Another decent week for the global equity markets with gains across the board. The S&P 500 picked up +0.6% while small-caps added +1.1%. EM was strong with a +2.3% gain. Equities have rallied despite slowing global growth, in part due to a more dovish central bank backdrop, and in part due to hopes about a trade deal. Certainly, the change in central bank attitudes has helped push bond yields lower. The yield on the 10-year dipped fractionally this week, intermediate-term Treasury bonds gained +0.2%, and high-yield added +1.4%.
What Is It with Slow Growth in The First Quarter?
The economic data has been decidedly on the soft side the last couple weeks. This isn’t much of a shock – we knew the government shut down, harsh winter weather, and market swoon in the fourth quarter would all conspire to put a damper on things. Also, the first quarter has a long history of being soft, as we note below. But first a quick summary of the recent economic reports:
Sales in December unexpectedly fell -1.2%, a sharp turn from November’s +0.1% gain, as you can see below.
The retail sales report is somewhat at odds with Walmart’s earnings report this week. The company easily beat earnings estimates and posted the best fourth-quarter sales number in a decade.
The retail sales report is traditionally volatile and the truth probably lands somewhere between it and Walmart’s numbers.
The Federal Reserve Senior Loan Officer Survey for January showed a broad-based decline in the demand for consumer credit. Consumers are borrowing less and saving more.
As you would expect with credit demand shrinking, auto sales have taken a hit.
Capital Goods Orders
Along the same lines, orders for big ticket items shrunk in December. Non-defense capital goods orders excluding aircraft fell by -0.7% in December. Jitters about trade are undoubtedly weighing on confidence, but the dip isn’t unusually large for this time of the year.
Existing-home sales experienced a minor drop for the third consecutive month in January, as you can see below.
And while inventory levels continue to increase nationwide (blue line below), the months of supply of homes on the market remains pretty low (red line). This means there isn’t a huge overhang of inventory that will weigh on prices.
While the weak data is being spun as recessionary, the reality isn’t that bad. The Atlanta Fed estimate for first quarter GDP growth is running at +1.4%.
Granted, this is down significantly from the roughly 2.6% estimate a couple weeks ago, but it isn’t unusual to see softer growth at the beginning of the year. The table below shows first quarter growth numbers going back to 2010.
The Fed is Waiting on Inflation
The immediate implication of weaker growth is a likely end to monetary tightening. At the end of January the Fed unanimously decided to keep rates unchanged. Their post-meeting communication marked a stark about-face from the decision it made just six weeks earlier. The Fed dropped explicit references to future interest rate-increases that have been in the statement since the central bank began lifting its benchmark rate from near zero in 2015.
This week the minutes from the January meeting were released and they put more color on the conversation the committee members had. Specifically:
They all agreed that holding interest rates steady for a time posed “few risks”, with several saying further increases would only be necessary if inflation accelerated more than they expected.
The Fed minutes also showed that “almost all” participants wanted to announce a plan soon to end the process of reducing the Federal Reserve’s balance sheet later this year.
Many Fed officials are not yet sure what changes to the target range for the federal funds rate may be appropriate later this year.
There was also some speculation that the so called ‘dot-plot’ wasn’t helping with clear communication.
On the last point, the chart below shows the dot-plot for the next few years (yellow dots, obviously). As you can see, the average estimate from the Fed committee is that rates will hit a bit over 3% in a couple years. However, the market is pricing in no hikes this year and actually a cut next year (white and purple line).
The path forward is dependent on the direction of inflation. As you can see below, inflation expectations have slumped recently. It will be hard for the Fed to start hiking again while expectations are falling.
But if the data changes the Fed will change its mind. In an interview Wednesday, Federal Reserve Vice Chairman Richard Clarida said there are scenarios where the Fed may raise interest rates but there are other scenarios the central bank might not hike at all. So basically, they don’t know what they are going to do, and in a sense the Fed will follow the markets.
As Tim Duy notes:
“Bottom Line: With policy rates near neutral, low inflation, and questions swirling around the economic outlook, the Fed is content to take a pause through at least midyear before changing rate policy. If the Fed were to move before midyear, I suspect that it would only happen in response to negative news that forced a rate cut…While we wait for new information on the path of rates, the Fed will be updating its balance sheet policy.”
There is growing speculation that the Fed will outline their plan to end their Quantitative Tightening program at the next Fed meeting in March. This will come at the same time the European Central Bank starts to grow their balance sheet again.
Could the Next Move be a Cut?
This is a bit wonky, but it goes a long way towards explaining why the Fed Funds rates isn’t going back to the levels we saw 15 or 20 years ago. Researchers at the Federal Reserve Bank of New York released a study in the third quarter last year that attempted to estimate the neutral level of interest rates (or r-star) over time. Neutral would mean a Fed Funds rate that is neither stimulative or contractionary. As you can see below, they estimate that back in 1980 a neutral rate was 4%, or 400bps, over inflation. Today it is just 50-to-80bps over inflation.
Today the core PCE inflation measure is running at +1.7% year-over-year. This would put neutral between 2.2% and 2.5% – essentially where we are today.
Why has the neutral rate come down? An aging population, poor productivity growth, technological changes, a heightened demand for safe haven assets, and globalization all probably play a role. Just take demographics as one example. The chart below shows the change in working age populations over the last 30 years.
The next chart shows the likely changes over the next 30 years (the swing in China is enormous!!).
One possible implication of this is that negative interest rates around the world aren’t going away. As you can see below, there is roughly $9 trillion of debt with negative yields around the world (see our post yesterday about how falling European yields led to Bill Gross shutting up shop). This has grown in the last few months as the global economy has slowed and inflation expectations have slumped.
This is a testament to the deflationary pressures in large parts of the developed world. Just imagine how big this number will get if we see a global recession in the next year or two.
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