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Weekly Update 7/1/2022: Fed's Preferred Inflation Gauge Shows Glimmers of Moderation in Prices

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Domestic Economic News

There was a lot of data out on the U.S. economy this week and it was decidedly mixed. Orders placed with US factories for durable goods rose more than expected in May, suggesting business investment so far remains firm even in the face of rising interest rates and mounting concerns about the economy. Bookings for durable goods -- items meant to last at least three years -- increased 0.7% in May after a revised 0.4% advance a month earlier, Commerce Department figures showed Monday. The figures aren’t adjusted for inflation. The value of core capital goods orders, a proxy for investment in equipment that excludes aircraft and military hardware, rose 0.5% after a 0.3% gain a month earlier. The median estimates in a Bloomberg survey of economists called for a 0.1% increase in orders for all durable goods and a 0.2% gain in the core figure.

A gauge of US pending home sales unexpectedly rose in May for the first time in seven months, a mere respite in an otherwise downward trend for housing as mortgage rates climb. The National Association of Realtors’ index of pending home sales increased 0.7% from a month earlier to 99.9, according to data released Monday. An index of 100 is equal to the level of contract activity in 2001. Economists in a Bloomberg survey called for a 4% drop, per the median forecast. Compared with a year earlier, contract signings were down by 12% on an unadjusted basis. The NAR noted that at the median single-family home price and with a 10% down payment, the monthly mortgage payment has increased by about $800 since the beginning of the year. “Despite the small gain in pending sales from the prior month, the housing market is clearly undergoing a transition,” NAR’s chief economist Lawrence Yun said in a statement. Mortgage rates are hovering near the highest since 2008, compounding affordability challenges on top of high housing prices. While rising rates are expected to make borrowing costs even more expensive, that could temper demand for homes and potentially ease price pressures. That’s the expectation of Federal Reserve Chair Jerome Powell, who told Congress last week the housing market is slowing down and home prices could flatten “fairly quickly.” The Fed is raising interest rates to cool demand broadly in the economy, including for housing, to tame decades-high inflation.

The US merchandise-trade deficit narrowed in May to its smallest this year as exports rose to a record. The shortfall shrank 2.2% to $104.3 billion last month, Commerce Department data showed Tuesday. The figures, which aren’t adjusted for inflation, compared with a median estimate for a gap of $104.8 billion in a Bloomberg survey of economists. Exports rose 1.2% to $176.6 billion, while imports were little changed. Aggressive lockdowns by the Chinese government to curb the spread of Covid-19 that saw imports plunge in April started easing a month later, illustrating an otherwise complicated near-term trade picture. Beijing’s measures -- coupled with Russia’s war in Ukraine -- have strained already-tenuous global supply chains.

Home-price growth started to slow in the US in April. That is actually good news on the inflation front. A national measure of prices climbed 20.4% in April, down from the 20.6% gain in March, the S&P CoreLogic Case-Shiller index showed Tuesday. Craig Lazzara, a managing director at S&P Dow Jones Indices, noted that April data was showing initial, but inconsistent, signs of a deceleration in price gains. Mortgage rates have nearly doubled since the end of 2021. The run-up in rates, combined with high prices, are squeezing potential buyers and starting to slow housing markets in some of the most popular pandemic boomtowns. Still, Lazzara noted that growth rates are strong by historical standards. A measure of prices in 20 US cities accelerated, climbing 21.2% in April following a 21.1% gain in March, according to the index. Tampa, Florida; Miami and Phoenix had the biggest gains. “Mortgage financing has become more expensive as the Federal Reserve ratchets up interest rates, a process that had only just begun when April data were gathered,” Lazzara said in a statement. “A more challenging macroeconomic environment may not support extraordinary home price growth for much longer.” The housing market slowdown is having ripple effects across the industry. Mortgage lenders are forecasting a slump in business and brokerages including Compass Inc. and Redfin Corp. are laying off workers. The index, which accounts for more than 27 years of data, is an important gauge of the health of the US housing market in part due to its breadth of measurements around the country.

US consumer confidence dropped in June to the lowest since February 2021 as inflation continues to dampen Americans’ economic views. The Conference Board’s index decreased to 98.7 from a downwardly revised 103.2 reading in May, data Tuesday showed. The median forecast in a Bloomberg survey of economists called for a decline to 100. Household sentiment remains weak as Americans contend with decades-high inflation that’s outpacing wage gains. As the Federal Reserve raises interest rates to curb price pressures, higher borrowing costs could dent purchases for big-ticket items like homes, cars and appliances. US personal spending expanded in the first quarter at the weakest pace of the pandemic recovery, marking a surprise sharp downward revision that suggests an economy on weaker footing than previously thought. Outlays on goods and services rose an annualized 1.8%, compared with a 3.1% pace in the previous estimate, according to Commerce Department data out Wednesday. Overall gross domestic product was revised down slightly to a 1.6% annualized decline in the first quarter. Spending on both services and merchandise was revised lower. Within services, outlays for financial services, insurance and health care were marked down. Spending on goods was revised to an annualized 0.3% decline from little changed, reflecting less robust spending on durables. “This is a case where GDP revisions alters the view of the first quarter,” said Alex Pelle, US economist at Mizuho Financial Group Inc. “Instead of accelerating in the first quarter versus the prior two quarters, consumption actually moderated.” Outlays for non-durable goods shrank at a 3.7% rate in the January-March period. While spending disappointed expectations, it also showed demand isn’t collapsing. Demand for services proved resilient, underscoring a long-anticipated shift in consumer preferences from goods to services. Spending on international travel strengthened in May. Initial unemployment claims decreased by 2,000 to 231,000 in the week ended June 25, Labor Department data showed Thursday. The median estimate in a Bloomberg survey of economists called for 230,000 applications. Continuing claims for state benefits fell slightly to 1.33 million in the week ended June 18. Jobless claims have been hovering in the 230,000 range for the past four weeks, a level not seen since the beginning of the year when the Omicron variant was at its peak. Demand for labor is expected to weaken further as interest rates rise and firms anticipate a potential recession.

Finally the big news this week, the Federal Reserve’s preferred inflation gauge remained high but showed glimmers of moderation in May, data released Thursday showed, at a moment when central bankers are watching each incoming price data point worriedly and are rapidly raising interest rates to wrestle cost increases under control. The Personal Consumption Expenditures price measure, which the Fed officially targets when it aims for 2 percent inflation on average over time, climbed by 6.3 percent in the year through May, matching the April increase. Over the past month, it picked up 0.6 percent, a rapid pace of increase as gas prices rose. But after stripping out food and fuel prices, which can be volatile, the P.C.E. measure climbed by 4.7 percent over the past year, down slightly from 4.9 percent in the prior reading. On a monthly basis, that core measure picked up by 0.3 percent compared with the prior month, roughly matching the previous few months. Central bankers are closely watching that core monthly pace to try to get a handle on where underlying inflation pressures are headed. Both the annual and monthly core price index increases core price index increases were slightly slower than economists in a Bloomberg survey had expected. While there were some positive signs in the report, they were far from conclusive, and come as a variety of other data sources have suggested that, for now, inflation remains painfully rapid. The Consumer Price Index inflation report for May, which comes out earlier and is calculated differently, showed prices reaccelerating to the fastest pace in four decades. The P.C.E. inflation index tends to be less volatile than the C.P.I. measure. The core P.C.E. number is much lower than the C.P.I. right now because it gives a lower weight to rents and vehicles and because it measures airline fares differently, Ian Shepherdson, the chief economist at Pantheon Macroeconomics, wrote in a report following the release.

The central bank is unlikely to take a dramatically different signal from Thursday’s inflation data than from earlier inflation reports. While the core P.C.E. inflation measure is moderating more quickly than economists had forecast on an annual basis, it remains very high, and the inflation figures that includes gas and food are the ones that tend to matter most for consumers’ inflation expectations — so the reality that overall inflation remains stubbornly high is likely to worry policymakers. A variety of gauges that measure inflation expectations, which track how consumers think price increases will change over time, have been climbing higher. The Fed fears that if businesses and employees begin to expect higher future prices and change their behavior — negotiating higher wages and passing along cost increases more readily — inflation might become a more permanent feature of the economy backdrop. Central bankers have signaled that they plan to quickly raise interest rates until they are well above 3 percent, double their current level, and are debating between a half-point or three-quarter point increase in July. Higher rates should help to slow down spending as money becomes more expensive to borrow, but they could also risk cooling the economy so much that it tips into a recession. That’s especially true as supply issues persist, suggesting that the Fed may have to choke off demand more decisively to drive price increases lower. As we have noted, it will take time and patience for this process to unfold and a lot of the pain has been already priced into asset prices as we completed the most negative first half of a year for stocks and bonds since 1970. There is light at the end of the tunnel and as we consistently note, many of our core equity holdings have actually increased their dividend this year which is a sign of long term confidence in their business models and prospects.

The last bit of news we received Friday was on manufacturing. A measure of US manufacturing activity weakened in June to a two-year low as new orders contracted, restrained by lingering supply constraints and some softening in demand. The Institute for Supply Management’s gauge decreased to 53 last month from 56.1 in May, according to data released Friday. Readings above 50 indicate expansion. The figure was weaker than most economists’ estimates in a Bloomberg survey, which had a median projection of 54.5. The group’s index of new orders dropped nearly 6 points to 49.2, the poorest result since May 2020, when the economy was digging its way out of the pandemic-induced recession. Shrinking orders come as consumer spending slows under the weight of inflation and inventories pile up. The ISM gauge of manufacturer inventories ticked up to 56, near the highest reading since 2010. Timothy Fiore, chair of ISM’s Manufacturing Business Survey Committee, said that manufacturing growth was “held back by supply chain constraints,” with respondents noting that and pricing were their biggest concerns. Fifteen manufacturing industries reported growth in June, led by apparel, textiles, printing and computer and electronic products. Stocks pared gains after the release, while Treasuries & high quality bonds extended their advance and the dollar strengthened.

Interest Rate Insight and the Fed

Federal Reserve Chair Jerome Powell said the US economy is in “strong shape” and the central bank can reduce inflation to 2% while maintaining a solid labor market, even though that task has become more challenging in recent months. He also vowed to ensure rapid price increases don’t become entrenched, saying that “we will not allow a transition from a low inflation environment to a high inflation environment.” “We hope that growth will remain positive,” Powell said Wednesday during a panel discussion at the European Central Bank’s annual policy forum in Sintra, Portugal. Household and business finances are also in solid shape, and “overall the US economy is well positioned to withstand tighter monetary policy.” Raising interest rates without sparking a recession “is our aim and we believe there are pathways to achieve that,” Powell said, reiterating comments he’s made this month. The Fed on June 15 raised interest rates by 75 basis points, the biggest increase in three decades. Powell has signaled that another move of that size -- or a 50 basis-point increase -- will be on the table when they meet again in late July. He reiterated Wednesday that the Fed is raising rates “expeditiously” and aims to move “into restrictive territory fairly quickly,” referring to having borrowing costs at levels that would restrain rather than spur economic growth. Powell and his colleagues have pivoted aggressively to fight the hottest inflation in 40 years amid criticism that they left monetary policy too easy for too long as the economy recovered from Covid-19. They’ve raised rates by 1.5 percentage points this year and officials forecast about 1.75 points of further cumulative tightening in 2022. Powell said financial markets’ pricing for Fed rate-hike expectations is “pretty well aligned with where we’re going,” noting that it’s roughly in line with the forecasts that Fed policy makers issued earlier this month. That seems to be the case – as we have mentioned markets have effectively priced in the current path of Fed interest rate hikes.

Impactful International News

There has not been much positive news this quarter with respect to either the stock or bond market but the stock market did get some encouragement after China cut its quarantine period for travelers. There are some hints that runaway food inflation may be tamed soon — at least temporarily — as farm commodities have fallen after a surge that pushed up prices of everything from bread to chicken wings earlier this year. Four months after Russia’s invasion of Ukraine upended trade flows and sent futures soaring, fear of grain shortages is giving way to optimism that key producers will reap harvests large enough to help replenish war-pinched reserves. That’s critical for the wheat needed to feed the world; the corn to nourish hogs, chicken and cattle; and the oilseeds to process food. “Supply may not be as impaired as we think because other areas will compensate for any losses from Ukraine, and it is happening across the board,” said Marc Ostwald, global strategist at ADM Investor Services in London. Australia, one of the biggest wheat exporters, is forecast to produce another huge crop this year, while Brazil’s biggest-growing area has so much corn it’s piling up outside bins. Nervousness in North America that spring weather woes would significantly cut grain and soybean acreage has abated. The Bloomberg Agriculture Spot Subindex is on track for its biggest monthly drop since 2011. Along with easing concerns about dwindling grain and oilseed reserves, worries that an economic slump could slash demand also knocked soaring crop futures down from recent highs. While such changes can take time to reach grocery shelves, chicken and beef prices are cooling a bit, according to Darden Restaurants Inc., owner of the Olive Garden and LongHorn Steakhouse chains.

Fuel pump prices also will play a big part in determining the course of food inflation for the remainder of this year. Supermarket bills are expected to “moderate over the next six months, particularly if energy prices fall,” said Joe Glauber, former chief economist at the US Department of Agriculture. As of June 24, the average US daily price of a gallon of gasoline had declined for 10 straight days after climbing to some of the highest on record. Crude oil futures are down more than 10% from a near all-time high in the days following Russia’s late February attack on Ukraine, one of the world’s top grain and vegetable-oil shippers. Fertilizer, a key expense for farmers, has retreated after surging to records. The United Nations’ food price index pulled back from a record high in March after the war choked exports from Ukraine and triggered a raft of sanctions on Russia. Still, even if reduced rates of increase continue, high prices for food likely will continue pressuring the needy. A US government forecast released last week estimates that food prices across the board will climb as much as 8.5% this year, though the report didn’t account for the recent drop in agriculture futures. Darden Restaurants is taking an optimistic view. The Orlando, Florida-based company says it’s not passing higher prices for meat, dairy and wheat along to customers because it doesn’t expect elevated costs to stick around long-term. Meat is beginning to “come down a little bit,” and upcoming grain harvests should help curb wheat costs, Chief Financial Officer Rajesh Vennam told analysts last week. Wheat and soybean futures have fallen about 15% this month, while corn has dropped 13%. Coffee, sugar and cocoa also have pulled back.

In China, food is more of a national-security issue than an inflation concern. As grain and cooking-oil costs cool off, June consumer-price growth there is expected to be less than 2.5% from last year, said Zhaopeng Xing, a Shanghai-based senior China strategist at ANZ Bank China Co. It’s still too early, though, to call an end to food inflation, given the uncertain outlook for grain supplies from Ukraine, India and other major exporters, he said. Palm oil, the world’s most-used vegetable oil, has plunged about 30% from its peak as top shipper Indonesia ramps up exports to reduce bloated stockpiles. The nosedive, along with a drop in soybean oil and similar commodities, could portend cheaper household items such as chocolate, margarine and shampoo. But, as with other crop markets, any sign of supply disruption or bad weather could trigger another red-hot rally. For now, the drop in key commodities may allow for a much-needed pause in inflation. “Markets would really love to be able to breathe less stressfully again,” said Arnaldo Correa, partner at Archer Consulting in Sao Paulo. “Light a candle for your guardian angel, and let’s see how things will play out.” We are certainly monitoring this area closely.

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