Market Update

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Market Update

5/25/16

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“Inflation is Back and there’s Gonna be Trouble…
Hey-Na – Hey-Na… Inflation’s Back!”

For the better part of a year now we have discussed how non-energy inflation was running at or above the Fed’s 2% target. Overall inflation was muted by the big drop in energy prices that began in late 2014. Since January, crude oil prices have risen 50% and have led to a rise in headline inflation. Consumer Prices (CPI) rose 0.4% in April thanks, in part, to rising energy costs, but the rise was broad-based. “Core” CPI (which exclude the volatile food and energy components) rose 0.2% in April and has been trending at a 2% clip for the past twelve months. The increase in the core CPI in April was led by housing rents and medical care. Owners’ equivalent rent, which makes up about 25% of CPI, rose 0.3% in April, is up 3.1% in the past year, and will remain a driver of higher inflation in the year ahead.

Energy prices rose 3.4% in April, as prices for gasoline and fuel oil more than offset declining electricity costs and, given the continued rise in oil prices through the first half of May, the trend in higher energy costs looks likely to continue into next month’s report. Excluding energy, consumer prices are up 2.0% in the past year and, as energy prices rise, the headline index will follow at a faster pace than many investors are expecting. Food prices rose 0.2% in April as dairy prices rebounded from March. This consistent pace of “core” inflation above 2% (along with continued employment gains) certainly boosts the prospects for a rate hike in June.

Screenshot 2016-05-25 at 2.14.44 PMIf that weren’t enough, the markets were shaken mid-week when the Fed released the of minutes of the April FOMC meeting where Fed governors expressed concern that the markets had become too complacent about continued low interest rates. In fact, the FOMC minutes actually laid out some criteria for a June rate hike:

  • The US economy continues to improve
  • Employment continues to grow
  • Inflation rises to a 2% annual rate of growth
  • Global economic risks continue to recede

They were also heartened by improvement in US and international financial conditions.

The Fed warnings were apparently justified, as market action before and after the release of the minutes confirmed once again the extent to which financial asset prices remain sensitive to perceptions of the Fed’s policy stance. In anticipation of the release, traders had started to re-price the probability of a Fed hike. This was reflected in the upward move in yields on 2-year Treasuries (which is the maturity most sensitive to Fed action – which rose from 0.75% to 0.90%). This re-pricing accelerated markedly after the FOMC release on Wednesday afternoon, with large yield spikes, particularly for 2-year and 5-year Treasuries (which rose from 1.30% to 1.41% before easing off a bit by week’s end). The futures markets also saw a huge adjustment, as the probability of a June rate hike went from 4% last week to 32% this week. And, as we have come to expect whenever the prospect of a rate hike rears its ugly head, stocks sold off, touching an eight-week low.

The rest of the economic news points to better times through the summer, at least. On the real estate front, April Housing Starts rebounded 6.6% from a drop in March. Single-family starts (at a 1.17 million unit annual pace) are up 4.3% from a year ago while multi-family starts are down 11.7%. Meanwhile, single-family building permits are up 8.4% from a year ago while multi-family permits are down 23.8%. The shift in the mix of homes toward single-family units is a positive because, as we’ve discussed before, each single-family start contributes twice as much to GDP than does a multi-family start. Growth in this sector should continue as the US needs around 1.5 million new units each year to keep up with demographics and replacement of obsolete homes.

The NAHB Index (which measures confidence among home builders) remained unchanged at 58 in May. Readings greater than 50 mean more respondents report good market conditions. One year ago, the overall index was at 54.

Sales of Existing Homes rose 1.7% to a three-month high in April. Sales in the largest sector of the US residential real estate market reached a 5.45 million annual rate; 6% above year-ago levels. As has been the norm, tight supply and rising prices continue to be the main factors holding back sales. While inventories rose 9.2% (18,000 units) in April, they are still down 3.6% from a year ago. The supply of existing homes for sale is only 4.7 months, which is considered “tight,” and demand for homes was so strong last month that properties for sale averaged only 39 days on the market before selling, and 45% of properties in April sold in less than a month.

The median price for an existing home is up 6.3% versus a year ago, for the 50th consecutive month of year-over-year price gains. While this may be pricing some lower-end buyers out of the market, it may also help alleviate some of the supply constraints as “on the fence” sellers take advantage of higher prices and trade-up to a new home, bringing more existing properties onto the market.

US Industrial Production surged 0.7% in April, following two straight monthly declines, for its strongest monthly showing since November 2014. Production was boosted by utilities, where output jumped 5.8% – the largest monthly gain since 2007. Utility output had lagged for months, following an unusually warm winter. The other bright spot was manufacturing which rose 0.3% and sits 0.5% above its year ago level, thanks to a pop in auto production (up 1.3% in April, and up 4.3% from a year ago). Production of business equipment rose 0.9% in April and is up at a 4.4% clip over the past three months as demand rises for US capital goods. Mining output continued to slide in April (- 2.3%), reflecting a 6.8% drop in oil and gas extraction. Mining (actually, energy drilling) has been a drag on production over the past year, but this sector should turn around as energy prices are rising again

Weekly Claims for Unemployment benefits declined 16,000 last week to 278,000, for the 63rd consecutive week below 300,000, the longest stretch in more than forty years. Continuing claims declined 13,000 to 2.15 million. These figures are consistent with a payroll increase of about 200,000 in May, which should also raise the odds of the Fed hiking rates in June.

The criteria laid out by the Fed for a June hike are currently being met. Q2 is shaping up to be quite a bit stronger than the weak Q1 performance. That said, we have seen a number of upward revisions to tepid Q1 economic reports and wouldn’t be surprised to see Q1 GDP growth revised up from its 0.5% initial reading next Friday. The flames of inflation are being fanned by the bounce in energy costs. Barring a major domestic or international economic calamity, the Fed appears inclined to gradually normalize monetary policy and the likelihood of at least one rate increase in 2016 is almost a done deal, and the chances of this being followed a second hike before year end, while less certain, should not be dismissed.