Focused Investing: Economy & Markets Update
The past two weeks were full of reports on the current state and outlook for the U.S. and global economies. Perhaps most importantly, the updated inflation data gave a more optimistic outlook for future Fed moves. Also, the key U.S. service sector activity index unexpectedly improved in November. Conversely, U.S. manufacturing activity weakened and wage growth, which has underpinned strong consumer spending, and a resilient economy that is falling and expected to fall further.
What Happened
Two weeks ago, we got the October U.S. consumer price index (CPI) and both the headline and core metrics were below expectations. The headline CPI was flat in October and has now increased 3.2% since October 2022. Core inflation increased 0.2% in the month and is up 4.0% over the past year. The surprise was driven by smaller increases in food prices and big declines in energy commodities. The surprise in core inflation was driven by auto prices, and airline ticket prices, and smaller increases in the housing sector.
S&P released early estimates of November activity in the services and manufacturing sectors. The service sector activity increased compared to an outlook for a small decline, whereas the manufacturing sector dropped when a small increase was expected. The contrary results in both indexes relative to expectations was generated by demand. The service sector saw an uptick in demand while the manufacturing sector experienced a decline in demand. Manufacturing companies did note that margins improved in the month because of more efficient operations and lower input prices, which should lead to lower inflation readings in the coming months. On the flipside, the outlook for production in both sectors is negative as service companies highlighted an expected slowdown in activity as consumers close their wallets to new spending.
Supporting the weakness in the manufacturing sector index above was durable goods orders which declined 5.4% when expectations were for a 3.4% drop. The big decline was focused in the transportation sector, but the overall report aligns with other manufacturing reports. These reports showcase that the manufacturing sector of the U.S. economy is in contraction territory and despite the improvements in efficiency and price inputs, this contraction is unlikely to abate soon.
The news was not all negative as first-time unemployment claims declined to 209,000 from a recent high of 233,000 the week before. The labor markets have been one of the main sources of resilience in the consumer and economy, so the recent weakness increased concerns that a reversal was imminent. This report should at least temporarily put to rest those concerns. On the other hand, slowing wage growth continues and is now about equal to inflation. As noted above, wage growth was one of the biggest underpinnings of the splurging consumer the last two years, so as wage growth slows, we expect consumer spending will also slow.
Next Two Weeks
Over the next two weeks, we will see several economic reports that are likely to move the markets. This week, personal consumption expenditures (PCE) and the PCE price index are released, and like the CPI report, we expect to see continued moderation of inflation and a slowdown in consumer spending. This report also gives us wages, which once again are likely to decline from the month before. We will also see October consumer confidence, which are expected to have declined again. Next week, we will get a look at the labor markets as the ADP employment report is released on Wednesday and the U.S. employment report is out on Friday. We will also keep an eye on oil prices, which have declined from a recent high of about $91 per barrel to the $74 range. The oil markets are indicating a global slowdown is coming and supports economic reports released around the world.
Our Take
The reports from the last two weeks support our view that the economy is slowing from the level of the second quarter. Third quarter GDP growth was a robust 4.9%, which we view as anomalous and therefore use the more normal second quarter as our point of comparison. The weaker outlook for the U.S. service sector is based on lower consumer spending growth, which we have highlighted numerous times the past few months. We believe this trend will continue well into next year, even with solid job growth. The consumer is tapped with consumer credit card debt at near all-time highs of $1,023.7 trillion; consumers must repair their balance sheets. Supporting this outlook is the earnings reports from retailers which had great earnings for the previous quarter but highlighted a dour outlook. Walmart in fact expects to see deflation in many goods categories in the near term due to weak consumer spending. Thus, many retailers may not have a very cheery Christmas. Despite this Grinch-esque outlook form the retailers, we believe there are reasons to invest. With inflation coming in below expectations, interest rates have declined, and we expect the decline in rates will continue, but it will be lumpy. Thus, we think bonds are a buy right now. Additionally, there are areas of the equity markets that have not participated in this year’s bull market and are therefore offering the opportunity to buy at prices below our estimate of intrinsic value.
Clinton S. McGarvin, CFA, is a Senior Portfolio Manager. He received his B.S in Mathematics from The University of Arizona and an MBA/MSF from The University of Denver Daniels College of Business. Later Clint received the Certificate in ESG awarded by the CFA Institute. To speak with Clint McGarvin, please contact our office at (503) 292-1041 or via email at info@allentrust.com.