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Markets End Quarter on a Choppy Note  

June 30, 2017 

**An unexpected decline in U.S. orders for business equipment in May indicates cooling capital-goods investment may weigh on second-quarter economic growth, Commerce Department data showed Monday. Orders for non-military capital goods excluding aircraft fell 0.2% (the estimate was for a 0.4% gain) after a 0.2% increase in the prior month. Shipments of those goods, which are used to calculate gross domestic product, fell 0.2% after 0.1% gain the prior month. Bookings for all durable goods fell 1.1% (the estimate was for a 0.6% drop) following 0.9% decline in the previous month.   Excluding transportation equipment demand, which is volatile, orders rose 0.1% (the estimate was for a 0.4% gain). The broad slowdown in equipment orders and shipments raises the risk that business investment will provide less of a boost than anticipated to the economic rebound this quarter, leaving the heavy lifting to household spending. The outlook for capital-goods production is clouded by cooling automobile sales, while overseas markets -- though improving -- are yet to show the kind of demand acceleration that would spur exports of U.S. made goods. In addition, some companies may be waiting for clarity on more favorable tax policies from Congress before stepping up investment. 

We had a couple of Fed governors giving speeches this week with comments that were worthy of note. New York Fed President William Dudley indicated that easier financial conditions support the Fed tightening policy. A muted market response to plans to shrink Federal Reserve’s balance sheet “suggests that these communications have generally been effective in fostering an orderly adjustment in expectations about how we are likely to normalize our balance sheet,” he went on to say. “Monetary policymakers need to take the evolution of financial conditions into consideration,” Dudley said in remarks delivered Sunday at the Bank for International Settlements’ Annual General Meeting, in Basel, Switzerland and posted online Monday. “For example, when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease, as has been the case recently, this can provide additional impetus for the decision to continue to remove monetary policy accommodation.” Additionally, Federal Reserve policy maker John Williams also spoke this week indicating he sees interest rates rising as inflation moves up. He made the case Monday for further gradual increases in interest rates, saying he expects inflation to rise to the central bank’s 2 percent target next year as unemployment edges lower. “Gradually raising interest rates to bring monetary policy back to normal helps us keep the economy growing at a rate that can be sustained for a longer time,” Williams said in remarks prepared for delivery at the University of Technology Sydney. The comments by the president of the Federal Reserve Bank of San Francisco suggest that he’s lining up with Fed Chair Janet Yellen, his predecessor at the bank, in an emerging debate on how to respond to an easing in inflation during the last few months. While some Fed officials have argued for a pause in the rate-hiking campaign to wait for clearer signs that inflation is indeed headed higher, Yellen has played down the significance of recent weak price data and suggested that the Fed remains on course for higher rates. Williams seemed to agree. “Some special transitory factors have been pulling inflation down,” he said. “But with some of these factors now waning, and with the economy doing well, I expect we’ll reach our 2 percent goal sometime next year.” 

Those special factors include a steep drop in the cost of mobile-phone services. That helped pull down the Fed’s favorite inflation gauge to 1.7 percent in April from 1.9 percent in March and 2.1 percent in February. Williams also saw a danger in the Fed allowing the unemployment rate to fall too far. “The very strong labor market actually carries with it the risk of the economy exceeding its safe speed limit and overheating, which could eventually undermine the sustainability of the expansion,” he said. At 4.3 percent in May, the U.S. jobless rate was already below what Williams thinks is its long-run sustainable rate of 4.75 percent. And he sees it dropping some more. “Given the strong job growth we’ve been seeing in the United States, I expect the unemployment rate to edge down a bit further and remain a little above 4 percent through next year,” Williams said. The Fed earlier this month raised interest rates for the second time this year. Policy makers have penciled in one more rate increase for 2017 and three more for 2018, according to projections released after their June 13-14 meeting. Williams is not a voting member of the Federal Open Market Committee this year but will vote in 2018. Williams affirmed the Fed’s intention to begin trimming its $4.5 trillion balance sheet this year, saying the central bank would start off “nice and easy.” The aim will be to gradually reduce bond holdings in a widely telegraphed and predictable fashion, he said. “I hope I’ll not be perpetuating an unfair stereotype about economists if I say that ‘boring’ is a virtue,” Williams said. “Indeed, my new mantra is, ‘Boring is the new exciting.’”  It’s nice to see a Fed governor with a sense of humor! 

In European Central Bank news, Mario Draghi called for continued euro-area stimulus this week even as the economy enters a new phase in its upturn, saying support is still needed to entrench the trend. “All the signs now point to a strengthening and broadening recovery in the euro area -- deflationary forces have been replaced by reflationary ones,” the European Central Bank president said on Tuesday in Sintra, Portugal. “However, a considerable degree of monetary accommodation is still needed for inflation dynamics to become durable and self-sustaining. So for us to be assured about the return of inflation to our objective, we need persistence in our monetary policy.” The comments at the annual ECB Forum reflect the intensifying public debate over whether the central bank should continue pumping liquidity into the financial system after more than four years of economic growth and improving resilience.  Policy makers didn’t use their latest policy meeting to discuss whether to wind down their 2.3 trillion-euro ($2.6 trillion) bond-buying program, which is scheduled to run until the end of this year, meaning investors may get relatively short notice of any change. The euro jumped as Draghi said that most factors damping inflation are temporary. The Governing Council used its June 8 meeting to say that risks to growth are now broadly balanced instead of tilted to the downside, and dropped its expectation that interest rates might be cut again. Draghi acknowledged that further changes in the policy stance are coming, but said they should be slow. “In the past, especially in times of global uncertainty, volatility in financial market prices has at times caused an unwarranted tightening of financial conditions,” he said. “So in the current context where global uncertainties remain elevated, there are strong grounds for prudence in the adjustment of monetary-policy parameters, even when accompanying the recovery. Any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.” The ECB president did leave room for policy steps that would signal a reduction in the pace of stimulus, without necessarily tightening financial conditions. That could encourage more hawkish members of the Governing Council to push for action. “As the economy continues to recover, a constant policy stance will become more accommodative,” Draghi said. “The central bank can accompany the recovery by adjusting the parameters of its policy instruments -- not in order to tighten the policy stance, but to keep it broadly unchanged.” We respect Mario Draghi and his position – traders seem to also have a great deal of confidence in his ability to lead the central bank. 

In other European news, euro-area economic confidence jumped to the highest level in a decade as the European Central Bank edged toward unwinding unprecedented stimulus. An index of executive and consumer sentiment rose to 111.1 in June from 109.2 in May, the European Commission in Brussels said Thursday.  The reading is the strongest since August 2007 and compares with a median estimate of 109.5 in a Bloomberg survey of economists. The report comes two days after ECB President Mario Draghi confounded investors by arguing that there’s room to adjust stimulus measures as the economy improves, even though he called for prudence and patience.  A gauge for private-sector activity signaled the euro-area economy recorded its fastest expansion in six years in the second quarter as business confidence in Germany hit a record and consumer sentiment in France surged. 

The job market continues to boost U.S. consumer confidence as expectations rise. An unexpected rebound in U.S. consumer confidence reflects a buoyant labor market and improved business conditions, though Americans are slightly less optimistic about where things will be in six months, data from the New York-based Conference Board showed Tuesday. The Confidence index rose to 118.9 (the estimate was for 116) from 117.6 in May. The present conditions measure increased to 146.3, highest since July 2001, from 140.6 the prior month. The gauge of consumer expectations for the next six months fell to 100.6, the lowest level since January, from 102.3 the previous month. Americans are drawing encouragement from an economy that continues to provide jobs, rising stock and home prices and steady pay gains, as the share of respondents expecting higher incomes was the second-highest since 2002. At the same time, the easing of the overall expectations index adds to other sentiment figures that suggest mounting skepticism about the ability of Washington lawmakers to enact economic policies that will drive growth. “Expectations for the short-term have eased somewhat, but are still upbeat,” Lynn Franco, director of economic indicators at the Conference Board, said in a statement. “Overall, consumers anticipate the economy will continue expanding in the months ahead, but they do not foresee the pace of growth accelerating.” 

Sustained increases for home prices in 20 U.S. cities in April indicate the housing industry is juggling stable demand with a shortage of inventory, figures from S&P CoreLogic Case-Shiller showed Tuesday. The 20-city property values index rose 5.7% year-over-year (the estimate was for a 5.9% gain). The national price gauge increased 5.5% year-over-year. The seasonally adjusted 20-city index climbed 0.3% month-over-month (the estimate was for a 0.5% increase). Stubbornly low inventory in housing, particularly for more affordable properties, has helped drive steady home-price gains. While rising property values are helping cushion homeowners’ balance sheets, they also are inhibiting lower-end buyers, especially first-timers, from getting a piece of the action, as wage gains haven’t kept pace. At the same time, industry demand remains healthy, with solid job gains and low mortgage rates supporting purchases. “Since demand is exceeding supply and financing is available, there is nothing right now to keep prices from going up,” David Blitzer, chairman of the S&P index committee, said in a statement. “The supply of homes for sale has barely kept pace with demand and the inventory of new or existing homes for sale shrunk down to only a four-month supply. All 20 cities in the index showed year-over-year gains, led by a 12.9 percent advance in Seattle and a 9.3 percent rise in Portland, Oregon.  

The U.S. economy’s first-quarter growth was less tepid than previously reported, as consumer spending and trade added more to expansion, Commerce Department data showed Thursday. Gross domestic product rose at a 1.4% annualized rate (the forecast and previous estimate were for 1.2%). Consumer spending, the biggest part of the economy, rose 1.1% (the forecast and previous estimate were for 0.6%). Exports grew at a 7% rate, which was revised up from the prior estimate of 5.8% growth. While the revision was more positive than most analysts anticipated, the report still underlines a relatively weak start to the year, with consumer spending growing at the slowest pace since 2013.  Weather and other temporary factors in the period, along with rising wages and salaries, support the idea of a consumer-led rebound in the second quarter.  Federal Reserve policy makers raised interest rates earlier this month, seeing the first-quarter slowdown as transitory as the labor market improves further. The Commerce Department attributed the latest upward revision to spending data for financial services, insurance and health care.  Exports of industrial supplies and materials were higher than previously reported, boosting trade’s contribution to expansion in the period. Analysts estimate the U.S. economy will grow at a 3 percent rate in the April-to-June period, though the slowdown in equipment orders and shipments reported earlier this week raises the risk that business investment will provide less of a boost than anticipated.  Cooling automobile sales and a housing sector limited by a scarcity of affordable homes also remain headwinds for the economy this year. 

As always, stay tuned!

Fed Policy Makers Debate Inflation Outlook

Federal Reserve officials engaged in a detailed debate about inflation while keeping the door open for a September announcement on the timing of balance-sheet reductions, according to minutes from their policy meeting in July.  The minutes showed a majority of Federal Open Market Committee participants sticking with a forecast that inflation would gradually rise to their 2 percent target over the medium term.  However, “many” saw some “likelihood that inflation might remain below 2 percent for longer than they currently expected,” according to minutes from the July 25-26 Federal Open Market Committee meeting released in Washington on Wednesday.  “Several indicated that the risks to the inflation outlook could be tilted to the downside,” the minutes said.  There was also a group of “some other” participants who cautioned that easy financial conditions and tight labor markets could result in an “overshooting” of the inflation target that could be costly to reverse.  They “cautioned” against “a delay in gradually removing policy accommodation.”  The minutes didn’t specify when the Fed would begin shrinking its balance sheet this year.  “Although several participants were prepared to announce a starting date for the program at the current meeting, most preferred to defer that decision until an upcoming meeting,” the minutes said.  The Fed next meets on Sept. 19-20. 

The Fed’s portfolio stands at $4.5 trillion in total assets, the legacy of three rounds of quantitative easing as the central bank added additional stimulus with direct bond purchases once its benchmark lending rate was cut to zero in December 2008.  The Fed staff pushed up its assessment of financial stability risks to “elevated” from “notable,” the minutes said.  Fed officials discussed stock valuations with “a couple” saying they were supported by “favorable macroeconomic factors.”  U.S. central bankers in June forecast they would raise the benchmark lending rate a third time this year to a range of 1.25 percent to 1.5 percent.  That step may depend on officials’ evolving forecast for inflation to rise back to their 2 percent target.  The minutes showed some officials questioning an inflation framework that rested on employment and growth rising above long-term sustainable levels.  “A few participants cited evidence suggesting that this framework was not particularly useful in forecasting inflation,” the minutes said.  “Most participants thought that the framework remained valid.” 

The Fed has missed its price goal for most of the past five years.  The consumer price index rose 1.7 percent for the 12 months ending July, while the Fed’s preferred measure, which is tied to consumption, rose 1.4 percent in June.  In June officials lowered their 2017 inflation forecast, and indicated they didn’t expect to hit the 2 percent target until 2018.  The unemployment rate last month matched a 16-year low of 4.3 percent, and average hourly earnings rose 2.5 percent for the year, around the average rate during the recovery which began in June 2009.  A broader measure of labor costs which includes benefits, the employment cost index, has also fallen short of the rates of increase seen before the recession.  The economy continues to expand.  Non-farm payrolls rose by 209,000 jobs last month, and gross domestic product expanded 2.6 percent in the second quarter.  Basically, our expectation is the Fed will begin the process of shrinking their balance sheet in September but an actual rate hike is more likely for their December meeting.   In general, the minutes were received favorably by traders and there were no real surprises in them. 

U.S. housing starts stumbled in July on an abrupt slowdown in apartment construction and a modest decline in single-family homebuilding that shows the industry will do little to spur the economy, Commerce Department data showed Wednesday.  Residential starts decreased 4.8% to a 1.16 million annualized rate while the estimate was for 1.22 million.  Multifamily home starts slumped 15.3%, while one-family home starts dropped 0.5%.  Building permits, a proxy for future construction, also fell 4.1% to a 1.22 million rate annualized rate.  Despite overall starts being weighed down by less apartment construction, ground-breaking on single-family properties has declined in four of the last five months.  That indicates little support for the economy.  While staying close to an almost 10-year high, the pace of one-family homebuilding is being held back by labor and lot shortages, according to construction firms.  At the same time, builders remain optimistic that the market will benefit from strength in the job market and cheap borrowing costs. 

A slump in motor vehicle production pushed down U.S. factory output unexpectedly in July, Federal Reserve data showed Thursday.  Factory output dropped 0.1% while the estimate was for a 0.2% gain.  Total industrial production, which also includes mines and utilities, increased 0.2% which was below the estimate for a 0.3% rise.  Manufacturing output minus motor vehicles rose 0.2%, reflecting a pickup in non-durable goods production.  Basically automobile production fell 3.6 percent in July, the fourth decline in the last five months.  That reflected a slowdown in sales that were a bright spot for the economy in recent years.  While factory production excluding automobiles increased, the data showed some other areas of softness.  Output of business equipment and construction materials dropped for the second time in three months.  While manufacturing is projected to continue to grow, an acceleration in the near term would require bigger gains in household demand, business investment and stronger global sales.  The monthly data, which are volatile and often get revised, contrast with other recent reports.  While the Institute for Supply Management’s factory index eased in July from the second highest level since 2011, it showed steady growth in production, orders and employment.  The latest Empire State Manufacturing survey for August also posted a strong gain.  Meanwhile, the U.S. labor market remains on solid ground.  Initial jobless claims fell by 12,000 to 232,000 last week, the lowest in six months, Labor Department data showed Thursday.  The median forecast in Bloomberg survey called for 240,000. 

A sense of growing unease gripped financial markets on Thursday as Donald Trump exacerbated the controversy sparked by a racist rally in Virginia and terrorists struck a crowded street in Barcelona.  U.S. stocks retreated and a measure of market volatility rose higher, while high quality bonds increase in price as traders sought havens.  Stocks began the day lower on speculation Trump’s policy agenda was increasingly coming into question after he disbanded two advisory councils staffed by CEOs and slammed Republican members of Congress who were critical of his remarks on race.  Rumors that Gary Cohn would resign as head of the national economic council added to the selling before reports that he’d opted to stay on momentarily buoyed the market.  Cohn has been leading the president’s efforts on tax reform.  Losing him would have been a major setback in our view.  While Cohn’s continued presence in the White House brought a measure of calm to markets, it failed to end the controversy sparked by Trump’s polarizing remarks.  The unfortunate terror news was a reminder that geopolitical unrest remains a threat to global growth, with nerves still raw after last week’s escalation of tensions on the Korean peninsula.  Still, many strategists cautioned that equity markets don’t appear poised to crack and for perspective despite the drop Thursday, the S&P 500 still sat about 2% off of its all-time high reached 10 days prior to that on August 7th.  Earlier Thursday, European stocks dropped as minutes from the region’s last central bank meeting revealed concern among officials that the currency could overheat.  Most European bonds edged higher as they tried to catch up to U.S. yields and Sterling slipped after growth in U.K. retail sales dropped.  Friday it was announced that Steve Bannon was out as the White House chief strategist, which seemed to be well received.   Better he then Gary Cohn or Steven Mnuchin in our view, as the latter two gentleman are the principal drivers behind the White House tax reform plan.  

In further European news, the euro-area economy gathered pace in the second quarter as more nations joined the recovery.  The 0.6 percent expansion matched an Aug. 1 estimate and was supported by continued growth in Germany, the region’s largest economy, and the strongest Spanish performance in almost two years.  But after years of unprecedented stimulus, the upswing is finally starting to spread across the 19-nation region.  Exports and investment have led France to its strongest continuous expansion since 2011 and the Netherlands posted the fastest growth since the end of 2007.  Italy, which has lagged the pickup of its peers, is starting to shake off its reputation as the sick man of Europe with an increase in gross domestic product that may top 1 percent this year for the first time since 2010.  “The recovery is stronger, broader and once again proves to be resilient to external shocks,” said Frederik Ducrozet, an economist at Banque Pictet & Cie in Geneva.  “The ECB can sound confident on their premise that inflation will indeed rise, maybe not as fast as we’d like, but the data is on their side.”  European stocks advanced on Wednesday amid growing optimism over the region’s economy.  The Stoxx Europe 600 Index rose 0.7 percent, the highest in a week, and Germany’s benchmark DAX Index increased 0.7 percent.  The euro fell 0.3 percent in a low-volume market typical of summer periods.  

Even though the euro area’s economic revival comes with steadily declining unemployment and business confidence at a decade high, price pressures have so far remained largely elusive.  The European Central Bank is confident that inflation will eventually pick up as wages rise and economic slack abates, and President Mario Draghi has had to upgrade his view of the economy in recent months.  The 69-year-old Italian will have an opportunity to share his assessment in an Aug. 23 speech in Germany, before heading to the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.  Investors will scrutinize his comments for any clues on the future path of stimulus.  Before breaking for the summer, policy makers signaled that they’re getting closer to phasing out quantitative easing, currently scheduled to run at a pace of 60 billion euros ($70 billion) a month through December.  “It’s all about inflation now,” Florian Hense, European economist at Berenberg Bank in London, said before the report.  “Draghi is sounding slightly more confident that core inflation will indeed respond to the resilient recovery, but so far it hasn’t translated into stronger price dynamics.”  The Governing Council holds its next policy meeting on Sept. 7. 

As always, stay tuned!

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