Weekly Economic Commentary by Scott J. Brown, Ph.D.

Through the noise: more of the same

October 16, 2017

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.

Of course, even if the Trump agenda were to be enacted in its entirety, economic growth would still be limited by demographic constraints. Now, there may be more slack in the labor market than is widely believed (that is the argument of administrative officials), but – unless you allow a lot more immigration – you will still eventually run into labor market constraints. One could make the argument that tax cuts will fuel business investment, which will boost productivity growth, offsetting the impact of slower labor force growth. However, there’s nothing to prevent firms from expanding now.

The UM’s mid-October report on consumer sentiment contained a new and startling observation. That is, while consumers (regardless of political affiliation) are more optimistic about the current state of the economy and about the economy’s prospects for the next six months, they appear to be increasingly resolved that the upside potential for their own personal financial situation is limited. That is, they are content with the low inflation, low unemployment rate environment and appear to be more acceptant of “the new normal” (that demographic constraints will limit the pace of economic growth). It is, according to the report, “an acceptance of lackluster growth rates in personal income and the overall economy” – a reluctant recognition of “limits on the pace of improving prospects for living standards.” Wow!

A moderate growth outlook is still consistent with expanding corporate profits and the Fed is not going to slam on the brakes any time soon, but investors will still want to pay attention.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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