Capital Markets Fall In Love With Strong Manufacturing Data

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by: Learn Bonds

Yesterday, the equity market surged higher and UST yields increased due to pro-growth policy comments, by President Trump and strong economic data. We discussed President Trump, yesterday. My view is that markets were cheered not by what Mr. Trump said, but how he said it. Fair enough, but what about economic data?

Capital markets loved the strong manufacturing data, particularly the ISM data. The February ISM Manufacturing Index surged higher to 56.7 from 56.0. That indicated stronger manufacturing output, right? Wrong! The ISM Manufacturing Index is a sentiment index. It measures optimism in the manufacturing sector. Optimism (or the lack of it) often translates into actual output data, but not always. Output data, such as the Chicago Fed Index, Construction Spending and Durable/Capital Goods data, indicate manufacturers and their customers are not putting their money where their mouth is.

Other data has been less positive. Real Consumer Spending indicates that consumers are having difficulty dealing with price increases. PCE and CPI data indicate that much of the inflation increase has been focused in rents, healthcare and energy prices, with energy prices responsible for headline inflation converging with and, recently, surpassing core inflation.

When this phenomenon materializes, it is usually indicative of bad inflation. So-called bad inflation comes from price increases in sectors of the economy, which have fairly inelastic demand. Good inflation would be when price increases are focused in discretionary areas of the economy. This scenario augurs for very healthy consumers. We are not seeing that today.

Then there is the Fed's Beige Book. Yesterday, the Fed released its read of the U.S. economy. Fed data indicate that the economy is growing at a "modest to moderate pace." The Fed described the labor market as "tight" amid "widening labor shortages," while wages have increased "modestly," and have only been able to support moderate growth in consumer spending.

The Beige Book indicated that, in spite of businesses remaining "generally optimistic" about the economic outlook, post-election policy uncertainty made consumers feel positive "to a somewhat lesser degree than in the prior report." The latest Beige Book indicated that growth at the beginning of 2017 is consistent with the moderate trend prevalent over the last several quarters.

What stood out to me was that, while labor market conditions appear tight, wage growth has been modest. This does not jibe unless either additional employees is more of a want than a need for businesses or that businesses have other means of production (automation, such as robots, software, etc.).

I have read retail-oriented investment commentary, which suggests that the pace of economic growth is (clearly) picking up. The data suggests otherwise. Although it is true that a recession is nowhere to be seen, other than sentiment, where is the evidence that U.S. GDP is in an upward trend? GDP ran at 1.9% in Q4 2016. Yesterday, the Atlanta Fed lowered its Q1 '17 GDP forecast to 1.8% from 2.5%.

According to the Bloomberg Survey, Q1 '17 is expected to run at 2.0%. For calendar year 2017, the Bloomberg Survey consensus estimate stands at 2.3%. This probably includes some degree of fiscal reforms positively impacting U.S. GDP this year.

There is much for which we can truly be optimistic. However, when markets and market strategists begin cherry-picking data and focusing on animal spirits, it smacks more of hope than true strategy. The clincher is when strategists and pundits haul-out mean reversion as the basis of their strategy. If all we had to do was wait for conditions and history to repeat, why would we need research, strategy and financial news? The answer is: We wouldn't. However, history and conditions often rhyme, but I have yet to see them repeat.

As for inflation, unless we see growth-driven inflation or stagflation from wanton debt-fueled infrastructure spending (either is possible, but neither are close to a certainty), I believe that headline inflation pressures should fade, with headline inflation again converging (falling, this time) with core inflation, by summer. This is mainly due to a narrowing of year-over-year oil price comps.

At this time last year, the price of WTI was about $34.50 a barrel. Today, it is priced at about $53.10 a barrel. If WTI remains largely range-bound, into the summer, the year-over-year price change will narrow. In June 2016, WTI was trading mainly between $45 and $50 a barrel. There could be another shot of inflation later in July, when 2016 WTI prices fell back to around $40, but after that, the year-over-year comps could all but disappear. Thus, we might be witnessing the near-term peak in headline inflation.

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