Implications:  Consumer prices were unchanged in November as declining energy costs offset gains in nearly every other category.  Recent months have been a textbook example of how volatility distorts the headline reading. While energy prices swung from a 0.5% decline in September, to a 2.4% increase in October, to a 2.2% decline in November, "core" inflation (which excludes the typically volatile food and energy categories) has risen steadily month-to-month. That is why, in addition to emphasizing the core measure, we focus on the trend, which shows inflation continuing to run steadily above the Fed's 2% inflation target.  In the past year, consumer prices are up 2.2%, and the index has matched or exceeded the Fed's 2% inflation target in each of the last fifteen months ("core" has exceeded 2% in each of the last nine months).  So, after running stubbornly below the Fed's inflation target for the first five years of the recovery, the much-anticipated pickup has clearly arrived.  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.  Looking at the details of the November report shows medical care and housing led the rise in "core" prices, up 0.4% and 0.3%, respectively.  And while new car and truck prices were unchanged in November, prices for used vehicles rose 2.4%, the second largest single month increase since the start of 2010.  Maybe the best news in today's report was that real average hourly earnings rose 0.3% in November.  These wages are up just 0.8% in the past year but are heading higher, with wages up 1.1% at an annual rate over the past three months and up 1.3% 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 we still expect a visible pickup in wage pressure in the year ahead.  The labor market remains strong and companies continue to report that finding available qualified labor remains a top headwind to even faster growth. Put it all together, and today's report shows an economy continuing to strengthen.  The Fed would do well to focus on the data as they forecast their path for 2019, rather than letting media narratives influence their actions.

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Implications:  After posting the largest single-month increase in more than six years in October the producer price index continued its climb higher in November, though at a slower pace.  The main source of strength in today's report came from final demand services where prices rose 0.3%, offsetting the 0.4% decline in prices for final demand goods, keeping the headline index positive for the month.  Looking at the details of final demand services shows that prices were driven higher by increased margins to wholesalers, which rose 0.3%.  More specifically, margins for fuels and lubricants retailing soared 25.9%, probably the result of wholesalers not fully passing on November's 14% drop in gasoline prices to their customers.  Recent increases in wholesaler margins could be a sign of rising demand paired with limited supply; ISM reports have shown strong order and business activity, but companies struggling to hire and ship products due to a tight labor market.  Or it could simply be companies adjusting prices higher following months of rising input costs cutting into margins; remember, these wholesaler margins fell overall in Q3.  The biggest source of weakness in today's report was the 5% decline in final demand energy, which represents the largest monthly drop for that index since the oil price crash of 2015.  This was driven by the decline in gasoline prices mentioned above and resulted in an overall drop of 0.4% in final demand goods for November.  Some analysts have recently been citing falling energy prices as a reason for the Federal Reserve to hold off on continued rate hikes in 2019. However, no matter which way you cut it – headline prices up 2.5% in the past year or "core" prices up 2.7% -- trend inflation clearly stands above the Fed's 2% target.  These data support our expectation for one more hike this year and up to four more hikes in 2019.

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Last Friday, the 10-year Treasury Note closed at a yield of 2.85%.  That's up from 2.41% at the end of 2017, but down from the peak of 3.24% on November 8th, and well below where fundamentals suggest yields should be.

In the last two years, nominal GDP growth – real GDP growth plus inflation – has run at a 4.8% annual rate.  Normally, we'd expect yields to be close to nominal GDP growth, but Treasury yields have remained stubbornly low.

Some analysts are spooked by the recent movement of 3-year yields above 5-year yields, thinking this "inversion" signals a recession.  We think this is sorely mistaken.  With a lag, recessions have often (but not always) followed periods when the federal funds rate exceeds the 10-year yield. If anything, that's the inversion to look out for; feel free to ignore the rest.  But, at present, the 10-year is yielding about 70 basis points above the funds rate, well within the normal range.   

One reason that the 10-year yield has remained below where economic fundamentals suggest it should trade is that the Federal Reserve set short-term interest rates near zero.  Longer-term bonds, including the 10-year reflect the current level of short-term rates as well as the projected path of those rates in the future.  So, back when yields were essentially zero, and the Fed was signaling they could stay there for a long time, this pulled down longer-term yields.  The Fed has now lifted short-term interest rates by 200 basis points from where they were, but investors still don't believe they will go much higher. 

Part of the issue is that many think low rates themselves are the only reason the economy came out of the Great Recession. So as the Fed lifts rates, many investors expect the next recession is a small tip of the scale from returning in force.

If you're buying 10-year Notes under the premise that a recession will happen sometime in the next ten years – and you also expect the next recession to tie (or beat) '08-'09 for the title of worst recession since the Great Depression – then the yield on the 10-year Treasury makes a lot more sense. 

But we wholeheartedly disagree with your assessment.  We think the bond market is anticipating a far weaker economy over the next ten years than the data justifies.

No matter how many believe it, the bond market is not all-knowing.  In November 1971, the 10-year Treasury was yielding 5.81%.  Over the next ten years, inflation alone increased at an 8.6% annual rate and nominal GDP grew at a 10.7% annual rate.  In other words, 10-year note investors got hammered as yields soared.  And notice that back in 1971 we had a Republican president (Richard Nixon) leaning heavily on the Fed to maintain a loose monetary policy.  Sound familiar?
 
The next recession is unlikely to be like the last.  Our calculations suggest national average home prices were 40% overvalued at the peak of the housing boom – pumped up by government rules and subsidies artificially favoring home buying.  Meanwhile overly stringent mark-to-market accounting rules created a once in a 100-year panic.  Mark-to-market rules have now changed to allow cash flow to be used to value assets, plus banks are much better capitalized.  In other words, fundamentals suggest another panic is not in the cards.     

What's more likely is that, when the next recession hits – and we don't see one happening until at least 2021 – it will be softer than usual, more like 1990-91 or 2001, than 1973-75, 1981-82 or 2007-09.  As investors realize data trumps the rhetoric, we expect bond yields to rise.  In the end, math wins.      

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Good, not great.  That about sums up the employment report for November.  The most negative news in the report was that nonfarm payrolls grew only 155,000 for the month.  While that's more than enough to keep the unemployment rate gradually trending downward, it was slower than the average of 204,000 per month in the past year and weaker than any economics group was forecasting.  However, civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 233,000 in November.  This increase, combined with an increase in the labor force of 133,000 meant the jobless rate remained unchanged at 3.7%.  Look for a December reading of 3.6% and then a decline to 3.3% in 2019, as the corporate tax cut makes capital more plentiful, thereby driving the demand for labor upward.  Another sign of increasing demand for labor is wage growth.  Average hourly earnings rose 0.2% in November and are up 3.1% from a year ago.  (Remember, that's in spite of that measure excluding extra earnings from irregular bonuses and commissions, like the bonuses paid out after the tax cut was passed.)  Meanwhile, total hours, which slipped 0.2% in November, are up 1.7% in the past year.  As a result, total cash earnings are up 4.8% in the past year, which will help consumer spending continue to grow.  Nothing in today's report suggests the Federal Reserve should hold off on its final rate hike of the year on December 19.  The bigger issue is what the Fed will do next year.  Right now, the federal funds futures market suggests only one rate hike of 25 basis points next year.  We think the Fed is likely to move at least twice and possibly as many as four times, assuming the 10-year Treasury yield moves up, as well, which it should given continued healthy economic growth.    

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Implications:  Service sector activity continues to surge, with the November ISM Services index hitting the second highest reading (behind just September) in more than a decade.  And barring a massive decline in December, 2018 will average the highest full-year reading for the index since the series began in the late 1990s.  A look at the details of today's report shows that the pickup in activity was broad-based, with seventeen of eighteen industries reporting growth in November (the agriculture, forestry, fishing & hunting industry reported a decline).  In addition to the breadth of growth, the two most forward-looking indices – new orders and business activity – led the gain in November, suggesting we will see a strong close to this year and a healthy start to 2019.  That said, two major sub-indices moved lower in November, showing continued growth, but at a slower pace than October.  The employment index declined to a still robust reading of 58.4, from 59.7 in October.  As we noted in today's analysis of the trade report, we expect tomorrow's employment report to show a gain of 193,000 nonfarm jobs.  Growth in employment would be even faster, but the lowest unemployment rate in nearly fifty years has led to difficulties for companies in finding qualified labor (this also explains the pickup in wage growth as demand for labor exceeds supply at prior lower wages).  Finally, the supplier deliveries index declined in November, 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 – as reflected in the prices paid index, which rose to 64.3 in November.  While we don't expect prices will soar any time soon, this suggests inflation will continue to run at-or-above the Fed's 2% target, putting pressure on the Fed not to fall behind the curve with the pace of rate hikes in 2019.   In other recent news, automakers reported they sold cars and light trucks at a 17.5 million annual rate in November, down 0.2% from October, and down 0.8% from a year ago.  We expect auto sales will continue to gradually decline versus year-ago levels as consumers, who have plenty of purchasing power, shift toward other sectors.

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Implications: Trade data have received extra attention of late from pundits looking to play up trade war impacts, but too often they end up missing the forest for the trees.  Yes, the trade deficit widened in October to $55.5 billion as imports rose, while exports declined slightly.  But what matters more than the headline trade deficit number - and which you will not hear about as much - is the total volume of trade – imports plus exports – which signals how much businesses and consumers interact across borders.  Looking at that data, US trade hit a new record all-time high in October – the opposite of what we would expect in a trade war.   In terms of the trade deficit in October, exports fell by $0.3 billion, while imports rose by $0.6 billion.  Overall, in the past year exports are up 6.3%, while imports are up 8.5%, signaling very healthy gains in the overall volume of international trade and easily outstripping the pace of nominal GDP growth.  While many are worried about protectionism from Washington, especially regarding China, we continue to think this is a trade skirmish, and the odds of an all-out trade war that noticeably hurts the US economy are slim.  We believe better trade agreements for the United States and world are on the way.  We have already seen it happen with several countries, and now China looks to be extending a bit of an olive branch, too. Average tariffs in China will be cut from 9.8% last year to 7.5% this year and on Tuesday, China released a 58-page document showing an array of punishments for IP theft moving forward. We see this as real progress, and just the start.  The US's negotiating position simply continues to strengthen, 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 October, imports are down to 1.2 times exports and this trend should continue.  Not only does this reduce US reliance on foreign trade partners and lower their bargaining power, it has served to shift power dynamics on a global scale (witness the political turmoil in Saudi Arabia).  So at the end of the day, we will continue to watch trade policy as it develops, but don't see any reason to sound alarm bells. In other news this morning, initial jobless claims declined 4,000 last week to 231,000.  Meanwhile, continuing claims fell 74,000 to 1.63 million.  Also this morning, the ADP index reported private payrolls rose 179,000 in November.  Plugging all of these labor market data into our model suggests Friday's employment report will show nonfarm payrolls rose a healthy 193,000 in November. 

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Implications: The ISM manufacturing activity index has been volatile in recent months, but one constant has remained: growth.  In fact, if the December reading stays in line with November, this year (2018) will average the highest reading for the index since 1983!  Digging into the details shows thirteen of eighteen industries reported expansion in November, while three reported contraction.  And the mix of growth in November was positive, with the two most forward-looking indices – new orders and production – both rising.  The new orders index, which dipped below a reading of 60 in October for the first time in seventeen months (the longest stretch above 60 going all the way back the early 1970s) jumped to 62.1 in November. Production also returned to a reading above 60 in November, despite continued labor shortages and respondents noting pressure from tariffs.  In other words, the growth in manufacturing is real, and robust enough to grow at the fastest pace in more than thirty years.  On the jobs front, the employment index rose to 58.4 from 56.8 in October.  Looking towards this Friday's employment report, we are expecting that private payrolls grew by about 200,000 in November. That would be a slowdown from October's hurricane-bounce-back pace of nearly 250,000 but stands in-line with the robust jobs growth we have seen over the past year.  A look at delivery times – as reflected in the supplier deliveries index – shows those, too, continue to rise.  Some may view it as a negative, but the stresses in the manufacturing sector are coming from too much demand, not too little. In short, these are good problems to have, and point to more investment, hiring, and production in the months ahead.  On the inflation front, it looks like rapidly falling energy prices led the ISM price index lower in November, although the index remains above 50, signaling continued inflation.  This should maintain pressure on the Fed to stick to its course of gradually raising short-term interest rates.  Reason for concern?  Hardly.  For more on how the Fed is (or isn't) impacting the markets, check out today's Monday Morning Outlook.  In other news this morning, construction spending declined 0.1% in October (-1.5% including revisions to prior months).  The decline in October was led by home building and power plants, which were partially offset by a pickup in office construction.  Construction spending is up 4.9% in the past year, a clear acceleration from the pace in the year ending October 2017. Finally, our thoughts and prayers are with the family of former President George H.W. Bush as they mourn his passing. We will be observing the National Day of Mourning on Wednesday to honor the former President and his service to our country, and as such will resume reporting with the International Trade and ISM Non-Manufacturing reports on Thursday.

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