There is a growing consensus that a recession is right around the corner, perhaps as soon as late 2019, but surely by 2020. Why? I think the primary reason is that the current expansion will be the longest on record come June of this year, surpassing the 10-year period of prosperity during the 1990s, and everyone knows that expansions don't last forever. Yet, today I don't see the excesses in the real economy that have led to two quarters of contraction in economic activity in the past. The only excesses appear to be in financial markets.
NFIB Small Business Optimism
At first glance, small business optimism looks like it has tumbled, falling to levels (101.2) last seen leading up to the 2016 election. Still, it remains well above its average of 98, but the measure of uncertainty is at one of its highest readings on record. This is understandable given the government shutdown, trade negotiations with China, and continuing unrest in Washington. So, while business conditions and activity remain strong, the uncertainty is starting to give some business owners pause about expansion and a continuation of the economic strength we have seen.
December's retail sales report was a headline shocker, showing the largest monthly decline (-1.2%) since 2009. Nearly every segment saw declines, including e-commerce, except for auto sales (+1%). There was no doubt that sales would slow due to the government shutdown and the near 20% plunge in the S&P 500 index during December, but this report is probably not as horrific as the headlines suggested.
I expect to see a significant upward revision, in particular for e-commerce sales, which the report claims declined 3.9%. There was no evidence of such a decline in reports from various internet retailers. This decline is also not consistent with the underlying trend in consumer spending growth.
After increasing 0.1% in December, industrial production declined 0.6% in January, driven largely by a big downturn in motor vehicle assemblies. This is what led to a 0.9% decrease in manufacturing activity, while mining (+0.1%) and utilities (+0.4%) saw increases. When we exclude auto production, manufacturing activity slid 0.3%, but it remains up 3.1% from January a year ago.
The year-over-year increase of 3.9% in overall industrial production is a more positive view, but it is clear that in the near-term this report indicates that the rate of economic growth is slowing.
CPI and JOLTS reports
The Consumer Price Index was unchanged in January and is up 1.6% from a year ago, while the core rate, which excludes food and energy, was up 0.2% in January and is up 2.2% from a year ago. It is important to note that the core rate has risen 0.2% for five consecutive months, but the overall rate has declined because of the plunge in energy prices. If energy prices make a comeback, the Fed is going to have a real headache. Regardless, I think the core rate is more likely to increase from current levels for one important reason - the rate of growth in real wages is accelerating.
The CPI report also showed that we are seeing the highest percentage increase in real average hourly earnings since this expansion began, as can be seen below. Real average weekly earnings growth for production and non-supervisory employees was growing at an annual rate of just 0.3% a year ago. Today the growth rate is 2.4%.
A continued increase in wages is supported by the most recent NFIB Small Business Job Report that showed a net 20% of business owners are planning to raise wages and benefits.
Additionally, the Labor Department's JOLTS report (Job Openings and Labor Turnover Survey) for January shows that job openings continue to accelerate at a faster rate than hiring, with the gap between openings and hires at a new record of 1.428 million. This is a prescription for higher wages.
The Fed's Balance Sheet
This is something that I plan to follow on a weekly basis, given the close correlation between the size of the Fed's balance sheet and the performance of the stock market. For the first week so far this year, the balance sheet grew in size by a meager $2.1 billion. It is down $432 billion since the Fed began unwinding its balance sheet in October 2017. The Fed still plans monthly reductions of $30 billion in Treasuries and $20 billion in mortgage-backed securities.
The rate of economic growth is undoubtedly slowing from the tax-cut-induced pace of Q2 and Q3 2018. As the impact of that fiscal stimulus wanes, in combination with the headwinds from the government shutdown, tariffs and the trade dispute with China, we should see growth slow to a rate of 1-2% in Q4 2018 and the current quarter. Third-quarter growth (2018) was also boosted by 2.3% from inventory accumulation, which will not repeat in the coming quarters. This does not mean a recession is in the offing. Outside of an unforeseen shock, so long as real-wage growth continues, the government keeps running $1 trillion deficits and interest rates remain low, we can keep growing at 1-2%. The big IF is interest rates.
The coming deceleration in the rate of economic growth has been absorbed by the bond market, as seen in the rapid decline in long-term interest rates from the peak of 3.25% in early November to the current rate of 2.66%.
While the rate of growth may be slowing, I see the seeds of an increase in the rate of inflation taking root. These countervailing forces will tug on long-term interest rates in both directions, making it extremely important to determine which ultimately wins out.
Inflation expectations over the next five-year period, while up substantially from the low in early 2016, remain relatively muted today. Still, note that they were not significantly higher than they are now when the 10-year Treasury yield rose to 3.25%.
I see signs that the core rate of inflation will continue to increase, while the rate of economic growth is likely to weaken. That is not a good combination, as it has the characteristics of stagflation. Stagflation results from a combination of expansionary (quantitative easing) and contractionary (rising interest rates) policies, as we saw in the 1970s. To say it can't happen again is a fool's errand. History rarely repeats itself, but it often rhymes.
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Disclaimer: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.
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