The U.S. economy is showing a strength and durability that other major nations can only envy. China and other emerging markets are slowing, Japan is contracting, and the International Monetary Fund (IMF) has put the odds of a triple-dip recession in the Eurozone area at almost 40.0%. Meanwhile, the U.S. is coming off of its best back-to-back quarters of growth since 2003. Indeed, the U.S. economy continues to demonstrate a great deal of resilience, and we expect improving domestic demand in the months ahead to off set enough of the weakness overseas (as well as the negative effects of a stronger dollar) to keep the economic expansion on track.
The manufacturing sector is typically the first to display the effects of slower global growth. However, the American industry has held up in the face of international headwinds. Manufacturing production rose 0.2% last month on broad-based gains, and with most of the recent regional purchasing managers’ indices holding at strong levels, production looks set to continue to rise. It is also important to remember that while foreign growth remains a concern and the U.S. will not be immune to its effects, exports make up only 13.0% of U.S. gross domestic product (GDP), limiting the impact of weakness overseas.
At the same time, lower commodity prices and declining long-term interest rates are providing a powerful tailwind for the U.S. economy, offsetting much of the negative effects of dollar appreciation and sluggish global demand. The risk of deflation pressures from the Eurozone is helping to push down long-term U.S. interest rates, keeping financing costs low for consumers and businesses. Meanwhile, with most major countries outside the U.S. not strong enough to support elevated commodity and oil prices, globally driven low inflation should help the Fed to keep short-term interest rates lower for longer.
Importantly, the sizable decline in crude oil prices over the past several months has led to a $0.77 drop in the price of gasoline from the 2014 peak of $3.70 (April 28). Th is represents an estimated savings of more than $250 million each day for American motorists. At a time when wage growth is just keeping pace with inflation, this boost to household income is coming at a good time. In total, the impact from falling oil prices should lift real household income by as much as 0.3 percentage points in the fourth quarter of this year alone – just in time for the holiday shopping season.
It appears that the recent strengthening in retail sales growth is here to stay with the boost to spending power from lower gasoline prices and the rise in U.S. consumer confidence. Th e household sector is in a better position now than it has been for many years. Fewer Americans are filing for unemployment benefits than at any time in the past 14 years, equity prices are back at record highs, and gasoline prices are plunging. We believe these strengthening domestic fundamentals should be more than enough to help weather slowing global demand in the months ahead and should be able to prevent a major slowdown here at home.
THE FED - There is broad agreement among the members of the Federal Reserve Board that the economy is doing well. In fact, the Federal Reserve is confident about the prospect for further expansion in the foreseeable future. It is anticipated that labor gains will continue and that the labor market slack in the system should subside as the hearty gains in payrolls this year should continue into next year, forcing the unemployment rate down further. Inflation, which is below target, is expected to gradually firm up in the coming years.
Th ere continues to be much disagreement between the committee members regarding monetary policy and when to start hiking the federal funds rate. Th e doves continue to see excessive slack in the labor markets and believe the economy is too fragile to raise interest rates. On the other hand, the hawks believe the economy can have higher interest rates and would like to start moving them back to a more “normal range” to prevent a bubble or financial imbalance that may lead to an economic crisis. As for the market, it expects the Fed to begin raising interest rates in the second half of 2015.
LABOR - October posted another month of solid gains and a lower unemployment rate, which is consistent with the ongoing moderate GDP expansion we have been experiencing for more than five years. Nonfarm payrolls (NFP) increased to 214,000, marking nine consecutive months above 200,000. More importantly, NFP have been positive for 49 consecutive months, the longest stretch of job creation since the end of World War II. The unemployment rate is down to 5.8%, a level that many economists view as being near the natural rate of unemployment.
The continued positive employment reports this year (on track to be the strongest increase in payrolls since 1999) helps to reinforce the Fed’s conviction of the need to increase the federal funds rate in 2015. At that point, the hawks in the Fed will start to worry about inflation.
Despite the good news, average hourly earnings continue to disappoint. They are up only 2.0% in the past year and have been in a feeble range of around 2.0% since 2010. As the unemployment rate continues to slide into the natural range (5.0% to 5.5%), it should start to put some upward pressure on wages.
INFLATION - Consumer prices, which have increased 1.7% year-over-year, continue to hover just below the Fed’s target level of 2.0%. Although below target, inflation is significantly higher than most other areas of the world. For instance, the Eurozone's inflation is running at just 0.4%.
Th e service component of inflation (61.0% of Consumer Price Index [CPI]) has increased 2.5% in the past year, pushing the overall index higher – mainly due to higher housing costs. The goods component (the remaining 39.0% of CPI) has increased only 0.3% this past year. Th is component has been forced down by lower commodity prices, which have been driven by lower energy prices. Energy prices have fallen in each of the past four consecutive months and are down 1.6% in the past year. Although prices of all the major components of energy are down, gasoline prices are the most noticed by consumers. Overall, gasoline prices have fallen 87 cents since hitting a recent peak back in late June. Th e continuation of lower gasoline prices, which is expected by the Bureau of Labor Statistics (the group that calculates CPI), should be a boon for consumers as they head into the holiday season.
CONSUMER CONFIDENCE/SENTIMENT - Consumer attitudes have been on an upward trend for the past several years. Household moods have been boosted due to a combination of many strong conditions. Consumers are excited about the lower gasoline prices, which provide more disposable income and are especially important going into the holiday season. In addition, an improving economy with expectations for better business conditions, which should boost employment and income (lower unemployment rate), resonates well with consumers and adds to their confidence and optimism. Finally, higher stock prices are adding to household wealth. It is interesting to note that the ongoing turmoil in the Middle East, higher than normal market volatility, fears of Ebola, and weakness in the global economy do not seem to have a significant impact on domestic household confidence.
CHARTS OF THE MONTH - INFLATION
For the past few years, inflation has been below the Federal Reserve’s target rate of 2.0%. CPI, the most broadly known inflation metric, is at 1.7%, and the core personal consumption expenditures price index (PCE, the Fed’s preferred inflation index) is at 1.5%.
One of the driving forces on inflation, as of late, has been the stability of commodity prices, which make up about one-third of the index. Commodity prices have increased only 0.3% in the past year. Services, driven mostly by housing prices and making up the remainder, are up 2.5% in the same period.
Within the commodities group, gasoline prices have been falling and are down about 14.0% in the past year.
The housing component, which makes up 41.0% of CPI, has increased 2.7% in the past year, contributing the most to the overall inflation rate. Transportation costs have been negative in the past year due to lower gasoline prices.
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