade is only 0.8% below the record high set in October of 2018, and we expect it to hit new highs later this year as global growth starts to reaccelerate and trade deals eventually get made.  In the past year, exports are up 1.3% while imports have risen 2.1%.   There is a lot of angst out there from the pouting pundits, that the China trade battle is nowhere near done.  We believe the worst-case-scenarios much discussed by the financial press will prove excessively pessimistic, as they have before.  We still don't believe an all-out trade war will materialize, but these short-term skirmishes will lead to longer-term gains for all countries involved.  We have already seen it happen with several countries.  China is hurting, and the negotiation tactics that the President is using look very similar to the tactics he used just a few months ago against Canada.  A deal couldn't have looked farther from getting done with Trudeau, and yet just a few days later the USMCA was agreed on.  We believe it will be no different with China, whether a deal is struck this week, or in the near future.  Average tariffs in China were cut from 9.8% in 2017 to 7.5% in 2018.  We see this as real progress, and just the start.  The US's negotiating position is strong, in no small part due to the rise of the US as an energy powerhouse.  As recently as 2005, the US was importing more than ten times the petroleum products that we were exporting.  As of March, petroleum imports are down to only 1.1 times exports and this trend should continue.  This massive shift means the US has changed power dynamics on a global scale (witness the political turmoil in Saudi Arabia and elsewhere in the Middle East).  We will continue to watch trade policy as it develops, but don't see any reason to sound alarm bells yet.  In employment news this morning, initial jobless claims declined 2,000 last week to 228,000.  Continuing claims rose 13,000 to 1.684 million.  These readings suggest another solid month of job creation in May.

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If you take a long hike up a mountain, there's plenty to appreciate along the way.  But, sometimes, you just have to stop and enjoy the view.  With that in mind, let's forget about the April employment report – which saw a combination of very fast payroll growth and moderate wage growth – and think about where the labor market stands in general.

Nonfarm payrolls have grown by 2.6 million in the past year, well ahead of the roughly 2.0 million jobs the consensus was forecasting a year ago.

Due to the rapid job creation, the unemployment rate has dropped to 3.6%, the lowest level since 1969.  Some analysts claim the jobless rate is being artificially suppressed by lower labor force participation, but participation is higher now than it was in the late 1960s, when 3.6% was considered full employment.

Regardless, the labor force is up 1.4 million from a year ago, and the labor force participation rate has been essentially flat since late 2013.  And that's in spite of an aging population.                    

The unemployment rate for those with less than a high school degree has averaged 5.6% in the past twelve months, the lowest on record, and well below the previous cycle low of 6.3% reached during the internet boom two decades ago 

The Hispanic unemployment rate has averaged 4.6% in the past year, while the Black unemployment rate has averaged 6.4%, both also record lows.

Meanwhile, wage growth has accelerated.  Average hourly earnings are up 3.2% from a year ago, versus the gain of 2.8% in the year ending in April 2018, and 2.5% in the year ending in April 2017.  And the gains in wages are not just tilted toward the rich.  Among full-time workers age 25+, usual weekly earnings are up 3.5% for those in the middle of the income spectrum.  But wages are up 4.9% for workers at the bottom 10% of earners, while up 1.7% for those at the top 10% of income earners.  A rising tide is lifting all boats.

Some observers are claiming we should discount strong job creation because workers are taking multiple jobs.  But, in the past year, multiple job holders have been just 5.0% of the total number of employed workers; that's lower than at any point during the 2001-07 expansion, or during the previous longest recovery on record during the 1990s.  Meanwhile, part-time jobs are down since the expansion started, meaning, on net, full-time jobs account for all the job creation during the expansion.

What's interesting is that President Trump, Vice President Pence and NEC Chief Larry Kudlow all think things could be even better if the Fed hadn't raised interest rates.  President Trump, in fact, is calling for a 1% interest rate cut.  This puts the Administration at odds with Fed Chair Jerome Powell, who thinks interest rates are at appropriate levels.

We don't disagree with the theory behind the thinking of Trump, Pence and Kudlow who say faster economic growth, by itself, doesn't have to cause higher inflation.  A "permanent" supply-side boost to "real" growth from deregulation and marginal tax rate cuts is not inflationary.  In fact, as we've previously written, the growth potential of the US economy has accelerated.  Productivity (output per hour) is up 2.4% in the past year, deep into this recovery, when normally productivity growth should slow. 

But "nominal" GDP (real growth plus inflation) is still up 4.8% at an annual rate in the past two years, and is set to equal, or exceed, that in the year ahead.  If we think of nominal GDP as the average growth rate of all businesses in the economy, then a federal funds rate of 2.375% is not holding anyone back.  Even projects with a below-average return could justify borrowing, which is a recipe for disaster – what Ludwig von Mises called "mal-investment" – when people push investment into areas that are unsustainable at normal interest rates.  Remember the housing bubble?

That's why we want Powell and the Fed to resist calls to cut rates.  The Fed is not tight.  Interest rates are not discouraging investment.  If anything, the Trump administration should work to cut government spending, which has grown so large it's crowding out private sector growth.

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

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Source: St. Louis Federal Reserve FRED Database