What a strange day Friday turned out to be. For economic geeks, the FBI’s announcement about reopening its probe into Hillary Clinton’s emails was only the second biggest surprise. The bigger revelation was that the economy expanded at an estimated 2.9% annualized rate in Q3, far above recent growth estimates and the best quarterly growth reading since Q3 2014. Both announcements made for splashy headlines. While we don’t yet know what is actually included in the emails, we have transparency into the GDP data and it was not as good as it looked. More than half of the 2.9% growth came from two sources that are not likely to be repeated any time soon: a spike in soybean exports and growth in inventory levels. Net of these two factors, GDP growth matched that of Q2 at 1.4%. Moreover, consumption growth (by far the biggest source of economic growth) is trending lower. The current state of the economy and the consumer is covered in detail in the forthcoming “Q3 Economic Review and Outlook”, which will be released within 48 hours.
Equity markets reacted more to the FBI’s announcement than to the GDP print, closing lower for the day. But Friday’s performance was really an extension of the week which saw equities grind lower in 4 of the 5 trading sessions. International markets did not fare much better, with the exception of Japan (+1.4%) and China (+0.4%). The yield on US Government bonds continued to move higher as the market is pricing in a Fed rate hike in December – according to Bloomberg data, the market odds for a December rate hike are 69.2%. Precious metals rose on the week: gold (+0.7%) and silver (+0.7%), while the price of WTI Crude declined 3.3%.
Missing the Mark – The Federal Reserve (aka the “Fed”) is commonly understood to have a dual mandate:
1) maximizing employment; and
2) stabilizing prices
There is a third mandate, moderating long-term interest rates, but that can generally be incorporated into the second mandate. The term “stabilizing prices” has come to be associated with a steady inflation rate of 2%. As has been well documented, achieving inflation of 2% has been extremely difficult in light of tepid domestic and global economic growth. But how difficult? As it turns out, it has been nearly impossible. According to research from FTN Financial, the Fed’s favored measure of inflation (Core Personal Consumption Expenditures) has not exceeded 2% in 70% of the months since the turn of the century, and on a rolling 5-year basis, inflation has been below the target 90% of the time. Granted this century has been beset with major economic events including the Dot.com bust and the Financial Crisis, but the Fed’s actions to raise rates prematurely have prevented inflation from reaching 2% the vast majority of the time. Thus it begs the question, do the hawks on the FOMC view 2% more as a ceiling than as a target? If the answer is ‘yes’ and the hawks win the rate battle, we can look forward to rate increases that are too early and/or too fast. Treating 2% inflation as a ceiling (vs. allowing inflation to fluctuate above that level) will not only keep inflation low, but economic growth low as well.
Core PCE Inflation vs. 2% Target
Sources: Bureau of Economic Analysis and FTN Financial.
Earnings “Beats” vs. Estimates – Aggregate earnings for companies in the S&P 500 have contracted for five consecutive quarters coming into Q3. Yes, the energy sector has played a large role in the contraction, but even when the Energy sector is excluded earnings growth has decelerated rapidly since Q1 2015. Yet, over that same timeframe, aggregate earnings for the S&P 500 have exceeded analysts’ quarterly earnings estimate 100% of the time. How can this be? A research firm called 720 Global has compiled data that they believe explains this phenomenon. The data in the chart below was compiled from the 17 prior quarters ending in Q2 of this year. What the chart shows is that on average management teams begin the year with an optimistic outlook for growth in the coming twelve months, but subsequently “guide” analysts lower throughout the year. In fact, the data shows that on average management teams reduce expectations below what they believe actual earnings will be so that they can “beat” those expectations even as it is a large “miss” relative to their original guidance. As a result, earnings have been declining yet companies are able to beat lowered expectations. There is nothing inherently wrong with this approach, but it does explain why the percentage of corporate earnings that beat expectations is so high, while in the aggregate earnings have been contracting.
Economic Wrap-up: New Home Sales rose to a 593k annual rate in September. Although previous months’ numbers were revised downward, Q3’s home sales averaged 599k – the highest 3-month average since early 2008. Housing remains stable, but tight supply, rising prices, and muted wage growth will limit the overall impact on GDP growth. The September Durable Goods report was mixed – the manufacturing sector still has a pulse, albeit a weak one.