The Michael Corleone Economy
Over the past month, the news cycle has been, in a word, dreadful. Meanwhile, the economy, the markets and the financial world in general, have been fairly quiet. Oh sure there was a flurry of downside summer selling in stocks, mostly due to geopolitical jitters, but a four percent move lower is not exactly a classic 10 percent correction. But like Michael Corleone in The Godfather III who famously said, “Just when I thought I was out...they pull me back in”, every time the economy appears to be gaining steam, something pulls it back. After a rough winter, there were three strong months of job creation, followed by a decent, not great reading in July. The ISM Manufacturing Index rose to a three-year high in July and the service index reached its highest level in eight years; but then last week, the July reading of retail sales was flat. (The once-indomitable American consumer has yet to rediscover his love for shopping on a consistent basis, which is acting as a headwind to economic progress.)
This week, the drag may come in the form of housing, which has yet to recover from the early-year severe winter weather. Despite an improving economy, still-relatively low mortgage rates, an easing of credit conditions and a slowdown in price increases, the housing market remains subdued. Economists believe that housing’s extended hibernation will draw to a close this summer, but the real estate data have been inconsistent at best.
The problem with disappointing economic reports is they raise concerns that third quarter growth will slow down from the brisk four percent annualized pace seen in the second quarter. But in the topsy-turvy, post-financial crisis world, the periodic backwards slides in economic progress can actually be good news for investors. The reason is that every time a “bad” report hits the wires, investors are reminded that the Federal Reserve is likely to keep short-term interest rates low for a “considerable” period of time. To wit, after the weaker than expected US retail sales report and a myriad of punk data from Europe, Japan and China, government bond yields in the U.S., Germany and the U.K. closed at their lowest levels of the year, as investors bet that major central banks will keep interest rates lower for longer to support economic growth. (The yield of the 10-year Treasury note dropped below 2.4 percent, the lowest level in a year.)
Low short and long-term interest rates cannot continue forever, because at some point, the economy will shift into a higher gear and the Fed will need to change its policy. Fed-watchers are hoping that this year’s three-day conference in Jackson, Wyoming, which begins on Thursday, might provide clues as to when that change could occur.
When Fed Chair Janet Yellen delivers the keynote on the topic of “Re-evaluating Labor Market Dynamics,” many expect her to reiterate that there is slack in the labor market and that inflation is not yet a problem. However, the analysts at Capital Economics predict “the combination of faster income growth, rising wealth and easier access to credit should support spending over the rest of the year. As such, the economy will still be much stronger in the second half of the year than in the first.”
If those forecasts come to fruition, we may finally escape the “Michael Corleone economy”. But there is a downside to the rosy outlook: a stronger economic showing would mean that the Fed would likely raise interest rates sooner than expected -- probably in the first quarter of 2015. Additionally, the central bank could also increase rates by more than is widely anticipated. If that’s the case, the good news for the economy could spell trouble for investors, who may be underestimating the timing and magnitude of interest rate increases.
MARKETS: The Dow crawled back into positive territory for the year and the S&P 500 is within two percent of its all-time high of 1991, reached on July 24th.
- DJIA: 16,662, up 0.7% on week, up 0.5% YTD
- S&P 500: 1955, up 1.2% on week, up 5.8% YTD
- NASDAQ: 4464, up 2.2% on week, up 6.9% YTD
- 10-Year Treasury yield: 2.34% (from 2.42% a week ago) 52-week low in yield
- September Crude Oil: $97.24
- December Gold: $1305.50
- AAA Nat'l average price for gallon of regular Gas: $3.46 (from $3.54 a year ago)
THE WEEK AHEAD:
Mon 8/18:
10:00 Housing Market Index
Tues 8/19:
8:30 CPI
8:30 Housing Starts
Weds 8/20:
2:00 FOMC Minutes
Thurs 8/21:
Federal Reserve 3-day conference begins in Jackson Hole, WY
8:30 Weekly Jobless Claims
10:00 Philadelphia Fed Index
10:00 Existing Home Sales
10:00 Leading Indicators
Fri 8/22:
Fed Chair Janet Yellen delivers the keynote address at Jackson Hole Fed conference