The US economy: going solo?

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US Retail Sales data for April showed unexpected strength after a lackluster first quarter, with 1.3% growth over the prior month. Unlike 2014 and 2015 where March data was strong, there was no weather-related bounce: this appears to be actual spending, concentrated particularly in autos and housing. While many retailers have been struggling, Amazon’s revenues released on April 28th grew 28% versus the prior year. Ford also reported its best quarter ever on the same day. The University of Michigan sentiment index also beat economists’ expectations by a wide margin, and its reading of 95.8 is noteworthy. Interviewed by Bloomberg News, Professor Richard Curtin, one of the people who puts together the index, said:

the gain was due to more frequent income gains reported by consumers, a better job outlook, and the expectation of lower inflation and continued low interest rates. Importantly, the largest gains were among lower income and younger households, although we recorded improvements across all income and age groups, as well as across all regions.

Exhibit 1: University of Michigan consumer sentiment index  consumer sentiment indexSource: Bloomberg, University of Michigan, as at May 16, 2016.

The Fed has noticed. Jeffrey Lacker, president of the Federal Reserve of Richmond, was quoted in the Washington Post saying, “it looks to me as if the case for raising rates looks to be pretty strong in June.” His counterpart at the San Francisco Fed John Williams arguably went further, stating that the Fed “definitely” does not need to wait for markets, and that in his view the Fed should be thinking about additional hikes. New York Fed President Bill Dudley had spoken to the press the week before commenting that it is a “reasonable expectation” that the Fed will hike twice this year, and that the global situation is “dramatically better.

June remains unlikely, but that puts a hike in July as quite likely, with another in December – September likely being too close to the presidential election. In addition, the June 23 Brexit referendum in the UK has the potential to roil markets significantly.

Other data is more ambiguous. The Empire Survey from the New York Fed came in much lower than forecasts, at -9.0 versus estimates of +6.5, and a prior reading of +9.6. This goes directly to manufacturing weakness, and in particular export weakness. It is one data point of course, but it reflects clearly the lack of strength in much of the rest of the world, and it also echoes what has been the weakest earnings season since 2009, with Q2 earnings already being revised down.

Central banks around the rest of the world – the European Central Bank, Bank of Japan, Reserve Bank of Australia, Reserve Bank of New Zealand, Norway, and India to name a few – have all either been easing policy, or are expected to take more measures in that direction. The Bank of England is also on hold given the aforementioned referendum, but also CPI is well below its target: the market expects a rate hike in February 2017, which is so far in the future as to tell us almost nothing.

China remains a source of significant concern. The Caixin PMI has come in below 50, indicating contraction, and market GDP estimates are also below 7%. Most measures, from construction to lending to retail sales are all getting weaker. Where this sluggishness may be most interesting is commodities. Oil has rebounded strongly since February, but copper has given back around 70% of its post-February rally. The drop is greater for iron ore. The Baltic Dry bulk shipping index has come off, though not by nearly this magnitude – but it implies shipping costs near their lows. Some of this represents increasing capacity – but by no means all of it.

We are left with two quite opposite visions. Is the global economy slowing such that the Fed raising rates would be a huge policy error? Or, is the Fed right to observe that a more confident US consumer can justify higher rates and perhaps lead the world to stronger growth? We will soon find out.

Alex Johnson

Head of Absolute Return Multi-Sector Fixed Income

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