US economics, inflation, and the Fed

The pace of inflation showed further signs of easing in April. On the heels of a more benign Consumer Price Index report, the companion Labor Department report revealed more progress at the producer (wholesale) level. Specifically, the April Producer Price Index (PPI) and the core PPI, which excludes the food and energy components, fell 0.5% and 0.1%, respectively. On a 12-month basis, the PPI and core PPI increased 2.4% and 2.9%, respectively, with both easing from the 3.4% and 3.5% paces recorded in March.

The worries about stagflation have lessened a bit according to Value Line. That is because inflation moderated last month, and the labor market has held up well. April’s job-creation figures were better than expected, and initial unemployment claims are still running at a level not indicative of stress in the labor sector. The growth picture, though, is unclear, with the gross domestic product (GDP) contracting in the first quarter amid concerns about the Trump Administration’s tariff policies. Value Line’s sense is that a new tax deal on Capitol Hill and increased deregulation in the energy and financial markets will be needed to drive growth over the next 12 months.

Then there is the recent downgrade to the United States’ debt rating. The credit rating agency Moody’s cited the increase in spending this decade, and the resultant ballooning of the debt level to $36 trillion, as the primary reasons for the downgrade. This news pushed Treasury yields higher and weakened the value of the U.S. dollar against international currencies. The subsequent increase in borrowing costs will make it more expensive to fund investments and capital spending projects. The higher lending rates also are not a good backdrop for home sales and residential and nonresidential building.

Professor Siegel expressed his opinion on the Moody’s downgrade:

“After Friday’s close, Moody’s downgraded U.S. treasuries, as S&P had 14 years ago, in 2011. I criticized the downgrade then…and I do now. The government cannot technically default, as the Fed can always buy the bonds for any auction. The question is not whether a payment will be made, but what the dollar will be worth. Although the long-term projections of debt growth are unsustainable, I see a lot of debt capacity in the near term before this becomes a problem. As of Sunday night, futures are down by about 75 bps, and I don’t think there will be much further reaction to Moody’s action.”

Global economy

While the US economy seems to be holding up well, the global economy stands at an inflection point. Economic activity grew solidly through the first four months of the year, led by a goods sector surge. But three drags linked to this year’s trade war are building and are set to generate subpar growth according to JP Morgan. First, the front-loaded boost to the goods sector in advance of realized and threatened tariff hikes should unwind by midyear, stalling manufacturing output gains. Second, a squeeze in US household purchasing power that weakens a major engine of global demand is imminent as tariff hikes pass through to consumer prices. Finally, a slowing in capex and hiring is in the offing due to the business sentiment slide linked to heightened US policy disruptions.

An immediate concern is that these drags interact to generate a business sector retrenchment that pushes the US into recession. This risk rose significantly as both the tax hike and sentiment shock associated with US tariff hikes increased in an unexpected manner last month. A similar unexpected unilateral US tariff backtrack this month prompted a reassessment of recession risk, as this policy shift was expected to quickly lift global business sentiment from its March–April slide into recession territory.

Stock market

Despite macro level concerns, Corporate America performed well in the first quarter. Earnings growth for the S&P 500 companies was averaging nearly 14%, easily exceeding the consensus forecast for a high-single-digit advance. This growth provided support for equities at a time when fiscal and monetary policies remain uncertain.

While the US market seems overpriced relative to the other developed ones (see a message from the recent Market Monitor by Goldman Sach below), the profitability of the US firms seems to be the justification to that premium.

Empirical Research notices:

“It’s amazing how quickly the tables can turn. Just ask the Knicks, up 14 in Game 1 at the Garden with just a couple of minutes left on the clock. The U.S. stock market powered into this year with similar momentum behind it, but just a few months later the cosmic challenges are piling up. The tariffs have been watered down but are still meaningful, the deficit looms and the cost of funding it is up, there’s the potential drag on the economy from fiscal austerity, questions about the Dollar’s reserve status are percolating, and there’s ongoing policy uncertainty in arenas beyond trade (e.g., health care). It’s a long, serious list and investors have been wondering, quite legitimately, if the era of American Exceptionalism is finally over. Is it time to look to other regions for the winners of the next decade?

A rebuttal to that argument is that the opportunity cost of abandoning U.S. stocks is still quite high. In aggregate, U.S. stocks are generating an ROE (return on equity) just short of 19% and pay out 72% of earnings via dividends and net buybacks. In other words, investors pocket 14% of the equity base every year. In Europe, that number is 9% and in Japan, it’s 5%. Compounding that differential over time is powerful, so one needs to be sure that the profitability advantage of the U.S. system is eroding before rushing to the exit…”

Keep the faith and stay tuned!

The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: WSJ.com, Jeremy Siegel, Ph.D. (Jeremysiegel.com), Goldman Sachs, J.P. Morgan, Empirical Research Partners, Value Line, BlackRock, Ned Davis Research, First Trust, Citi research, HSBC, and Nuveen.

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