A popular rule of thumb for defining a recession is two consecutive quarters of negative growth. As we all know, the U.S. economy shrank by 0.7 percent in the first quarter. Since then, a steady flow of positive economic indicators has successfully removed any concerns that U.S. economic activity is diminishing, confirming that the ruminations of recession based on the first quarter’s soft patch were entirely overblown.
As the U.S. economy resumes its upward march, the Federal Reserve is becoming increasingly convinced that the environment is strong enough to begin raising rates. Core inflation has increased at a 2.4 percent annualized rate through the first five months of the year, above the 2 percent goal the Fed has been saying inflation needs to reach in order for it to tighten monetary policy. This is additional confirmation that a September increase in rates is still on track.
This week, the Federal Open Market Committee (FOMC) confirmed this hypothesis in what can be generally described as a more dovish outlook for the long term, but one that clearly puts September in the crosshairs for an interest rate hike after six long years at the zero bound. The Fed’s “dots” represent where Fed presidents and governors believe short-term rates will be in the future. The market is getting more intensely focused on this rather obscure piece of information, and with good reason. In March, the last time the dots were released, the market rallied because of the unexpected decline, reflecting an expectation of lower short-term rates. This time around, the Fed did the same and U.S. stocks rallied once again, albeit modestly.
As far as the rest of the world is concerned, pressure is on China to reflate and on Europe to remain strong in the face of floundering negotiations with Greece. Volatility is a constant companion. While Europe is fairly well insulated against a collapse in the Greek economy, a breakdown in talks could cause bonds on the periphery to sell off hard, and lead German bunds and U.S. Treasury securities to rally.
In the United States, the market is starting to show signs of a summer slowdown. We’re seeing evidence of this in the subdued performance of equities, the negative performance of the high-yield bond market during the first two weeks of June, as well as in the lack of new money flowing into mutual funds. The bottom line is we are becoming vulnerable to some sort of summer risk-off trade. While I remain generally positive on U.S. equities over the next two to three years, I think it is very likely that we are going to have some sort of a nasty market event during the course of the summer. At this stage, it would be prudent to prepare for a risk-off period by the opportunistic liquidation of lower-quality high yield and bank loans, which have appreciated in price this year, and selectively taking gains in stocks while increasing holdings in cash and Treasury securities, as a precaution in preparation of a potential looming summer dislocation.
Fed Rate Hike Is Likely Despite Dovish Dots
The most recent Federal Reserve dot plot—a projection of where individual policymakers on the FOMC expect the fed funds rate to be at the end of each year—showed a more dovish stance compared to March. The median expected rates for 2016 and 2017 were lowered by 0.25 percent to 1.625 percent and 2.875 percent, respectively. While the median projection for 2015 remained unchanged at 0.625 percent, the number of members predicting rates will stay below 0.5 percent by the end of the year increased from three to seven. Despite its rather dovish stance, the Federal Reserve remains on track to end its zero-rate policy later this year, as 15 out of all 17 members indicate that a rate hike is likely before the end of the year.
FOMC Dot Plot for 2015 Year-End Fed Funds Rate
Source: FOMC, Guggenheim Investments. Data as of 6/17/2015.
Economic Data Releases
U.S. Core Inflation Edges Up; Building Permits Surprise to the Upside
- Headline inflation in the U.S. rose 0.4 percent in May from April's level, although core inflation, which excludes the rebound in energy prices over the month, crept up just 0.1 per cent.
- Industrial production unexpectedly fell 0.2 percent in May from the prior month, according to the latest report from the Federal Reserve. This was below Wall Street's forecasts for production to rise 0.2 percent, following a revised 0.5 percent decline in April.
- Construction on new homes fell by 11.1 percent in May from the April level, when they rebounded from the winter freeze. Economists had predicted a decline of 4 percent.
- Building permits rose 11.8 percent in May, better than the 3.5 percent decline forecast, and followed a revised 9.8 percent gain in April.
- Manufacturing activity in the Philadelphia region expanded at the quickest rate this year in June, according to an index from the Federal Reserve Bank of Philadelphia. The index hit 15.2, up from 6.7 in May, and is at the highest level since December.
- The Conference Board Leading Economic Index for the U.S. increased 0.7 percent in May following a 0.7 percent increase in April, and a 0.4 percent increase in March.
U.K. Retail Sales Beat Expectations; German ZEW Survey Disappoints
- The U.K. consumer price index (CPI) edged up to 0.1 percent year over year in May, from a 0.1 percent fall year over year in April, the U.K.’s first instance of deflation since the 1960s.
- The German ZEW index of current conditions fell to 62.9 in June, down from May’s reading of 65.7. The expectations index fell to 31.5, down from the May reading of 41.9.
- Exports from Japan rose 2.4 percent year over year in May. Economists had forecast growth of 3 percent.
- U.K. retail sales, excluding fuel, rose 0.2 percent month over month in May. Economists had forecast a decline of 0.2 percent. U.K. retail sales, excluding fuel, increased 0.8 percent month over month in April.
(c) Guggenheim Partners