The employment report yielded an upside surprise in payroll growth but still low wage growth argued that labor markets have yet to overheat. It’s the kind of report that will support optimism at the Fed without raising concerns that policy rates need to be pushed higher. The Fed will instead remain poised to react to any emergent threats to the economy with rate cuts if needed. Separately, the search for repo solutions continues.

Nonfarm payrolls grew by a better-than-expected 225k for the month and and a monthly average of 211k for the past three months:

Although revisions dragged down 2019 numbers overall, it appears that job growth picked up later in the year. Note though that warm weather may have boosted January figures and as such we may see some payback in February. The unemployment rates held in its recent range at 3,6%, still well below the Fed’s estimate of the longer-run natural rate of unemployment:

Needless to say, the failure of inflation to ignite with persistently  low unemployment suggests the Fed will be again lowering estimates of the natural rate this year.

Wage growth remains off its peak:

It is important to remember that adjusted for inflation, wage growth remains in-line with productivity growth. That said, low wage growth also suggests that the labor market is not overheating. Unless the labor market is overheating, it is difficult to see how any uptick of inflation can be sustained. Increased participation in the labor market helps account for contained wage growth:

So far, fears that the economy will run out of workers overall have yet to be realized. One sector that might be feeling the pinch is temporary employment:

Employment growth in the temporary employment sector is not collapsing as we might expect ahead of a recession, but neither is it booming. To be sure, the recent weakness is attributable at least in part to manufacturing softness like in the 2015/6 era. But the failure to get much upward momentum despite solid job growth otherwise might reflect the availability of better, permanent jobs in other sectors. This is consistent with the idea any current labor market supply constraints remain sector or geographic specific and not reflective of broad constraints.

Overall, the employment report suggests the U.S. economy continues to grind forward with perhaps not the most exciting pace of growth but steady growth nonetheless. The Fed won’t be itching to raise rates anytime soon with these numbers.

Separately, Federal Reserve Governor Randal Quarles gave a wide-ranging speech on the economy. Importantly, Quarles’s thinks the labor market has more room to run:

I am in the camp that believes that some additional slack remains in the market, particularly in the potential for higher labor force participation.

Still, his optimism is tempered by recent events:

Although I feel good about the outlook, a few developments give me pause. Significantly, investment continues to be weak, declining over the course of 2019. Increasing the capital stock and investing in new technologies are important for productivity growth, rising living standards, and the economy’s long-run growth rate, so reversing the recent downward trend is essential for the overall health of the economy.

He cites weak global growth and trade disputes as well as the impacts of the coronavirus as  factors weighing on the outlook. Quarles overall conclusion:

In summary, I remain optimistic about the outlook, but I am also highly aware that some notable risks still threaten growth, both overseas and at home.

Still then looking for downside risks. On inflation, Quarles indicated a lack of concern with the recent low numbers:

A few words on inflation. Both headline and core inflation, as measured by the price index for personal consumption expenditures, or PCE, came in at 1.6 percent in December, somewhat below the FOMC’s 2 percent objective. This deviation does not worry me that much, in part because I expect inflation to move back to target over the medium term, in part as some unusually low readings in early 2019 pass out of the data. Already, various trimmed price indexes are running much closer to 2 percent.

This is interesting and I wonder that Quarles is pushing back on the idea that the Fed will lower rates later this year to push inflation higher. Overall, he sticks with the party line as far as interest rate policy is concerned:

Policy is in a good place to support continued economic growth, strong labor market conditions, and inflation returning to target.

Quarles turns his attention to recent repo market problems and how they relate to the balance sheet. There is a lot going on in this paragraph:

Taking stock, I note that one approach to the constraints on policy imposed by the current low level of interest rates is to make what were previously unconventional tools—balance sheet policies and forward guidance—as conventional as possible. Although I fully support the FOMC’s current plan to purchase Treasury bills and increase the size of the balance sheet in the very short term, over the longer-term, I believe that the viability of balance sheet policies is enhanced if we can show that we can meaningfully shrink the size of the balance sheet relative to gross domestic product following a recession-induced balance sheet expansion. In effect, I believe that balance sheet policies are more credible if we can show that there is not a persistent ratcheting-up effect in the size of the Fed’s asset holdings.

When Quarles describes shrinking the balance sheet relative to GDP, this can be an active or passive shrinking, as least in theory. The Fed could simply allow the economy to grow into the balance sheet. One gets the sense that Quarles is seeking a more active approach when he says “meaningfully.” That sounds like a combination of time and quantity; it’s not “meaningful” if done slowly because of the last sentence in which Quarles thinks the balance sheet policies are more credible if not associated with a persistent increase in the size of the balance sheet.

I am not entirely clear why Quarles thinks balance sheet policy is more credible if it is seen as temporary policies. I feel like we have been down this road and concluded that the signaling the temporary nature of quantitative easing reinforced expectations of tighter policy in the future that translated into tighter policy today.

Quarles, in a pursuit of minimizing the size of the balance sheet, appears to want to touch the hot stove again:

Looking ahead, I judge that it is reasonable that we ask ourselves whether it may be possible to operate with a lower level of reserves and remain consistent with the ample framework.

To accomplish this, he proposes making Treasury holdings and reserves more similar (both are high quality liquid assets but reserves are more available). He argues that this fits with the Fed’s original mission:

Yet it is worth remembering that a principal reason for the Federal Reserve’s creation was to facilitate the movement of reserves when needed from banks with an excess reserve position to those in need of reserves. Indeed, it is the reason we are called the Federal Reserve. I do not think that is a fact of purely historical interest. Excessive friction in the movement of cash in the financial system was likely a contributor to the market dislocations of last September. In that regard, I think it is worth considering whether financial system efficiency may be improved if reserves and Treasury securities’ liquidity characteristics were regarded as more similar than they are today—that is to say, that reserves and Treasury securities were more easily substitutable in the context of liquidity buffers. To be clear, the ideas I will discuss do not involve any decrease in banks’ liquidity buffers. Rather, I want to explore options that would maintain at least the level of resilience today while also facilitating the use of HQLA beyond reserves to meet the immediate liquidity needs projected in banks’ stress scenarios.

He suggests allowing banks to assume the use of the discount window as part of their liquidity planning, an approach that has the benefit of using existing facilities. Something along these lines appears to be his primary focus. He half-heartedly suggests a standing repo facility but he prefers to working with existing tools first. A third suggestions is to alter the calculation of the surcharge for systemically important banks to something less dependent on year-end inputs in favor of averages for these inputs.

I takeaway is that Quarles would like to further reduce any discount window stigma and rely on that to again push the on the boundary of the adequate level of reserves. Seems unnecessarily risky to me.

Bottom Line: Employment report supports an outlook of cautious optimism. No reason to think the Fed needs to switch gears anytime soon, and if they do switch gears it is still more likely down than up with rates. Watch the talk about inflation; not everyone is worried about the low numbers. The Fed is still feeling around for answers to the repo market problems; not all believe that expanding the balance sheet is best approach to those issues.

Coming up this Friday is the jobs report for January. In addition to the usual items of interest – payroll growth, unemployment, wages, labor force participation – we also get revisions for last year. The revisions are in some sense old news; we know employment will be revised downward and reveal that 2019 job growth was less than initially reported. The bears will focus on the revisions, but I think it is wiser to keep attention on the January numbers and what they tell us about the upcoming year. We are looking for a report that is both consistent with firming economic indicators this week yet gives no hint that the Fed needs to rethink its current dovish policy stance.

We have seen plenty of questioning about the durability of the equity rebound since last fall:

I tend to think the rebound is not surprising given how events have unfolded in the past six months. The Fed cut rates a third time and signaled no hikes are likely in 2020 (if not the rest of the cycle), the housing market has clearly recovered from the 2018/19 soft spot, global manufacturing firmed, and trade concerns were moved to the back burner. Moreover, there was always an excessive emphasis on the manufacturing data while ignoring the declining importance of that sector.

The short version is that the odds of recession dropped precipitously in the last quarter of 2019 and markets reacted as expected. And the data increasingly confirms the more optimistic scenario of this year. The ISM manufacturing index climbed back above 50, reverting toward the already more positive Markit reports:

Notice the international side of the report, with both rising import and export numbers:

I tend to think the import numbers are more important as they reflect stronger domestic demand. The ISM service sector numbers also improved:

Note that the service side of the economy never softened as much as the manufacturing side. The pattern is not dissimilar from 2015/16:

Will the January employment report also tell a story of firming economic activity? Today’s ADP report clearly provides reason for optimism with is 291k private sector job gain. Using that as one of the inputs into a simple forecast yields an expectation for job growth of 218k in January:

That feels high to me; Wall Street is looking for a more modest 160k. Continued job growth along that more modest pace, however, would still indicate that the US economy has the momentum heading into 2020 consistent at least with growth around trend, which is what the Fed is looking for to support their current forecast.

But job growth is not all the Fed is looking for. They are also looking to confirm their current belief that the U.S. economy is not set to overheat and send inflation to an unacceptably higher level. It’s not enough to just look at the unemployment rate on this issue anymore. The unemployment rate has held below the Fed’s estimates of the natural rate of unemployment for over three years yet inflation remains at bay.

At some point, if for example, unemployment slipped further to 3%, the Fed might become more worried that the economy will overheat if they don’t act to tighten policy, but right now this is not the case. Powell & Co. instead are willing to sit on the sidelines as long as inflation remains close to their 2% target. Continued weak wage growth would help keep them there. While strong wage growth does not necessarily imply high inflation, it is difficult to see that higher inflation could be self-sustaining absent corresponding wage growth.

Bottom Line: So far the economy is firming as expected with no sign that inflation will accelerate to a worrisome pace. Continued evidence of such a trend will keep the Fed on hold. And if they were to shift policy, the Fed would more likely cut rates to boost inflation higher than raise rates. To be sure, the random negative shock (think coronavirus) always lingers in the background. At the moment though, a firming economy with inflation low enough to keep the Fed focused on steady to easier policy is the best bet. 

Now that the economy looks to have escaped the clutches of a manufacturing-induced recession, the attention of market bears has turned to that bulwark of spending activity, the American consumer. Not a week passes without a story that households are skating on thin ice and that a consumer-induced recession should be the new focus. In reality though, household spending both stands on a stronger foundation and is more resilient than commonly believed. It’s not the threat to the economy you are looking for.

In a recent Bloomberg article, Lakshman Achuthan and Anirvan Banerji argue that consumer spending power is less than meets the eye. Market participants should approach such fears warily. Consider the opposing view that the consumer is just fine.

First, while nominal wage growth has disappointed, this in part reflects low inflation. Real earning power, in contrast, has been on a tear since 2014:

This, combined with solid job growth and low unemployment both supports the solid consumer confidence numbers we see and provides the basis for spending growth.

Second, remember that retail sales a.) only tell part of the consumer spending story and b.) unless you strip out gasoline sales, energy prices can hide underlining trends. Real person consumption expenditures provides a more comprehensive story of household spending:

With the exception of some gyrations around in 2018, consumption growth has been stuck in the 2% to 3% range since 2016. For all the angst, the underlying pattern of spending has held fairly constant and arguably even a bit high relative to expectations that overall activity settles in close to 2% growth this year.

Third, if households were starved for income to support spending, we would expect the saving rate to be in decline. In fact, the opposite is that case:

The saving rate rebounded after the recession and has maintained an upward trend ever since.

Fourth, while consumers are often described as struggling under the burden of debt, household financial obligations dropped precipitously after the recession and remain near series lows:

Finally, any talk of consumer spending and recession can’t be separated from the housing rebound experienced this past year:

To be sure, warm weather boosted the December starts numbers, but by that time the reversal of the 2018 downdraft had already occurred. Moreover, homebuilder confidence numbers also confirm the strength of the rebound in the housing market. The housing rebound strikes at the core of the weak consumer story. Panicked consumers on weak financial footing are not going to be driving housing activity higher.

Quite frankly, the rebound in housing should have ended recession talk altogether. While a weak housing market does not always signal a recession (for example, see 1995), recessions are always preceded by housing downturns. Typically, housing starts peak around two years prior to the onset of recession. That means that if housing starts are still climbing, the likelihood of a recession in the upcoming two years is fairly small.

The reality of the situation is many ignore the fundamental strength and resilience of the U.S. economy and hence overestimate the probability of recession. Household are particularly resilient as once spending patterns are set they become very sticky. People don’t change their spending patterns absent a big shock to their income. The big negative shock is generally job loss, which means that a recession is likely to be what causes consumer spending to tank, not vice-versa.

Once you recognize that resilience, you realize why recessions are both rare events and hard if not virtually impossible to predict with any certainty. It takes a large shock to throw the economy into recession. A small shock to an increasingly small sector like manufacturing just lacks to the punch to make it happen.

Bottom Line: I know that it is easy to be seduced by the bearish warnings of market prognosticators. We seem to be hard-wired to be cautious, always worried that we are about to become prey. It is important to keep those fears in check. Years ago I quipped “As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying (and under-appreciated) impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.” That lesson is too often forgotten.

If you were looking for something exciting out of this labor report, you were disappointed. Mostly it is is a continuation of recent trends that will encourage the Fed to retain their basic optimism while providing them no reason to change course. Probably most important for policy was the weak nominal wage growth. Absent an explosion in wage growth, it is hard to describe the labor market as overheated. At the same time, note that low inflation means that the labor market is generating real wage gains.

Nonfarm payrolls grew a notch below expectations at 145k:

Although previous months were revised downward slightly, the average monthly gains in the final quarter of the year were a solid 184k. Still, there is a modest downtrend in the annual pace of job growth that will be more evident after annual revisions. The unemployment rate held at 3.5% while wage growth softened:

Obviously, the Fed is watching wage growth for signs the economy is overheating. And here is Federal Reserve Chair Jerome Powell from December:

“The labor market is strong, I don’t know that it’s tight because you’re not seeing wage increases,” Powell said in response to a question from Yahoo Finance on Dec. 11. “Ultimately if it’s tight, that should be reflected in higher wage increases.”

Faster wage growth does not necessarily mean inflation will accelerate, but it it difficult to expect any sustained acceleration of inflation absent faster wage growth. In other words, it is tough to get too bent out of shape about some inflationary threat with nominal wage growth crawling along around 3%. And minimal inflation worries will leave the Fed on hold; there is simply to reason to think that they need to reverse last year’s rate cuts anytime soon.

All that said, I think it is important to push back on this idea:

The weak spot – and ongoing concern – was wage growth, up just 2.9 percent over the past year. Experts say wages would have to grow between 3.5 to 4 percent in order for workers to really feel an impact.

Accounting for low inflation, the tighter labor market is now generating real wages on par or better than the pre-Great Recession boom:

I point this out to suggest that we should beware of excessive pessimism. Tighter labor markets appear to be having the intended effect of improving real wage growth, which in turn helps support consumer confidence and spending growth. Yes, I know, everything is terrible and you can never say anything good about the economy. That attitude though would have led one to sit out a multi-year equity rally as some surely have.

Bottom Line: The employment report will keep the Fed on hold. As always avoid excessive pessimism.

Keeping the Fed on the sidelines means having enough positive data to keep their forecast near one consistent with trend growth but not enough positive data to make them think they need to reverse last year’s rate cuts. It’s hard to see the latter situation happening anytime soon with Federal Reserve Chairman Powell looking for either actual, significant inflation or a real risk of significant inflation before raising rates. Instead, incoming data looks to be closer to trend growth; the employment report is expected to conform with that outlook.

Last week, the ISM manufacturing index disappointed, stubbornly refusing to match the more optimistic PMI story. Manufacturing, however, is only a part – an increasingly smaller part – of the economy. A manufacturing recession no longer guarantees an economy-wide downturn, a lesson learned in 2015-16. As far as recessions are concerned, we should be on the lookout for economy-wide shocks that pull down the services sector along with manufacturing. So far though the services sector remains resislient as seen in this week’s ISM services report:

This kind of divergence is what we saw in 2015-2016; note the contrast with 2007-2009 when both measures move in virtual lockstep deep below 50. That’s what we would expect with an economy wide shock and aren’t seeing now.

I have been on this soapbox before, but I will get on it again: If the manufacturing cycle is less tied with the overall cycle than it has been in the past, a lot of analysis is going to be upended. We need to be very careful when telling economy-wide stories with the manufacturing data.

As far as the Fed is concerned, the softness in manufacturing and associate economic risks were enough to justify last year’s rate cuts. The resiliency of the rest of the economy prevents any further cuts. Friday’s employment report is expected to confirm that resiliency. Wall Street expects a Goldilocks report with nonfarm payrolls growing by 164k, unemployment holding steady at 3.5%, and wages up 3.1% over the past year. Those are numbers that the Fed will see as consistent with solid but not spectacular trend-like growth with no reason to believe the economy is overheating or will soon overheat.

Today’s ADP number surprised on the upside with a 202k gain in private employment and thus provides for the possibility of an upside surprise Friday. My payrolls estimate for the report is a tad higher than Wall Street at 188k:

Anything in that zone would be consistent with the Fed’s basic story. What about outside that zone? Realistically, the data is sufficiently noisy that no single data point would change the overall story. We should instead be looking for patterns of data that threaten to send unemployment higher to justify a rate cut. So a single weak report would likely not do that in any meaningful way; two or three consecutive weak reports would be more interesting.

Bottom Line: Fed on hold until the tenor of the data meaningfully shifts. 

I propose a finance-wide New Year’s resolution: Stop using dual y-axis charts. This won’t happen as the practice is a staple in the industry and one I admit to regretfully dabbling in myself. But it is time to stop or, at a minimum, start challenging the charts more aggressively.

For instance, recently a version of this chart crossed my Twitter feed:

It was captioned “Fundamentals.” The implication being that the rise in equites over the past year is disconnected from any economic fundamentals. This seems particularly evident in the last few months with the ISM number continuing to disappoint even as equities pushed to record highs.

These kinds of charts are at best naive and at worst deliberately misleading. If a financial advisor/analyst/newsletter writer puts such a chart in front of you, I recommend asking them to convert it to a scatter plot:

That alone should lead you to question the strength of any relationship, but the chart’s author could point out that there exists an obvious positive relationship. How tight is that relationship? Ask for a simple regression line:

Sure enough, there is an upward sloping relationship, but do you really want to base your investment decisions on an R-squared of 0.18? I wouldn’t.

Next, look for any outliers that may influence the results. A little eyeball econometrics will draw you to the points in the lower left-hand quadrant.  These are dates associated with recessions. That stock prices and the ISM data both tank during recessions should be a no-brainer. But we aren’t in recession. So what happens if we pull out the recession observations?

If we aren’t in recession, any relationship basically disappears. Are you going to make an investment decision on a relationship with an R-squared of 0.01? Because yes, that it exactly what the purveyor of the original chart is asking you to do.

Let’s step back a second and give the chart’s author the benefit of the doubt and keep the recession observations. Now ask the author to show the regression results in a bit more detail:

Now you say “sure, the coefficient on the ISM term is significant even if there is a lot of noise, but that residual plot and Durbin-Watson statistic sure look like a problem.” Right, that’s the autocorrelation in the data that the chart’s author isn’t accounting for. Let’s do that now with the quick fix of adding a lagged dependent variable to the regression equation. The results:

Now the ISM variable has no explanatory power. The explanatory power is eaten up by the lagged dependent variable. In this case, if equities are up 1% this month (in y-o-y terms), they will be up 0.94% next month.

That conclusion amounts one of the oldest rules: “The trend is your friend.” Of course, it’s not always your friend, but don’t assume that it won’t be on the basis of the dual y-axis chart. You should be asking for more. A lot more.

Finally, if the chart’s author won’t follow through with this kind of analysis (which they might not for obvious reasons), feel free to poke around and look for other times when the fundamentals and whatever don’t match up. Like this:

Now that is interesting – equities rising in 1995 even as ISM falls to cycle lows. Now some interesting questions emerge. Suppose you reasonably say that proves the point – equities took off on a rampage now commonly considered a bubble. Well then you still have two problems. First, the economy did rebound. Second, the equity rally lasted five years. So should you pull out now when you could have a five year rally ahead of you?

Alternatively, you can argue that maybe the economy in 2020 is rebounding like in the mid-90s and the Fed will pull off a soft-landing just like then. That could be the signal the stock market is sending. Is it a bubble? Well, I covered that last week. My quick answer is that the current rally is really overstated on a year-over-year basis because of the base effect from stocks tanking at the end of 2018. Also, in my opinion, the path of equities bears no resemblance to that of the late 1990s. 

Bottom Line: Just say “no” to the dual y-axis graph. Or at least push back on that chart hard, very hard. They are dangerous in the wrong hands.

This past week I had an uncharacteristically snarky response to the latest entry in the “it’s all about QE” genre of market analysis:

Same data, past 10 years, or 520 observations compared to 13. R-squared 0.004! pic.twitter.com/LmhORrFQ7s

— Tim Duy (@TimDuy) December 31, 2019

Yes, my frustration with this line of reasoning – the supposed one-to-one linkage between the balance sheet and equities prices – got the better of me. My tweet prompted this response from Grant Thornton Chief Economist Diane Swonk:

Again, I empathize w your position on the vigor of the analysis. But, I am having a hard time finding the justification for the market’s moves in the fundamentals and worry how much perception is reality for markets.

— Diane Swonk (@DianeSwonk) December 31, 2019

I get  this; I see it as a deeper question than the QE-equity link. The analogy to the late 1990s is relevant given the similarities between Fed policy now and then. Is the rebound in stocks this year foreshadowing something ominous? Has the Fed set the stage for the next bubble? Below is how I think about these questions.

To start off, and in answer to the question that is the title of this post, I can’t tell you whether stocks are overvalued or not. I don’t really know, but it is not obvious to me that we should assume stocks are overvalued. The answer to that question assumes a known “true” model of valuation. But there appear to be many models and I agree with Ed Yardeni here – the answer depends upon your particular valuation model. Many of the models I see floating around suggest stocks are overvalued (but that is perhaps Twitter bias), but I tend toward Yardeni’s intuition that the appropriate model should recognize the impact of lower inflation and interest rates.

Yardeni’s preferred model said (as of November) that stocks were somewhat undervalued. That seems reasonable to me, but as I said before, I don’t know the “true” model. I think instead of a different question: “Is the path of equities substantially different from my expectations of that path during an economic expansion?” That depends of course on how I set my expectations. I tend to look at longer-term trends during the post-1984 period (the Great Moderation). Something like this:

Here I included a trend line derived from the beginnings of two rate hike cycles. From a qualitative perspective, the exact dating isn’t particularly important. You can eyeball the trend from 1987 to 1995 and extrapolate it out, or use the trend between roughly the beginning of the Great Moderation to the Great Recession.

I see two dominant features in this chart. The first is a clear acceleration in equity prices in the late 1990’s. I see nothing similar in today’s environment. This doesn’t surprise me as I think fears of financial excess are overplayed, effectively a case of fighting the last war. I also think the Japanese experiences is relevant here. Despite decades of ultra-low interest rates, nothing like the asset bubbles of the late 1980’s has reoccurred.

So, no, I don’t think the Fed has either created a bubble or necessarily set the stage for another bubble. To me, the dynamics don’t yet fit. Still, the operative word is “yet.” If stocks gain another 20% this year (unlikely in my opinion), I will obviously reassess this position.

The second feature I see is a level shift down in the value of equities after the Great Recession. I don’t think this will be corrected via some trend-reverting behavior of the series (it is not stationary around a trend). I think a better explanation is that there was a break in the trend for some fundamental reason such as secular stagnation. This suggests to me that a less optimistic view of the world has already been priced into equities. This I find interesting. I think the dominant view is the the trend path of equities should be flatter (?). To what extent has that view incorporated the possibility that a downward shift in the level of equities has already occurred?

Taking an alternative view, I also look at the path of equities after the Fed begins a rate hike cycle:

This view better highlights the 1987 run-up in equities though that ended more quickly than that of the late-1990s. As for the current cycle, the path of equities is pretty much exactly where I would expect in a continued expansion.

Zooming in on the more recent history does still tell a story:

To me, the obvious time that equities exceeded my expectations was late 2017/early 2018 (around day 600 here). Stocks subsequently reverted and then proceeded roughly in line with my expectations (maybe a little pricey) before sliding below my expectations late 2018. In my view, the behavior of equities this year is not an unexplainable deviation from fundamentals but an expected recovery from excessive pessimism. Is there excessive optimism now? Nothing dramatic relative to my expectations given the ongoing expansion.  That doesn’t rule out a correction, but absent a recession I would tend to view it only as noise around the trend.

(I do acknowledge the criticism that any similarity between my expectations and actual outcomes is attributable to dumb luck).

How does QE or, more generally, monetary policy fit into this story? To the extent that the Fed sets policy in a way designed to kill your recession call, it will support a general uptrend in equity prices over time because the economy remains in expansion. If the Fed commits a policy error or is unable to respond to a negative shock with sufficient speed and the economy tumbles into recession, I would expect equities to follow the economy down. With regards to the most recent months, I think the equity moves have more to do with a reduced risk of recession than repo-related balance sheet changes. 

Bottom Line: I don’t think you need to fall back on “it’s all QE” to explain the behavior of equities this past year or this cycle. It appears to me that the general path of equities is what should have been anticipated given continued expansion. To the extent the Fed is involved, it is because policy moves have sustained the economic expansion. It seems best to view the Fed as endogenous to the system not some conspiratorial exogenous factor.

The data flow provides little reason for the Fed to change course anytime soon. Housing starts for November came in slightly above expectations:

Permits were also up to a cycle high. Single family permits remain on a clear uptrend with last year’s dip just an unpleasant memory. Will it end anytime soon? Probably not. Yesterday I pointed to favorable demographics for housing. Today George Pearkes argues that housing is “on sale”:

One last thing about housing: mortgage rates are bumping along at local lows, prices have started to bottom out but aren’t really ripping, but wage growth is still grinding along. By any metric, new homes are *cheap* right now, and will be w/o big beat-steepening. pic.twitter.com/dOHtm1IlHD

— George Pearkes (@pearkes) December 17, 2019

Elsewhere, the nation’s industrial sector rose a better than expected 1.1% in November, propelled higher by manufacturing:

The return of striking GM workers clearly helped the numbers as truck production in particular bounced higher:

Still, it remains notable that despite all the angst of the past year, the weakness in manufacturing remains no worse than that of 2015-6. Note also that even excluding autos, manufacturing output was up 0.3% in November. Signs of stabilization? Reasonable given the Markit PMI numbers. Signs of recovery? Not yet. But again, stabilization is all we need to compare favorably with last year and say the worst is over.

Boston Federal Reserve President Eric Rosengren has an optimistic view of 2020:

My own view is that it is unlikely we will have an economic downturn in the coming year, given the generally positive financial conditions and the continued accommodative monetary and fiscal policies. Of course, this outlook assumes that we do not have a significant negative shock from abroad, or experience a negative shock from a sharp ratcheting up of trade disputes with major trading partners.

and he doesn’t see a reason for the Fed to change rates:

With the recent positive economic news, and with monetary and fiscal policy already accommodative, I see no need to make the current stance of monetary policy more accommodative in the near term. Given that monetary policy works with lags, and Federal Reserve policymakers have already eased monetary policy three times in 2019, my view is that it is appropriate to take a patient approach to considering any policy changes, unless there is a material change to the outlook. 

I guess we should wonder about Rosengren’s definition of the “near term.” Next month? Next quarter? I am thinking the next few quarters. Rosengren probably anticipates one rate hike this year. Still, it seems inconsistent with a serial dissenter who argues:

Since April, the economy has performed pretty much as many professional forecasters expected – this, despite recent concerns with downside risks, notably those associated with slower global growth and uncertainty about trade policy. 

Looks like he has fallen into line with the consensus view that a series of rate cuts were needed to keep the economy humming.

Tomorrow (Wednesday) is a light data day (mortgage applications, oil inventories) but things pick up again Thursday with unemployment claims, Philly Fed index, and existing home sales. None of these are likely to change the underlying narrative; still, the Philly Fed index should help us gauge the temperature of the manufacturing sector. Friday rounds out the week with the final read on third quarter GDP and, more importantly, November consumer spending and PCE inflation data. Also Friday is the final release of the November Michigan consumer sentiment numbers.

Bottom Line: Data stabilizing (manufacturing) to improving (housing) but not enough to prompt the Fed to change course. 

Late last year a mild panic arose when the housing market hit a bit of a speed bump. Higher interest rates finally made a dent in activity which in turn stoked fears of a sharp downturn and even recession. In some ways, the concern was expected if not even understandable given the memories of the housing crash over a decade again.

Today, the National Association of Home Builders released its confidence measure and one almost wonders what all the fuss was about:

Home builder confidence rebounded to levels last seen in 1999. A good part of the story is the Fed’s pivot to easier policy. Housing is an interest rate sensitive sector of the economy and lower rates reversed the downward momentum as should have been expected.

Demographics is another factor at play. Look for a structural upswing to take hold:

Now years 2020-2024 we have a much better demographic patch to facilitate demand, ages 25-31 are massive, first time home buyer age is now 32. pic.twitter.com/wUmb4dJdMD

— Logan Mohtashami (@LoganMohtashami) June 29, 2019

Tuesday AM we see the latest housing starts numbers. Market participants anticipate starts rose to 1.35 million, although of course this is a volatile number. The combination of low interest rates, solid job growth, and a demographic push, however, suggests we should take a weaker than expect number with a grain of salt. The underlying trend looks positive and should ease any residual concerns of impending recession.

The Fed will also deliver the industrial production report for November. Expectations are for a sharp 0.8% gain in activity, but of course this partially reflects a reversal of strike-related weakness in October. Mostly we will be searching through the data for any signs that the sector is stabilizing. Stabilization is all we really need to make the comparisons with 2019 much, much better. And it may be all we can hope for; the Boeing news certainly won’t help the sector.

Also today we get the JOLTS report for October, very interesting if you care about labor market dynamics (don’t we all?) but maybe essentially old news for a market buoyed by the November employment report. Finally, we also get to hear from Boston Federal Reserve President Eric Rosengren. Even though he dissented against this year’s rate cuts, he must have come to a place where he can accept the Fed’s policy path.  After all, almost all FOMC participants expect no policy changes in 2020, and only four see a single rate hike.  No one see a reversal of this year’s cuts as necessary to meet the Fed’s mandates.

Bottom Line: The data has yet to run counter to the Fed’s base case for growth near trend next year. That means a steady Fed remains the most likely outcome for the next few quarters at least.

The outcome of this week’s FOMC meeting largely met my expectations. The Fed left rates unchanged, following through on their signaling from the October meeting. More importantly, this month’s dot-plot indicates that the vast majority of FOMC participants believe rates will remain unchanged in 2020. Barring a dramatic shift in the direction of the economy, the Fed expects they can drift into the background next year and watch their soft-landing play out.

In the FOMC statement, the most notable change was this language in October:

This action supports the Committee’s view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain. The Committee will continue to monitor the implications of incoming information for the economic outlook as it assesses the appropriate path of the target range for the federal funds rate.

to this now:

The Committee judges that the current stance of monetary policy is appropriate to support sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective. The Committee will continue to monitor the implications of incoming information for the economic outlook, including global developments and muted inflation pressures, as it assesses the appropriate path of the target range for the federal funds rate.

Critically, the Fed dropped the reference to “uncertainties” in the outlook. This indicates that they are much more confident in the outlook, apparently believing they have now done enough to keep the economy on track. This suggests that the bar to another rate cut has edged higher from last October. They really need a “material” change in the outlook to take rates down another notch.

At the same time, however, the bar to a rate hike is still even higher. The dot-plot revealed that all but four meeting participants expect rates to remain unchanged in 2020; the remaining four expect only a single hike. Remember there was a subset of members opposed to any rate cuts so they would be looking to reverse sooner than later. Overall, there is virtually no expectation that the Fed needs to consider reversing this year’s rate cuts anytime soon. Rate hikes are anticipated in 2021 and beyond, but that is simply too far off to be very relevant at this point. In some sense, this is really just an artifact of the models; given persistently low unemployment, the models will forecast higher rates to stave off inflationary pressures.

Median growth forecasts were unchanged from September as the Fed retains the basic outlook for steady growth near trend. Unemployment forecasts edged down, unsurprisingly given the November employment report. The longer-run estimate of the unemployment rate dropped 0.1 percentage points as persistently low inflation bolsters the Fed’s confidence that estimates of the natural rate of unemployment are still too high. The longer-run estimate of the federal funds rate held at 2.5%; I had though we might see a downward revision.

Powell’s press conference was decidedly dovish. He wants to see persistent and significant inflation before raising rates and reiterated that the labor market can’t really be described as hot unless wage growth accelerates. Basically no indication that he is worried about the economy overheating.

Bottom Line: The Fed did almost exactly as expected this week, offering confidence in the outlook while making clear they had no intention of raising rates in the context of that outlook. To be sure, if conditions change, the Fed will too. But for now they have taken themselves off the table, looking for some well-deserved rest.