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Lofty Expectations Clash With Down To Earth Data

May 2018
 

As of this month, the current economic expansion is now the second-longest on record. Wow, talk about bad timing. After averaging better than 3.0 percent over the last three quarters of 2017, real GDP growth slowed to 2.3 percent (annualized rate) in Q1 2018 with inflation adjusted consumer spending growing at its slowest pace since Q2 2013. What had been rapid growth in business spending on equipment and machinery faded away in March while the ISM’s gauges of activity in the manufacturing and nonmanufacturing sectors are retreating from recent, and perhaps cyclical, highs. Job growth has eased, wage growth is stuck in the slow lane, and productivity growth is just stuck, but at the same time inflation is starting to move at a faster pace. Okay, sure, the unemployment rate sits below 4.0 percent for the first time in almost two decades, but that’s only because people are fleeing from the labor force, perhaps in panic over the obvious deterioration in economic fundamentals. Clearly it’s all going south, right?

We’re going to have to go with “no” on this one. This isn’t a case of us whistling past the graveyard or us being bound and determined to bend the economic data to conform to how we know the world to be. Instead, this is simply us adhering to what we think is the most important, not to mention the most basic, tenet of economic analysis, which is not simply accepting the headline numbers on any given data release but instead looking to the underlying details for the real story. For instance, in last month’s edition we cautioned that the initial estimate of Q1 2018 GDP would be plagued by the issue of residual seasonality, which for the past two decades has biased estimates of Q1 growth lower in any given year. As such, we weren’t fazed by the BEA’s initial estimate of 2.3 percent growth and do not see that as reflective of the state of the U.S. economy. Given that residual seasonality skews the Q1 data in any given year, one way around this issue is to look at the year-over-year percentage change in real GDP. On this basis, real GDP grew by 2.9 percent in Q1, the fastest such growth rate since Q2 2015.

We could go through a similar exercise with any number of economic data series. Whether it’s job growth, productivity growth, capital spending, or consumer spending, in each case we see the underlying trends as healthier than the recent headline numbers, though this is not to say there is not room for further improvement. By no means do we claim to always be correct in our interpretation of the trends in the economic data, but we remain comfortable with our assessment of current economic conditions and our outlook for growth over coming quarters.

One useful check we’ve relied on over the years is the survey data from the Institute for Supply Management (ISM). Each month the ISM surveys 18 manufacturing industry groups to compile the ISM Manufacturing Index and 18 industry groups in other sectors of the economy to compile the ISM Nonmanufacturing Index. While the headline index in each case is a diffusion index, with 50.0 percent representing the break between contraction and expansion, we find the underlying detail to be far more useful. For instance, in the recently released data for April, 17 of the 18 manufacturing industries reported growth (the remaining industry group reported no change in the level of activity) and all 18 of the nonmanufacturing industry groups reported growth.

One of our favorite parts of each month’s releases is the section in which the ISM relays comments from survey respondents pertaining to what they see in their industry. One common theme over recent months is that firms are having trouble keeping pace with growth in demand. This is consistent with the indexes in each survey showing growing backlogs of unfilled orders – 16 of the 18 industry groups in the manufacturing survey reported larger backlogs in April. At the same time, deliveries from suppliers have gotten progressively slower over the past several months in both the manufacturing and nonmanufacturing sectors, indicating supply chains being stretched to capacity. This is hardly a sign of an economy on its heels struggling to stay upright.

As would be expected with both suppliers and producers stretching to keep pace with demand, the ISM data show building price pressures in both the manufacturing and nonmanufacturing sectors, which is consistent with the signals being sent by the Producer Price Index over recent months. Higher prices for raw materials and other inputs to production along with labor costs that are growing at a modestly faster pace could lead firms to test their pricing power in the months ahead. If so, the prolonged period of dormancy of retail (or, consumer) level inflation that has baffled central bankers (and, sure, economists) could come to an end faster than anyone had anticipated at the turn of the year.

This has caused considerable uncertainty amongst many financial market participants as to how rapidly the FOMC will raise its Fed funds rate target. It is interesting that against this backdrop the FOMC, following their early-May meeting, noted that their inflation objective was “symmetric,” meaning that they would be willing to tolerate a period of inflation running above their 2.0 percent target rate just as for the majority of the time over recent years inflation has fallen short of this target. This tolerance, however, has its limits, but what makes it tricky for market participants is that these limits are not pre-defined. If we are correct in our assessment of current economic conditions and our outlook for economic growth is on or close to the mark, these limits could be tested sooner rather than later.

Source: BEA, BLS, ISM

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