Fed raises rates again, Goldilocks jobs report – solid job gains w/ no inflation
The U.S. economy grew 1.4% in Q1, ahead of initial disappointing expectations. While growth was subpar overall, the upward revision was due to better than expected consumer spending and a bigger jump in exports. Consumer spending was revised up from 0.6% to 1.1% and exports were revised to show a gain of 7% from the previously reported 5.8%. Consumer spending expanded at its slowest pace since Q2 2013. Economic growth should improve for the remainder of 2017, but recent data points on housing, inflation, and retail sales could spell trouble for the economy. Estimates are for 2.5-3% growth in Q2. The Fed hiked rates in June for the third time since last December and upgraded its forecast for unemployment and economic growth. The Fed also plans to start unwinding its balance sheet later this year. The plan is to gradually stop reinvesting proceeds from its portfolio. The Fed will start by allowing $6B in Treasury securities and $4B in mortgage-backed securities to mature each month. Eventually its limit will climb to $30B in Treasuries a month and $20B in mortgage securities. Most Fed officials see at least one more rate hike in 2017, but the Fed Fund Futures currently project a 52% chance of one more rate hike. June’s employment report was a “goldilocks” scenario. Job growth of 222K was ahead of expectations, but the employment rate rose 0.1% to 4.4% as more people reentered the workforce and average hourly earnings remained stagnant at 2.5% Y/Y. The April/May reports were also revised higher by a total of 47K jobs.
Manufacturing and services show a healthy U.S. economy, other data points weaken while confidence remains high
Economic activity in the manufacturing sector surged higher in June to its highest level since August 2014. The ISM Manufacturing Index rose sharply from 54.9 in May to 57.8 in June. Although other economic data point to a sluggish economy, this manufacturing report suggests the economy may have gained some steam to end Q2. New orders, production, employment and exports all expanded
in June, suggesting manufacturing remains quite healthy. Economic activity in the services sector gained ground in June based on ISM data. The ISM Non-Manufacturing Index rose to 57.4 in June, ahead of the 56.5 estimate and 56.9 reading from May. The new orders and business activity sub-components increased in June, but the employment gauge weakened a bit. Demand remains strong and both ISM reports suggest that the U.S. economy has gathered some momentum. The gauge on inventories actually jumped in June, likely in response to higher demand and a brighter outlook for consumer spending. Other key economic reports showed that durable goods orders fell 1.1% in May, retail sales fell 0.2% in June and auto sales hit their lowest annualized rate since February 2015. Consumer confidence rose to 118.9 in June which was well ahead of expectations and new and existing home sales also gained ground. CPI was unchanged in June at 1.6% Y/Y while core CPI edged up 0.1% to 1.7%.
U.K. falters while the Eurozone shines
The U.K. had the lowest GDP growth rate in the European Union in Q117, according to Eurostat. The U.K. economy expanded 0.2% Q/Q in Q1, down significantly from the 0.7% growth rate reported in Q416. As the British pound has depreciated following Brexit, inflation has been imported into the country. This inflation spike has caused a substantial slowdown in consumer spending.
U.K. inflation hit a four year high in May at 2.9% Y/Y (up from
2.7% in April). Inflation has surged higher following the Brexit referendum last year (inflation rate was 0.3% prior to the Brexit vote). Wage growth continues to hover around the 2.1% level which is below the rate of inflation. Weaker currency has made all things more expensive across the country including travel to other parts of the world. The BOE faces a conundrum as inflation now sits well above their 2% target, but there is a need to prop up economic growth in anticipation of looming Brexit negotiations. The fall in energy prices has provided some relief, but rising interest rates would increase borrowing costs at a time when consumers are already feeling pain from rising prices and lackluster wage growth.
Q2 was the best in six years for the Eurozone based on PMI data. The IHS Markit Eurozone PMI fell to a four month low of 56.3 in June, above the flash estimate of 55.7, but below April and May’s six year high levels of 56.8. Manufacturing led the way as production rose to its highest level since April 2011. Although the rate of growth in the service sector moderated from 56.3 in May to 55.4 in June, it was still among the strongest seen over the past six years. Stronger demand is increasing pricing power and accelerating new orders have put pressure on companies to keep pace. The Eurozone is forecast to grow 0.7% in Q2 after growing 0.6% in Q1.
Unemployment remains at 9.3% in the Eurozone, down from 9.6% to start the year. Greece (22.5%) and Spain (17.7%) continue to lead the way in terms of joblessness. While consumer confidence and retail sales gather steam, inflation (1.3% Y/Y, core = 1.2% Y/Y) continues to ease after spiking higher in April.
China’s economy remains on solid footing despite some monetary tightening
China’s official manufacturing PMI for June rose to 51.7, beating expectations and accelerating from 51.2 in May. Manufacturing continues to sit in expansionary territory de-
spite expectations for a slowdown. The average manufacturing PMI in Q2 was 51.4, down from 51.6 in Q1. Q2 GDP of 6.9% was ahead of the 6.8% expectation and ahead of the government’s 6.5% 2017 target. Risk should be tilted to the upside for the economy. The official China services PMI rose to 54.9 in June from 54.5 in May. The Caixin Services PMI, which focuses on smaller businesses, fell to 51.6 in June from May’s four month high of 52.8.
EMs shouldn’t fear the Fed
Every Fed rate hike cycle differs based on the level of growth, inflation, starting interest rates, etc. During the current tightening cycle that began in December 2015, the Fed has gradually raised interest rates four times. Investors typically fear the Fed and believe that EMs are negatively impacted by a rate hike cycle here in the U.S. The data tells a different story as EMs have been by far the best performing asset class since the first rate hike. EMs are experiencing a strong rebound in corporate earnings and the GDP growth differential between EMs and DMs is accelerating. EM equities have historically outperformed during periods when EM GDP growth accelerates faster than DM GDP growth. The EM to DM growth differential is projected to increase each year through 2021.
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