Through the Noise: More of the Same

Beyond all the twists, turns, and quirks in the economic data reports, the overall picture appears largely the same. Growth remains on a moderate track, somewhat beyond a long-term sustainable rate (as the job market continues to tighten). Ex-food and energy, we’re still seeing a deflationary trend in goods and moderate inflation in services, but pipeline pressures are somewhat higher. The “soft” (survey-based) economic reports are strong. The “hard” (actual data) reports remain lackluster to moderate. The global economy is improving. In this environment, corporate earnings can continue to advance.

The monthly inflation reports were mostly in line with expectations. The headline Consumer Price Index was boosted by higher gasoline prices, reflecting the temporary impact of Hurricane Harvey. Gasoline prices are now falling, which should add to consumer purchasing power in the near term. The CPI report showed a continued deflationary trend (-1.0% y/y) in consumer goods ex-food & energy. Rising inflation in shelter costs boosted inflation in non-energy services last year, but we’ve seen a moderation this year. Inflation in the Producer Price Index has been more elevated than the CPI and pipeline inflationary pressures have been picking up. That’s not a major threat to the inflation outlook, but it means that an important factor restraining inflation in the last few years is fading.

Financial market participants have often looked to surveys of consumer and business sentiment to gauge the underlying strength of the economy. However, since the November election, we have seen sharp divergences. The ISM Manufacturing Index hit a 13-year high in September. In mid-October, the University of Michigan’s Consumer Sentiment Index rose to its highest level since early 2004. Yet, the Federal Reserve’s index of manufacturing output was up a lackluster 1.6% year-over-year in September. Retail sales posted a strong gain in September, but that was fueled by inventory clearance promotions in motor vehicles, possibly a hurricane-related pickup in building materials, and higher gasoline prices. Core retail sales (which exclude autos, building materials, and gasoline) rose 0.4% (after no change in August).

Much of the divergence between the hard and soft economic reports appears to be political in nature. The UM consumer sentiment survey (among others) had shown a sharp division in perceptions by political affiliation in recent months. Republicans are optimistic, Democrats are depressed, and Independents are somewhere in between. Business owners tend to be Republican – hence, strength in business sentiment.

Does any of this matter? Probably not. The hard data are what count. Many market participants remain optimistic that we’re going to see a major infrastructure spending plan and large-scale tax cuts in the months ahead. However, nine months into the current administration, we still have no infrastructure plan. Moreover, leaders in Washington are not even talking about “tax reform” any more. It’s “tax cuts.”

The Republicans’ legislative strategy is to cut tax rates through budget reconciliation, which would require only 50 votes in the Senate, instead of the usual 60 (if done through the usual way). However, to do that, you need an actual budget, which we don’t have. There is some haste to complete a budget for the current fiscal year (the current Continuing Resolution that funds the government runs through December 8), so work on tax cuts can begin, but we may see some tax cuts included in the budget negotiations. None of this will be easy, but we may see somewhat lower tax rates by the end of the year.

A key question is whether stock market participants will be disappointed by the lack of infrastructure spending, more limited reductions in tax rates (relative to earlier expectations), and a continued moderate pace of growth in the overall economy. Probably not, as perceptions appear to matter more than reality, but we shall see.