Last week was a massive one for big news, but the S&P barely budged all week - closing up 0.01%.
The aftermath of the G7 meeting was intense. First, President Trump offered to drop all tariffs as soon as other G7 members did the same. This would be an amazing outcome. If the G7 nations had agreed, these tariff and trade spats would no longer disrupt the stock market; but G7 leaders did not agree, so President Trump refused to sign the agreement as he flew to Singapore, which caused German Chancellor Angela Merkel to say that it was "sobering and a little depressing" to see the U.S. refuse to sign the agreement.
The "G6" countries in the G7 have a smaller combined economy than the U.S.; so when President Trump taunted them for being hypocrites on trade, they did not have a good response, since they have multiple tariffs on U.S. goods and a massive surplus. For instance, the U.S. imposes a 2.5% tariff on German vehicles, while Germany imposes a 10% tariff on U.S. vehicles. This is why Mr. Trump is confronting our allies. Germany has a lot more to lose, so I feel they will likely work with us on an amicable solution.
President Trump now has a very outspoken core of economic advisors in his inner circle, so I expect more confrontations with major trade partners in the upcoming months. However, since Trump's ultimate goal is the removal of all tariffs, I don't think the stock market will react negatively to these escalating trade spats. The bottom line is that if U.S. trade deficits continue to decline, then annual U.S. economic growth in the 3% range is much more sustainable, and that will be good for the stock market and the economy.
The historic summit with North Korea and the U.S. in Singapore also dominated the news last week. The primary achievement at the summit was that a document was signed to eliminate nuclear arms from the Korean peninsula. Peace and prosperity won't suddenly break out in North Korea, but it was a step in the right direction and the more such steps we see the more financial markets are expected to react positively. The world seemed to breathe a sigh of relief that there is a serious ongoing dialogue now between North Korea and the U.S. since just a year ago, missiles were flying over Japan and the world was on edge.
P.S. Our best wishes are with Larry Kudlow, who is recovering well from a mild heart attack suffered on the Monday after the G7 meeting. He was released from Walter Reed Hospital after just two days there.
The FOMC Sees Little or No Long-term Inflation Threat
On Wednesday, the Federal Open Market Committee (FOMC) raised key interest rates a quarter-point, which was widely telegraphed and anticipated. The FOMC statement, as I expected, was decidedly dovish, which helped to excite financial markets. Specifically, Fed Chairman Jerome Powell said, "If you raise rates too quickly, you are just increasing the likelihood of recession." He added that "we've been very, very careful not to tighten too quickly … We had a lot of encouragement to go much faster and I'm really glad we didn't." This refreshingly clear statement caused the 10-year Treasury bond yields to decline significantly, signaling that the bond market does not expect too many additional rate hikes.
The FOMC remains divided on whether the Fed should raise key interest rates one or two more times in the rest of 2018 due to a lack of consensus on how high inflation will rise and how high the Fed can raise rates before hindering economic growth. I must add that Fed Chairman Powell is very direct, pragmatic, and does not use confusing "Fedspeak" like his predecessors, which is very good for market confidence.
The news on the inflation front last week was mixed. On Tuesday, the Labor Department reported that the Consumer Price Index (CPI) rose 0.2% in May, in line with the economists' consensus estimate. The core CPI, excluding food and energy, also rose 0.2%. Gasoline prices rose 1.6% and medical commodities rose 1.3%, but excluding those items, there was scant evidence of any significant inflation in May.
On Wednesday, however, the Labor Department reported that the Producer Price Index (PPI) rose 0.5% in May, due predominantly to soaring crude oil prices. Economists were expecting 0.3%, so this was a big surprise; but excluding food, energy, and trade, the core PPI rose only 0.1% in May, significantly lower than economists' consensus expectation of a 0.2% rise. So the bottom line is that wholesale inflation is tied predominantly to crude oil prices, which have moderated in June due to rising crude oil inventories.
It is important to note that the recent energy-related inflation is merely seasonal in nature, since crude oil demand rises in the spring and ebbs in the fall simply because there are more people in the Northern Hemisphere than the Southern Hemisphere. Both Saudi Arabia and Russia have recently boosted their crude oil production ahead of this month's OPEC meeting. Furthermore, now that the U.S. is the largest producer of crude oil, thanks to the fracking boom, the incremental U.S. production has offset the supply disruptions caused by Venezuela. There is now a growing surplus of crude oil being stored in oil tankers around the world, so if anything, the worldwide crude oil supply seems to be finding equilibrium and stabilizing at a high enough price level to be favorable for most major energy producers.
I should add that all that fracking in West Texas has resulted in a natural gas glut. The natural gas market remains very weather-sensitive, so only a hot and miserable summer or a freezing cold winter can reduce the current natural gas glut. The other glut in the energy patch is in heavy-to-intermediate (WTI) crude oil grades compared to light sweet (Brent) crude oil, which means that the refiners are poised to continue to post very strong earnings as long as the spreads remain wide. Energy prices should decline in the coming months, which will help inflation to moderate and cause the Fed to raise rates at a slower pace.
Consumers and Small Business Owners are Buoyant
Back in 1984, Ronald Reagan campaigned on the slogan, "It's Morning in America," and he was re-elected in a landslide. Small business owners have never felt better than they did that year - until now.
On Tuesday, the National Federation of Independent Business announced that their small business optimism index surged to 107.8 in May, up from 104.8 in April, reaching its highest level in 34 years. Since small businesses create most jobs in the U.S., this bodes well for second-quarter GDP growth.
Consumers feel just as good. On Thursday, the Commerce Department announced that retail sales soared 0.8% in May, substantially higher (double) than the economists' consensus estimate of a 0.4% increase. Retail sales for March and April were also revised substantially higher to increases of 0.7% (from unchanged) and 0.4% (from 0.2%), respectively. Excluding autos, gasoline, building materials, and food services, core retail sales rose an impressive 0.5% in May. In the past 12 months, retail sales have risen by 5.9%. Due to May's strong retail sales as well as strong upward revisions, GDP growth in the second quarter is on track to grow at over a 4% annual pace, perhaps up to the 4.8% rate predicted by the Atlanta Fed.
Finally, on Friday, we learned that the University of Michigan's preliminary consumer sentiment index rose to 99.3 in June, substantially higher than the economists' consensus estimate of 98.5. The current conditions component soared to 117.9 in June, up from 111.8 in May, which is a good omen for continued strong retail sales and second-quarter GDP growth, which will be released in late July.
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