As the second quarter draws to a close, the biggest economic news items focus on the perceived need for an interest rate cut and on the likelihood the Fed will accommodate. We believe this focus is totally misplaced. The more important news is the remarkable strength of the economy and an almost equally strong prognosis for its continued success.
Let’s start with the rate cut.
The storyline is that the U.S. economy is in trouble, with another recession imminent. If you believe this, a potential Fed rate cut makes sense, and may even seem necessary, to keep the good times rolling.
The implication is that the Fed is tight. But the facts just don’t back this up, nor does common sense. Does anyone seriously believe that a fed funds rate in the low to mid 2% range is dissuading any investor or senior manager from making an investment or expanding plant and equipment? The obvious answer is, no. The more plausible conclusion might be that the rate is too low, that 2.375% is encouraging some investments which really shouldn’t be made. Borrowing costs this low can make marginally profitable investments look attractive.
Another consideration to keep in mind is that rate moves themselves do not cause expansions or recessions. It is the amount of money in the system which is the more important statistic. Changes in the amount of money placed into or extracted from the economy are the driving factor. This is the root cause. When the Fed removes money from the system, this tends to drive interest rates up, not the other way around. Today, the Fed still has more than $1 trillion in excess reserves in the system. We are nowhere near being tight.
Other commentators point to various economic statistics, which have dropped in May, as signals a recession is on its way. Such observations miss the fact that not all economic indicators are of equal predictive value, and that many more indicators signal continued growth than are signaling recession. In fact, nominal GDP is up at a 4.8% annualized rate over the last two years, and the final report on first-quarter real GDP (nominal growth less inflation) showed a 3.1% annualized rate.
We don’t want to chronicle every indicator, if for no other reason than we don’t want to bore our readers. So, let’s consider some of the most important ones.
Most Important Data Sets
Among the most important data sets are “core” shipments of non-defense capital goods excluding aircraft. This is a key component of the business investment portion of GDP, and it’s up 0.7% in May. This puts us on track to see a 1.9% annualized increase in core shipments in the second quarter over the first quarter. This will represent a continuation of the trend seen in 2018, which was itself the fastest full-year growth rate in “core” shipments in six years. This is not what a recession looks like.
New single-family home sales also support continued economic health. May’s numbers put us at a somewhat low 626,000 annual rate for new single-family home sales. This which means that the pace of home building is likely to increase in the year ahead because relative to population the number of new home sales is well below where it needs to be to meet demand. Populations have to live somewhere, and ultimately new home sales will have to increase. This isn’t rocket science; it’s a pretty straightforward calculation. We actually expect sales and construction in 2019 to exceed 2018 and thus continue an upward trend.
Employment numbers are also good. In fact, they are fantastic. Initial unemployment claims as a share of total employment are at its lowest reading ever. Job openings are 1.5 million greater than the total number who are unemployed. There are jobs waiting to be filled rather than people waiting for a job to open.
On the retail front, sales for the last three months are up 10.9% on an annualized basis. People respond to polls for a variety of reasons, depending on who is asking the question, how the question is phrased, and sometimes on whether breakfast disagreed with them. But people spend money based on their real confidence in the future. No matter what the next random “consumer confidence” poll says, spending levels indicate consumers’ strong confidence in their jobs and the likelihood their income will grow.
What Does The Future Hold
We’ve already laid out the grass root reasons we expect continued economic growth. Stepping back, or upwards, to the 10,000 foot-level, we also assess a very strong economic foundation. The key components of any economic growth are monetary policy, tax rates, the regulatory environment, trade relations, and government spending levels. Today, the first three are all very positive, and the fourth is under discussion.
As discussed above, monetary policy is not tight. We could even see rates increase without jeopardizing economic growth. Tax and regulatory policy now both support economic vitality and growth. On the trade front, we do not perceive the current administration’s actions as dangerous. There is an effort to level the playing field – especially against China who has manipulated their currency and stolen massive amounts of the U.S., and European, intellectual property – not an effort to start a trade war. The administration is being hard on China, using elevated tariff levels to drive them to a reasonable agreement at the negotiating table. There is scant evidence of a broad, economically destructive, global trade war. That could change, but right now, the motivations and signs are positive.
The area which does need improvement is government spending. The truth is that government spending tends to drive out private spending. This, too, is simple math. If the government takes away (in the form taxes) or borrows a dollar, that is one less dollar the private sector has to spend. Government spending tends to be much less efficient than private spending, so ultimately if government spending becomes too high, the economy will suffer. We’re not there yet, but to be honest, in our assessments we point out one of five key components needs improvement.
The numbers show continued strength, and the underlying components of economic vitality are, on balance, very favorable. We believe that 2019 and 2020 will witness continued growth in corporate profits and continued growth in GDP. The stock market must ultimately reflect these realities, even if there are momentary downdrafts, corrections, and emotional spasms. Even with the higher interest rates which inevitably will come, we see stocks broadly measured as being roughly 20% underpriced relative to their true value today. And that assumes the Feds will get interest rates up to a more historically normal 3.5% level.
Regular readers of our blog know that we are not market timers – so this isn’t an argument to drop tons more into stocks – but we aren’t ostriches with our heads in the sand either. We strive hard to provide the best analysis possible and to make the appropriate recommendations for our clients’ portfolios and overall financial needs. Nothing here suggests altering a well thought out allocation; everything here once again supports sticking to the long-term plan without worrying about the roller coaster ride along the way. If we can be of any help, or answer any questions, don’t hesitate to call or email.