Research

Don’t be fooled by the markets

December 19, 2018

Markets are NOT the economy

We admit it – it’s not easy to ignore the daily gyrations of the public markets. We have watched the markets vacillate between optimism and pessimism on a weekly, if not daily, basis. With concern growing, market movements are becoming amplified by political events and even political non-events. Seemingly everything from U.S.-China trade negotiations to Brexit to a potential government shutdown at the end of this week roiled markets at some point recently.

But it is important to emphasize that the markets are not the economy. Although markets often reflect perceptions and forecasts of the future, they are also often subject to the whims of market participants and random events. When markets respond to news or events they do not respond perfectly (in terms of either direction or magnitude) as we have highlighted over the past few weeks.

Despite public market movements, the underlying economy still looks robust with data from last week affirming that view.

Inflation holding firm

Inflation data across several measures indicated that inflation held steady in November. The headline producer price index (PPI) showed a decline on a year-over-year basis to 2.5 percent, dampened by declining energy prices. But the core PPI held steady near 2.8 percent year-over-year. The headline consumer price index (CPI) did not change during the month, unchanged at 2.2 percent year-over-year. Much like the PPI, declining energy prices weighted on the headline CPI figure. But core CPI increased slightly to 2.2 percent year-over-year, back to its level from September. Meanwhile, headline import prices also declined under the weight of cratering energy-related import prices. The decline in energy-related import prices accounting for more than 75 percent of the decline in headline import prices, though overall import prices grew at a somewhat slower pace during the month. Clearly, the November inflation data shows that depressed energy prices impacted volatile headline inflation (exactly why headline data is deemed not as important or useful as core data). The more meaningful core inflation readings (which exclude volatile components like energy) held firm, reflecting slowly-increasing though inconsistent underlying price pressures in the economy. 

Retail sales also showed no sign of marked slowdown

Headline retail sales for November exceeded expectations and October’s figure was revised upward. Like the inflation indexes in November, weaker energy prices (notably from gas station sales) restrained headline sales data. More importantly, core retail sales, which factor into GDP calculations, increased at a solid pace.

We continue to foresee healthy holiday sales growth of about 5 percent on a year-over-year basis, fueled by a tight labor market, wage acceleration, and still-elevated consumer confidence. 

A “dovish hike”?

“Dovish hike” entered the vernacular last week to describe the action that the Fed will likely take at its meeting this week. The Fed has previously communicated that it intended to hike rates at this month’s meeting. The futures market continues to believe it, assigning a probability of roughly 80 percent to a rate hike of 25 basis points. But because of the gyrations in the market the Fed will seek to assuage fears that it is moving too far too fast. While we fully expect the Fed to hike this week, we also expect them to turn more dovish in their statement and it looks likely that the Fed’s forecast for 2019 will fall from three rate hikes of 25 basis points each to two. We will solidify our forecast for 2019 after the Fed meeting, but we have consistently thought 2-3 hikes in 2019 seemed appropriate given the strength in the economy and labor market. 

The Fed stands in a tough spot. They are hiking rates to keep things from overheating, particularly wage growth, which has gradually accelerated as the labor market has tightened. With the unemployment rate still well below any reasonable measure of the neutral rate and likely to keep falling, even stronger wage growth remains a realistic possibility.

The Fed is trying to prevent too-strong wage growth from either filtering through to inflation as companies pass higher wage costs onto their customers or eroding corporate margins which would further rattle public markets.

Typically, we would expect the former, not the latter, as companies seek to defend their margins, stock prices, and dividends. But either could cause disruptions. While inflation thus far has remained tame, the Fed has played a key role in the process of restraining inflation by raising rates 8 times over the last three years. Overall financial conditions have tightened, but they remain loose enough to stimulate growth and potentially inflation. If the Fed eases up on the reins because of technical factors in the public markets and not a true slowing in the labor market and economy, then inflation could slip away at a faster pace which could cause more meaningful disruption and true slowing in the economy. The Fed’s mandate does not include propping up the equity market. If it really sees a more pronounced slowdown since its last meeting, it will need to convey this clearly and definitively or potentially risk undermining their credibility.

What else are we watching?

A slew of other economic news and data releases will likely get ignored or overshadowed by the outcome of the Fed meeting. The National Association of Homebuilders (NAHB) index should decline again as too-optimistic feelings get reeled back in by the reality of the housing market. Housing starts and permits for November should diverge with starts down slightly and permits up a bit. Existing home sales for November should show a noteworthy decline amidst ongoing struggles in the housing market. The personal consumption expenditures (PCE) inflation index should reflect findings from other inflation indexes – a slight increase in the headline data due to lower energy prices, but a slightly more significant increase in the core reading. Consumer sentiment for December looks set to pull back slightly because of volatile, declining markets. Lastly, we will be watching for a government shutdown on Friday, although we do not expect one. 

What does it mean for CRE?

More than the impending rate hike, the commercial real estate (CRE) market will digest the Fed’s statement and forecast from this week’s meeting. The gut instinct to cheer any slowdown in rate hikes looks like the default reaction. But if the Fed eases off the pace of rate hikes, it is either overreacting to technical conditions in the public markets or it is indicating that underlying economic momentum is slowing meaningfully. All things equal, CRE tends to fare better during periods of stronger economic performance because it behaves in a procyclical manner. Therefore, if the Fed is easing because of slowing economic growth then the CRE outlook will become more challenging. But if the Fed is easing because of technical market factors and growth remains relatively strong, CRE conditions could remain favorable in the short run. But then the CRE market will confront the risk that inflation gets away from the Fed and larger rate hikes could take place down the road. Rate hikes tend to only impact CRE pricing on a cumulative basis, over a more prolonged period, and after economic growth has slowed meaningfully. We have yet to see signs of a meaningful economic slowdown, though the Fed might state otherwise. The Fed is attempting to do the virtually impossible: navigate a soft landing for the economy and consequently the CRE market. 

Thought of the week

Largely as we predicted, share buybacks in the U.S. recently passed $1 trillion in 2018, fueled by the changes in tax legislation passed last year. It marks the first time they have exceeded that threshold in a calendar year.

Note: Economic Insights will not be published for the next two weeks. Happy holidays! We will return with our global outlook to kick off 2019.

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