In this week’s edition of “Three on Thursday,” we take a deeper look into the U.S. Strategic Petroleum Reserve (SPR). Over the past three years as inflation has run rampant, along with a war in Ukraine, President Biden gave orders for emergency drawdowns from the SPR to help mitigate price increases. This, coupled with other exchanges and planned sales, has drained the SPR to its lowest level in 40 years. Many are concerned about this, but do they need to be? For a more in-depth perspective, click the link below.

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Implications:  Incomes and spending continued to grow in October, though at a more modest pace than in recent months, while falling oil prices kept inflation in check.  Incomes rose 0.2% in October led by dividends and interest, while private sector wages rose a modest 0.1%.  Personal income is up 4.5% over the last twelve months.  Consumer spending also rose 0.2% in October, with a pickup in services partially offset by a decline in goods.  Spending on services rose 0.4% in October and is up 6.8% in the past year (2.3% when adjusted for inflation).  Goods spending declined 0.2% on the month but remains up 2.4% in the past year, while “real” inflation-adjusted spending on goods is up 2.1%.  On the inflation front, PCE prices – the Federal Reserve’s preferred measure of inflation – was unchanged in October, bringing the twelve-month comparison down to 3.0%.  “Core” inflation, which excludes the ever-volatile food and energy categories, rose 0.2% in October and is up 3.5% versus a year ago.  Note that the Fed has prioritized a subset of inflation dubbed the “Super Core,” which is services only (no goods), excluding food, energy, and housing.  That measure rose 0.1% in October and is up 3.9% versus a year ago, down from the 5.2% peak in October of last year, but still well above the Fed’s 2% inflation target.  While many believe inflation has peaked (numbers from Europe helped reinforce this also today), inflation is still not contained.  In other news this morning, initial claims for jobless benefits rose 7,000 last week to 218,000.  Meanwhile, continuing claims rose 86,000 to 1.927 million. These figures suggest continued modest growth in employment in November.

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Implications:  Real GDP was revised upward for the third quarter to a 5.2% annual rate from a prior estimate of 4.9%, marking the fastest quarter of growth since 2021. The upward revision to the overall number was due to the cumulative effect of a series of upward revisions to business investment (mainly commercial construction), home building, inventories, and government purchases. These gains easily offset a downward revision to personal consumption which was in both durables and services. More important, today we also got our first look at economy-wide corporate profits for the third quarter, which rose 3.3% versus Q2, but are down 0.7% from a year ago.  However, the government includes Federal Reserve profits in these data, and the Fed has recently been generating unprecedented losses.  We follow profits excluding those earned (or lost) by the Fed, which were up 3.3% in the third quarter and up 5.4% from a year ago.  In effect, the losses by the Fed are the private banking sector’s gain, as the Fed pays banks a yield of about 5.4% to hold reserves and do nothing with them.  Still, plugging non-Fed profits into our Capitalized Profits Model suggests stocks are overvalued.  In addition to corporate profits, we also got a Q3 total for Real Gross Domestic Income, an alternative to GDP that is just as accurate.  Real GDI grew at only a 1.5% annual rate in Q3 and is down 0.2% versus a year ago, consistent with underlying economic weakness.  These are figures that are normally seen in and around recessions.  Regarding monetary policy, GDP inflation was revised slightly higher to a 3.6% annual rate in Q3 versus a prior estimate of 3.5%.  GDP prices are up 3.3% from a year ago, still higher than the Fed’s 2.0% target.  Meanwhile, nominal GDP (real GDP growth plus inflation) rose at an 8.9% annual rate in Q3 and is up 6.3% from a year ago. Look for lower real GDP growth and inflation in Q4.  In recent housing news, home prices are showing consistent gains after a drop late last year.  The national Case-Shiller index rose 0.7% in September while the FHFA index rose 0.6%.  In recent manufacturing news, the Richmond Fed index, a measure of mid-Atlantic factory activity, slipped to -5.0 in November from +3.0 in October. We also received data on the M2 money supply yesterday which declined 0.1% in October and is down 3.3% from a year ago.  Monetary policy operates with a lag, and we are likely to feel the negative economic effects of these declines in the months ahead.  

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Implications:  New home sales continued to look choppy in October, taking a breather following a gain in September.  Despite the 5.6% decline in October, sales have been in an upward trend in the past year and now sit 25.0% above the low in July of 2022.  However, they also still remain well below the pandemic highs of 2020. The main issue with the US housing market remains affordability.  Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle amounts to a 31% increase in monthly payments on a new 30-year mortgage for the median new home.  With 30-year mortgage rates currently sitting above 7.5%, financing costs remain a headwind.  The good news for potential buyers is that the median sales price of new homes has fallen by 17.6% from the peak late last year.  However, it’s important to note that this drop in median prices is likely due to the mix of homes on the market including more lower priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up nearly 150% versus the bottom in 2022.  This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  But this does not mean that housing is getting more affordable per square foot, with the Census Bureau reporting median prices on this basis up 45% from 2019 to 2022, the most recent data available. Though not a recipe for a significant rebound, more inventories giving potential buyers a wider array of options will continue to put a floor under new home sales.  One problem with assessing housing activity is that the Federal Reserve held interest rates artificially low for more than a decade.  With rates now in a more normal range, the sticker shock on mortgage rates for potential buyers is very real.  However, we have had strong housing markets with rates at current levels in the past, and homebuyers will eventually adjust.

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When Argentina entered the 20th Century, its prospects looked bright.  On a per person basis, its economy was on par with Canada and Sweden and about two-thirds of the United States.

This all changed in 1946 when the country elected Juan Peron to the presidency.  Peron launched plans to foster social justice through economic redistribution.  The government sector grew rapidly (spending and money printing) and very high inflation (300%+) became the norm.  Standards of living plummeted.

Without a change in policies, inflation could not be eradicated.  Then, in the 1990s, Argentina tried a currency board arrangement where each Argentine peso was backed by one American dollar.  Like the old-fashioned gold standard before the creation of the Federal Reserve, each unit of Argentine currency was backed by something that held its value.  That currency board system worked for about a decade, bringing inflation down to US levels and spurring a decade of solid economic growth.

However, it broke down in 2001-02, largely because government spending never really subsided.  When the government couldn’t print new money, it borrowed.  Investors (correctly) thought politicians would abandon the currency board and let the value of the peso fall at the first sign of economic trouble.   And that’s exactly what happened.

Now Argentina finds itself with another lost decade of growth and hyper-inflation.  Recently, Argentina’s per person GDP stood less than 20% of US levels, and below even Russia.

But last month brought a political earthquake: the presidential election was won in a landslide by Javier Milei, a libertarian economist, and an unbridled and outspoken critic of socialism and supporter of free-market capitalism.

Milei wants to end the Argentine peso and central bank completely and just use the US dollar as the country’s currency.  That way, re-introducing the peso would be very hard, so Argentines could be confident the government wouldn’t devalue again.  He wants to slash government spending, including spending on the social safety net and get rid of lots of government agencies.

Unfortunately, he has his work cut out for him.  Although he’s popular with voters he doesn’t come from a political party with widespread support in the legislative branch.  As a result, it remains to be seen how much Milei can accomplish.

And yet this isn’t the only big shift at the polls in recent months, with voters in New Zealand and the Netherlands swinging toward leaders seeking some major changes.

The long historic battle between those who support wealth creation and those who support wealth redistribution, continues.  The pendulum is starting to swing.  We think much of this recent pattern is due to voters getting fed up with governments that are too big.  Even the election of Geert Wilders in the Netherlands, ostensibly about immigration has a big government component, due to taxpayer-funded resources that, right or wrong, voters think recent immigrants’ demand.

When governments are already very large, and inflation rises while growth suffers, it’s harder for the left to make bigger government appealing to voters, and easier for the right to make trimming government look attractive. 

The pendulum is swinging toward smaller government.  If leaders fulfill this desire, investors around the globe will have reason to cheer.  While Argentina has followed a different rhythm than many Western countries, the elections of Margaret Thatcher and Ronald Reagan changed the direction of global economic growth.  Is it happening again?

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Durable goods orders fell in October after a September surge as the typically volatile transportation category continues to swing monthly readings.  Commercial aircraft orders plummeted 49.6% in October following a surge in September. Meanwhile orders for autos fell 3.8%.  Strip out the typically volatile transportation category and orders for durable goods were unchanged in October.  Excluding transportation, rising orders for fabricated metal products (+0.4%) and computers & electronic products (+0.3%) were offset by declines in orders for primary metals (-0.5%) and electrical equipment (-0.1%). New orders for machinery were unchanged in October.  Arguably the most important number in today’s report is core shipments – a key input for business investment in the calculation of GDP – which was unchanged in October.  If unchanged in November and December as well, these shipments would rise at a 0.9% annualized rate in Q4 versus the Q3 average, continuing the trend in slowing business investment that started in Q1 2022 and has slowed in every quarter since.  We expect this trend will continue as the economy feels the lagged effects of the Federal Reserve’s actions to tighten monetary policy.  In the past year, orders for durable goods are up a tepid 0.3%, while orders excluding transportation are up 1.3%.  A number of factors are likely to keep the path forward rocky as we close out 2023: restrictive monetary policy from the Federal Reserve, the tightening of lending standards following stress in the banking sector, and withdrawal symptoms following the COVID-era economic morphine that artificially boosted both consumer and business spending.  In addition, the return toward services likely means goods-related activity will continue to soften in the year ahead, even as some durables that facilitate services recover.  While the data to-date have shown continued economic growth, we believe a recession is likely before the end of 2024.  In other news this morning, initial claims for jobless benefits fell 24,000 last week to 209,000.  Meanwhile, continuing claims fell 22,000 to 1.840 million. These figures suggest continued growth in employment in October.

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Implications:  Existing home sales continued to struggle in October, falling for a fifth consecutive month to hit the slowest pace since the aftermath of the 2008/9 Financial Crisis.  The housing market is facing a series of headwinds, some of them temporary.  The first (and most significant) has been the surge in benchmark interest rates like the 10-year Treasury yield since the summer.  This has translated into 30-year fixed mortgage rates as well, which are currently hovering near 8% for the first time in more than two decades.  Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle in March 2022 amounts to a 44% increase in monthly payments on a new 30-year mortgage for the median existing home.  Eventually, the housing market can adapt to these increases, and the recent moderation in rates should help in the short term, but continued volatility in financing costs will cause some indigestion.    In addition, many existing homeowners are reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  That should limit future existing sales (and inventories).  Case in point, the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) was 3.6 in October, well below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.  A tight inventory of existing homes means that while the pace of sales may resemble 2008, we aren’t seeing that translate to a big decline in prices.  In fact, home prices appear to be rising again, although modestly, with the median price of an existing home up 3.4% from a year ago.  Putting this together, expect sales and prices to drag on in the months ahead, with no persistent recovery in existing home sales until 2024.

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Now that we’re about to enter the Christmas shopping season, expect even more focus than usual on the consumer over the next several weeks.

We are supply-siders and so usually cringe when we hear analysts and investors dwell on consumption as if it were the ultimate arbiter of economic growth.   Ultimately the economy depends on production, which, in turn, hinges on entrepreneurship and innovation, the labor supply, as well as the health of cultural institutions like property rights and freedom of contract.

The government can affect these factors by raising or reducing tax rates, increasing or lowering spending, and adding or cutting regulations.  Meanwhile, monetary policy can lead to temporary deviations from these long-run factors, with a policy that raises or reduces inflation.

On top of all this, the wild policy response to COVID – with enormous government checks sent directly to bank accounts – left consumers with more purchasing power than they’d normally have, given output.   In turn, that has meant following the consumer is one way to gauge the extra inflationary impulse still remaining in the US economy, as well as the timing of the onset of the tighter monetary policy – the M2 measure of the money supply has dropped 4.4% – that the Federal Reserve began implementing last year.

In the year ending in September, “real” (inflation-adjusted) consumer spending is up 2.4%, no different than the growth rate in the ten years immediately prior to the onset of COVID.  However, there are multiple reasons to believe that growth rate should soon decline.

First, much of the increase in spending in the past year has been driven by increases in jobs.  Total payrolls are up 243,000 per month in the last year, which is unusually fast given an unemployment rate below 4.0%.  A slowdown in job growth should limit the growth in consumer purchasing power.

Meanwhile, consumers have been eating into the excess saving they were able to accumulate during COVID, back when the government was passing out checks with reckless abandon.  Immediately prior to COVID, in February 2020, US consumers, in the aggregate, were accumulating savings at a $1.28 trillion annual rate.  That’s personal income, minus taxes, minus consumer spending.   By contrast, in September 2023, consumers were saving at a $690 billion annual rate.

For the time being, accumulating savings at a slower rate makes sense; the government showered consumers with checks during COVID and so they got used to not having to save for themselves.  But eventually we expect that old pace of saving to reassert itself.  Even if it takes two years to do so, an increase in the pace of saving back to $1.28 trillion per year should trim consumer spending by about 1.5 percentage points per year.  That alone could take a pace of real consumer spending growth of 2.4% per year down to less than 1.0% per year.  Ouch!

Then there are student loan payments that have finally re-started.  By itself, that’s unlikely to be a major issue; we estimate the effect at about 0.2% of consumer spending.  But it should be a small headwind.

None of this means that consumer spending has to plummet anytime soon.  But we don’t need consumer spending to drop in order to have a recession.  That’s what happened in 2001, for example, when real consumer spending rose a respectable 2.0%, while the unemployment rate rose almost two percentage points, as well.

Some economists are already taking a victory lap because they didn’t forecast a recession and a recession hasn’t started yet.  But we think they’re declaring victory too early.  Some of them say that we never should have been worried about a recession while inflation fell because the surge in inflation was due to supply-chain issues, and then the reduction in inflation has been due to fixing those issues.

The problem with their theory is that they ignore the link between the surge in the money supply in 2020-21 and the inflation that followed, as well as the drop in money and the reduction in inflation this year.  They think it’s a coincidence, but we think they’re going to get a rude awakening in the year ahead.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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Implications:  Housing starts rose slightly in October, as homebuilders continue to wrestle with all kinds of headwinds, crosswinds, and tailwinds.  Looking at the big picture, during COVID, a combination of extremely low interest rates and pressure to work from home led to a big migration to the suburbs (and beyond) and high demand for single-family homes.  Then the economy reopened, causing many people to flock back to cities, sparking a boom in apartment projects.  Currently, the number of multi-unit properties under construction is hovering near record levels, going back to 1970, when records began. Now it looks like the move back to the cities has petered out leaving a glut of apartments.  Meanwhile, owners of existing homes are hesitant to list their properties and give up fixed sub-3% mortgage rates, so many prospective buyers have turned to new builds as their best option.  This has created a huge gap in the data, with construction of single-family homes up 13.1% in the past year while multi-unit starts are down 30.0%.  In other words, home building isn’t falling off a cliff and this isn’t a repeat of the prior housing bust.  Looking at the details of today’s report, both single-family and multi-unit starts contributed to the headline gain in October, although starts were revised down modestly in prior months.  Housing permits rose 1.1% in October, beating the consensus expectation, driven both by single-family and multi-units.  Notably, single-family permits have risen every month since early this year, signaling that developers are finally finding their footing in what has been a challenging year of sales.   While we don’t see housing as a driver of economic growth in the near term, recent numbers are certainly not what you’d expect to see if there was a severe housing bust like the 2000s on the way, either.

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We live in unprecedented times. Since the COVID pandemic, the economy has been deeply influenced by a massive increase in government spending, COVID-related shutdowns, and a huge increase in the money supply.  In all our years of economic forecasting, the task of identifying where we are and where we are heading has never been so difficult.  Now more than ever, it is important to follow real-time data on the economy. The charts in the High Frequency Data Tracker follow data that are published either weekly or daily, providing a check on the health of the US economy. 

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