The Market Today
Fed Committed to 2% Inflation; GDP Boosted by Trade and Soft Inflation; nCov Virus Continues Rapid Spread
by Craig Dismuke, Dudley Carter
Coronavirus Update: Figures reported overnight show continued escalation in the number of people with confirmed cases of coronavirus. The N.H.C. reported 7,804 confirmed cases and 170 deaths in mainland China, up 1,855 and 38 from yesterday’s tallies. Today’s incident report from W.H.O. has not been released yet. As seen in the Charts of the Day, the coronavirus is spreading at a much more rapid rate than SARs did in 2003. However, the virus has been largely confined to mainland China thus far.
U.S. Economy Expands 2.1% on Drop in Trade Deficit and Soft Inflation: The U.S. economy expanded a better-than-expected 2.1% in 4Q on a soft inflation deflator and a big boost from the declining trade deficit. Exports rose 1.4% during the quarter but imports fell a significant 8.7%, the largest quarterly decline in over 10 years, as overall trade volume continues to shrink. This drop in trade poses a risk to global growth. As it relates to GDP growth, the drop in the quarterly deficit accounted for 1.5% of the final tally. As for the GDP inflation deflator, it fell from 1.8% to 1.4%, its second-weakest quarterly reading since 2017. The GDP inflation deflator is the amount that nominal growth is adjusted downward to account for inflation. As such, only 1.4% was stripped from nominal growth in 4Q. Inflation for core personal consumption items fell to 1.3%, its second weakest quarter since 2015. Coming on the heels of yesterday’s Fed decision highlighting their desire for inflation to move back to 2.0% (not near 2.0%), the 4Q GDP report is problematic.
Apart from the soft inflation and anomalous boost from the declining trade deficit, the consumer was modest, business investment was weak, housing was solid, and government spending continued to boost growth. Personal consumption grew just 1.8%, down from 4.6% and 3.2% in 2Q and 3Q, respectively. While the foundation remains solid for consumers, growth slowed into year-end and we will continue watching for evidence that activity is rebounding in 2020. Business investment contracted 1.5%, the third-consecutive quarterly decline. Residential investment, housing, rose a strong 5.8%, its second-consecutive gain after six quarters of decline. Housing, spurred on by sharply lower mortgage rates in 2019, continues to be a bright spot. Government spending expanded 2.7% on a 3.6% increase in federal spending and a 2.2% gain in state and local. While this is a tailwind to growth now, the federal deficit now exceeds $1T and remains a long-term challenge.
Bottom Line: The U.S. economy expanded at a better-than-expected pace in 4Q but this was largely due to an unhealthy decline in trade volume and a soft inflation deflator. The consumer remains an engine of growth. Housing is benefiting from lower rates. And business investment has shown no indication of rebounding.
Initial Jobless Claims Remain Solid: Also reported this morning, initial jobless claims for the week ending January 25 remain positive, falling from 223k to 216k.
Stocks Rose as Yields Fell Ahead of the Fed’s Decision: Stocks were mixed at Wednesday’s close after giving up early gains following the Fed’s latest decision and ahead of earnings from Facebook after the bell. U.S. equities rose at the open after global markets strengthened Wednesday, while Treasury yields remained lower on continued uncertainty created by the coronavirus. Stocks in Europe rose 0.4% despite China raising the number of deaths tied to the virus to more than 130 and the related cases to nearly 6,000. Just before the Fed’s decisions the S&P 500 had gained 0.35% while the 10-year yield had declined 4.1 bps. Those moves held after the Fed’s initial decision was announced alongside a Statement with only two changes, albeit dovish ones (more below).
Yields Declined as Rate Cut Expectations Rose: However, stocks began to give up their gains as Chair Powell’s press conference unfolded and yields steadily fell to new lows. Absent an obvious single comment during his remarks that may have spurred the move, the cumulative effect of changes to the inflation language; a statement that the Fed’s uncomfortable with inflation persistently undershooting the 2% target; an admission that a new framework could result in a new policy setting over time; a reminder that risks remain; and speculation that the labor market has room to run could help explain the move down in yields. By the end of trading, the 2-year yield fell 5 bps to 1.41%, just 2.5 bps from October’s two-year low. Fed funds futures repriced to imply a higher probability that the Fed will cut rates at least once this year, if not two times. The 10-year yield dropped 7.2 bps to 1.58%, a new low back to October.
Equities Slump Back After Coronavirus Updated: Global markets are backpedaling again Thursday following the latest upward revisions to China’s coronavirus statistics. The Chinese government announced that 170 have now died from the virus and the total number of cases in the country has grown to nearly 7,700. India and the Philippines confirmed their first cases of the illness and the total infected outside of China has moved to more than 100. While China’s stock market remains closed, a futures contract tracking the largest Chinese companies fell more than 3%. Stocks elsewhere in the region fell 1.8% and Europe’s Stoxx 600 was 1.0% weaker. U.S. futures were down 0.8% before this morning’s GDP report, also weighed by a 7.5% drop in shares of Facebook after the company reported slower-than-expected revenue growth in the fourth quarter.
Global Yields Decline, U.K. Yields Shoot Higher: Yields in most sovereign nations had pulled back in response to the daily drop in equities. Germany’s 10-year yield was 2.4 bps lower and the 10-year Treasury yields had declined 2.1 bps. The U.K. gilt curve, however, bucked that trend, with a sharp jump in shorter yields leading to a notable flattening of the curve. The 2-year yield moved up 6.2 bps after the Bank of England elected to hold rates steady on a 7-2 vote. Speculation had risen in recent weeks that the central bank could lower rates after several officials pointed to a weakening growth outlook. While they opted to wait at today’s meeting amid tentative signs of improvement, they did cut their growth outlook and now expect inflation to remain below their target for at least the next two years. U.S. yields and stocks both remained lower after GDP was released.
Fed’s Initial Announcement: The FOMC voted unanimously to keep its target range unchanged at 1.50-1.75%, a level officials believe remains “appropriate to support sustained expansion.” They did, however, make mechanical upward adjustments to the two rates used to achieve an effective fed funds rate within the target range; the rate it pays on reserves, the IOER rate, was raised to 1.60% and the repo rate was lifted to 1.50%, both 0.05% adjustments. As expected, the Fed took a minimalist approach in updating the Statement, tweaking just two words outside of the mandatory date change. The characterization of household spending was softened from “strong” to “moderate” and, instead of keeping inflation “near” 2%, the Fed believes current policy is appropriate to support inflation “returning to” 2%. While small, the adjustments were dovish. The implementation note was updated to show temporary open-market operations will run past the end of January to “at least through April,” to allow time for reserves to grow to the desired level through the ongoing permanent Treasury bill purchases.
Powell’s Presser: Fed Chair Powell was methodical in his post-meeting press conference, often answering questions with pre-scripted responses. On the adjustment to the Statement’s language around “returning” inflation to target, Powell said it was an intentional effort to prevent any misinterpretation that the Fed was comfortable with the persistent shortfall of inflation as consistent with the mandate. In describing the broader outlook, Powell said consumer spending had moderated but fundamentals remain solid, although the lack of wage pressure could be a sign of additional labor slack. Global developments, which he blamed for weakness in business spending, had shown some signs of improving. Still, plenty of risks remain, including the new coronavirus. The virus will impact China and its close neighbors, Powell admitted, but it’s still too early to assess any effect on the U.S. The tone of is response to several questions on the balance sheet was that the Fed believes the current bill purchases will push reserves into a range above $1.5T sometime in the second quarter, at which point the temporary operations are likely to be reduced.
Fed Bottom Line: Powell sounded cautiously optimistic about global growth prospects and believes strong consumer fundamentals will continue to drive positive economic activity. However, plenty of risks remain that could affect the actual outcome and, while the Fed expects inflation will pick up this year closer to 2% as weaker readings from 2019 roll out of the calculation, they are not comfortable with undershooting 2%. Taken together, Wednesday’s developments reflect a Fed effectively buying time to allow for more incoming data to inform any additional response to soft inflation, modest U.S. economic activity, and global uncertainties.
Surprisingly Weak Pending Sales Pose Risk to Existing Sales Early in 2020: Pending home sales slumped sharply and unexpectedly in December as activity slowed notably across all four geographic regions. After climbing steadily throughout 2019, the number of new contracts signed tumbled 4.9% in December, easily the largest one-month decline since early in the expansion, to the weakest level since February. While data from the Mortgage Bankers Association earlier on Wednesday showed that a new post-election low for mortgage rates had pushed weekly purchase applications to a new cycle-high, the National Association of Realtors’ Chief Economist pointed to a “shortage of affordable homes” and rising home prices as key reasons for the weakness in December’s pending sales. In the last existing home sales release, months supply of inventory fell sharply to 3.0 months, the lowest on record.