Will Higher Interest Rates Tame Inflation?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

September 19, 2022

We know many people think we are beating a dead horse, but this horse is far from dead. Instead, she’s in the middle of one of the most important races of her life. What we have been talking about – and will keep talking about until we think Americans understand it – is monetary policy and the Federal Reserve.

Ludwig von Mises once said that the value of money is at least as important to a society as its Constitution. The value of money should be sacrosanct, and Government, if that’s who’s in charge of it, has a responsibility to keep it stable. Fourteen years ago the Federal Reserve completely changed the way it manages the value of our money when it shifted monetary policy from a “scarce reserve” model to an “abundant reserve” model, and we believe there is a direct connection between these actions, and the dramatic decline in the value of our money the likes of which we haven’t seen in 40 years. Inflation undermines work, living standards, investments and is a nightmare for future planning. The Fed has failed.

In a scarce reserve model, the Fed can add or subtract reserves from the banking system and through this mechanism push the federal funds rate (FFR) up or down. Banks compete for these reserves and, through a market of bids and asks, set an interest rate for reserves. In an abundant reserve model, there are so many excess reserves that banks don’t need to compete for them. The FFR is essentially zero because only in very special situations do banks need to borrow reserves. So the Fed created an interest rate that it pays on excess reserves (the IOER), which acts as a floor for interest rates, and that rate is whatever the Fed decides it is.

In other words, while under the old system the market was involved in setting interest rates, today, the Fed now artificially sets interest rates. And as you might deduce, if the government sets interest rates, they likely set them lower than they would be if markets decided what interest rate was correct.

The Fed declares success when market rates move with its rates. But this is a test with a determined outcome. If the Fed grew five trillion bushels of corn, and corn was so plentiful that the price per bushel was essentially zero, then no private farm could sell corn for more. If the Fed then raised the price of its corn to $1/bushel, farmers could then sell theirs for 99 cents/bushel, but it’d be a completely manipulated market.

So, while raising interest rates may reduce economic growth and may throw the US into recession, there is no guarantee that this will fix inflation. Interest rates don’t determine inflation; the amount of money circulating in the economy determines inflation. And this is where the problem lies.

The Fed’s balance sheet held $850 billion in reserves at the end of 2007. Today, it is close to $9 trillion. Most of these deposits at the Fed are bank reserves which the Fed created by buying Treasury bonds, much of which was money the Treasury itself handed out during the pandemic. At this point, if we add excess reserves to reverse repos, there are over $5 trillion in excess money in the system.

Technically, banks can do whatever they want with these reserves as long as they meet the capital and liquidity ratio requirements set by regulators. They can hold them at the Fed and get the interest rate the Fed sets, or they can lend them out at current market interest rates. In turn, the big question is whether the Fed can pay banks enough to stop them from lending in the private marketplace and multiplying the money supply.

But we’ve never done this before. We’ve never tried to stop bank lending in an inflationary environment by just raising the IOER. What interest rate is enough? And when will politicians go bonkers over how much the Fed is paying the banks? After all, if we combine how much the Fed pays private (foreign and domestic) entities on both excess reserves and reverse repos, at a 3% rate it will be $150 billion per year.

If the Fed raises rates to 4% under this new method of managing monetary policy, it will pay private entities $200 billion per year! Wait until politicians who love to hate banks find this out! Moreover, the Fed is now losing money on much of its bond portfolio because it bought so many bonds at low interest rates. At some point the Fed will be paying out more in interest than it is earning on its securities.

Jerome Powell was recently asked if he would ever go back to a scarce reserve model. He said no way. He argued that because of recent crises (2008 financial crisis and the Pandemic) this new abundant reserve model is better. To be brief, government always uses crisis to grow and we would have never had the inflation we have today under the old model.

Like the rest of the government, the Fed has become way too big. Too many resources, and too much power in the hands of so few is antithetical to free markets. To say we are worried about this is an understatement. We just wish more people understood it and called the Fed to task. The Fed should return to a scarce reserve model as soon as possible. We feel like Don Quixote, but we won’t stop dreaming.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The Fed: What to Expect and What to Watch

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

September 12, 2022

If you’re still wondering how much the Federal Reserve will raise short-term interest rates next week, you should wonder no more: the Fed is almost certainly going to raise rates by threequarters of a percentage point (75 basis points), just like it did back in both June and July. That’ll put the target short-term rate at 3.125%, the first time it’s been north of 3.0% since early 2008.

Why are we so confident the Fed will raise 75 bps next week? Because Fed Chief Jerome Powell and other policymakers have been sounding hawkish and they haven’t pushed back on the futures market’s expectations of 75 bps. This Fed doesn’t like surprises, so if intended to do 50 bps, it would have pushed back forcefully by now against the expectation of 75 bps.

Beyond this week, we expect smaller, but continued rate hikes, of about 100 basis points total before the Fed is done by early next year. That means getting to around 4.0% on shortterm rates. After that, don’t expect the Fed to cut rates until it is either very confident inflation is heading down toward its 2.0% target or the economy is heading into recession.

But investors need to focus not only on what the Fed is going to do with interest rates, but also on what’s happening with the money supply and bank lending. The world of “abundant reserves” – how the Fed now manages monetary policy, as opposed to the “scarce reserves” system prior to the Financial Panic of 2008 – is an unprecedented, experimental, and potentially volatile world.

The M2 measure of the money supply grew a very rapid 24.8% in 2020 and 12.4% in 2021. Year-to-date through July, M2 has grown at only a 1.8% annual rate in 2022. Since inflation came from this money printing, we see this as progress!

However, bank credit (all securities, loans and leases on banks’ books) keeps expanding, having grown 8.6% in 2020, 9.1% in 2021, and 8.6% annualized through August in 2022. We will be watching both sets of figures, M2 and bank credit. If the Fed gets its way, bank credit should slow as the Fed’s higher interest payments to banks deter more lending. Remember, in the abundant reserve system, the Fed pays banks interest to do nothing with their reserves! If bank credit keeps expanding rapidly into next year, the Fed may have to keep rates moving significantly higher than 4.0% to shrink the amount of money circulating.

The problem is that the Fed thinks it can manage both real economic growth and inflation just by targeting short-term rates. We think the jury is still out and won’t be coming to a verdict anytime soon. Essentially, the Fed is hoping that it can pay banks enough to prevent them from lending, even though Powell says inflation came from the pandemic, not bad monetary policy. That process of tightening is in stark contrast to the old system, where the Fed would directly withdraw liquidity from the banks.

In this precarious environment, we are sticking to our view that the US stock market is “range bound.” (See MMO, June 21, 2022). It will not get back into a long-term bull market at least until we know how far the Fed has to go to control inflation and probably not until the next recession has started.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Home Prices Plateauing, Rents Catching Up

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

September 6, 2022

The housing sector surged during COVID in large part due to loose money. The Federal Reserve kept short-term rates artificially low and the M2 measure of the money supply soared. Now, with rising short-term rates and slower growth in M2 sending mortgage rates higher, the housing sector has a bad case of indigestion. Sales are down, construction is down, and the most recent reports on home prices show a sudden and sharp deceleration.

This should sound familiar, because it’s very similar to what happened to “real” (inflation-adjusted) retail sales. Sales soared in 2021 but have since plateaued, as growth in consumer spending has come from services, not goods. Expect something similar in the next few years with housing, with national average home prices roughly unchanged while rents continue to catch up.

Recent problems in the housing sector are widespread. Existing home sales have dropped for six straight months and, with the exception of the first few months of COVID, are the slowest since 2015. New home sales are the slowest since early 2016, even if you include those horrible first few months of COVID.

Private residential construction rose for twenty-four straight months through May and has now declined for two straight months. Meanwhile, after peaking at a 1.805 million annual rate in April, housing starts fell almost 20% to a 1.446 million rate in July. In time, fewer housing starts today will lead to less overall construction and home completions later this year.

But perhaps the most dramatic change is on prices. The national Case-Shiller index rose more than 1.0% in every month from August 2020 through May 2022. Every single month. Home prices rose a total of 8.9% in the first five months of 2022. More of the same. But then came June, when prices rose a meager 0.3%.

As a result, some are thinking we are in for a massive housing bust the kind of which hit the US after the last boom in the 2000s. But we think that’s highly unlikely. Housing is going to feel some pain, but we are facing nothing like what happened in the last housing bust.

Last time, national average home prices bottomed in 2012 about 25% below where they peaked in 2007. From peak to bottom, housing starts plummeted 79.0% and new home sales fell 80.6%. These are not typos! Existing home sales dropped 52.3%. Mix all these changes with mark-to-market accounting and no wonder we had a Financial Crisis and the Great Recession. That’s not happening this time around.

So why do we think we are not in for a huge housing disaster like last time? First, because the last housing bust was preceded by several years of massive overbuilding. We simply had too many homes; too many homes available for sale, as well as too many homes available to rent. By contrast, the most recent turbulence in the housing market has not been preceded by overbuilding. If anything, we’ve built too few homes in the past decade, not too many.

Second, although home prices have risen substantially since 2020, relative to replacement cost, they are only up about 2% and only about 4% higher than the median in the past forty years. No big deal. Why does replacement cost matter? Because the more it costs to replace your home, the more your current home is worth. So, yes, home prices are up substantially, but if the costs of copper pipe, drywall, lumber, and labor are up, too, then it makes some sense for home prices to be up, as well.

Third, rents should continue to rise at a rapid pace, putting a sturdier floor under home values. In the last housing crisis, not only did home prices fall but housing rents decelerated sharply and then temporarily went negative, as well. Think about that: many people were leaving home-ownership but landlords couldn’t squeeze them for more rent because there were simply too many homes.

Now, in the current environment, where higher mortgage rates are persuading some potential home buyers to remain renters, landlords are in a much stronger position. They can keep raising rents because the market isn’t oversupplied with homes. And, in turn, higher rents should keep home prices from falling like in the prior housing bust. The more a home can generate in rent, the more valuable the home.

The bottom line is that what we are seeing right now in the housing market is a bad case of indigestion from higher interest rates. Due to overly loose monetary policy and other COVID-related policies, home prices got too high versus rents in the past couple of years and both prices and rents need to correct. We project continued gains in rents in the next few years as home prices are roughly unchanged. The maximum drop in home prices from the peak to the bottom in this cycle should be around 5%, not a 25% implosion like last time.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Braving bear markets: 5 lessons from seasoned investors

BY: CAPITAL INTERNATIONAL ASSET MANAGEMENT

JULY 20, 2022

“No one knows when this decline will end, but I am confident it will end, so I encourage you not to get caught up in pessimism,” says equity portfolio manager Don O’Neal, who has 36 years of investment experience and has navigated several bear markets. “Declines create opportunities for investors who remain calm. If we make good decisions in times of stress, we can potentially set up the next several years for strong returns.”

To read more important information from this article, click on the link below!

https://advisoranalyst.com/2022/07/20/braving-bear-markets-5-lessons-from-seasoned-investors.html/

Fed is once bitten, twice shy on inflation

ECONOMY & POLICY

August 30, 2022

The Fed is hesitant to let up on inflation after its "transitory" misstep, said Larry Adam, chief investment officer at Raymond James.

As we approach the unofficial end of the summer with the upcoming Labor Day holiday, financial markets are laboring after the recent bounce back in equities. However, we continue to stress three dynamics when it comes to investing: perspective, patience and probing beyond the headlines. With regard to perspective, investors had been enjoying a strong summer rally, with the S&P 500 set for its strongest two-month period (+15.3%) since August 2020 – a return that would fall in the 99th percentile over the last 20 years. But recent downside volatility, with the S&P 500 trading 6.4% lower over the last nine days, was not unexpected as the index’s rapid rally took it above our year-end target of 4,180 and the market was in need of a digestive period. Patience is a virtue and neither the Fed, the economy, nor financial markets can adapt as quickly as investors would like. It takes time to unwind from the pandemic and war-induced drivers of inflation over the last two years! And third, and most important, investors need to probe beyond the headlines to understand the true underlying fundamentals.

One print doesn't make a pattern

Many economists and financial market pundits deemed the Fed’s use of the word "transitory" as the "worst call in the history of the Federal Reserve." While the definition can be debated (e.g., how long is transitory?) and other factors such as the Russia/Ukraine war put undue pressure on energy and agricultural inflation, the result is that elevated inflationary pressures have lasted longer than the Fed originally expected. Therefore, Chairman Powell’s rhetoric at the Jackson Hole Symposium on August 26 may be a reflection of the committee being “once bitten, twice shy.” In other words, psychologically, the Fed and Chair Powell do not want to make a second incorrect call and jeopardize their credibility. As a result, to exude confidence and control of the inflation and policy narrative, it is understandable that Chairman Powell would not declare premature victory over inflation and reaffirmed that interest rates would remain higher for longer until a sustainable, consistent streak (e.g., more than the one-month improvement we have seen in official inflation data) of easing pricing pressures was realized.

In our view, that pattern could well develop this fall and lead the Fed to eventually become less aggressive about raising rates as we go into 2023. Another aspect that frustrated the Fed was the fact that with the tightening cycle not even completed yet, the futures market was reflecting 50 basis points of interest rate cuts in 2023. But Chairman Powell’s latest commentary reined in these expectations, as the market’s prospects of cutting interest rates next year was erased. To be clear, the good news is that we are seeing the early signs that inflation is beginning to moderate, as gasoline is down over $1 per gallon from its recent peak and both the Consumer Price Index and the Producer Price Index declined on a monthly basis for the first time since mid-2020 in July. Our expectation remains that the Fed will raise interest rates 50 basis points at the September FOMC meeting (September 20-21), which from a historical perspective, is still aggressive. In fact, out of the 61 rate hikes dating back to 1985, only 20% of them have been of this magnitude or greater (only 12% have been 0.75% or greater). The economy still has to digest all the interest rate hikes this year as monetary policy acts with a lag of six to nine months. As a result, our economist reiterates his base case expectation of the fed funds rate peaking at 3.5% this year and remaining on hold throughout 2023.

No silo mentality

The recent equity weakness is driven by more than the U.S. economy, as other parts of the global economy have been on the brink of recession for months. More specifically, recessionary risks have been plaguing Europe, as elevated energy prices are prolonging the peak in inflation (e.g., the U.S. is past its inflation peak and Europe is on the way to its peak), the weakening of the euro has compounded the reduction in purchasing power (especially for commodities priced in dollars such as oil), and the European Central Bank (ECB) is poised to raise interest rates into a visibly weakening economy. With double-digit inflation in nearly half of the EU countries, the ECB halted its bond buying program, launched a crisis tool to counter rapidly rising interest rates and widening sovereign spreads, and lifted interest rates by 50 basis points last month – its first rate hike in over a decade. Given that this move brought the target rate to 0%, the ECB is forecast to raise rates by a similar magnitude at its next meeting (September 8). Tightening monetary policy in a weakening economic scenario is a recipe that could, as central bankers around the world have argued, result in “some pain” and “sacrifice” on behalf of consumers and businesses. It’s worth noting that the ECB’s decision to increase rates will be preceded by the Bank of Canada (September 7) and followed by the Bank of England (September 15) and Federal Reserve (September 21). The coordinated tightening by more than 80 central banks this year has continually weighed on economies and the potential negative ramifications have kept investors on edge. 

From micro to macro

The 2Q22 earnings season was under the microscope, as investors not only wanted to see the strength of corporate earnings but also needed to hear forward-looking commentary from CEOs about the status of the economy and their businesses. Why? To get more insights into the "boots on the ground" status of the economy. The results? Robust 2Q earnings were not consistent with the recessionary conditions that headlines were insinuating and corporate guidance was much better than feared—at least not recessionary in the near term. And while 2Q earnings growth of 7% was not nearly as impressive as the double-digit quarters we saw through 2021, healthy sales revenues and margins highlighted the effectiveness of corporate America. In addition, contrary to expectations, there was evidence of resilient consumer spending patterns and healthy levels of credit usage despite pricing pressures. This better-than-expected outcome helped the S&P 500 rally 14% from the unofficial start (e.g., big banks reporting) through the unofficial end (e.g., the big box retailers) of the reporting season—the best performance during the earnings season since 1Q97. Now, with earnings results no longer the focus, the equity market is transitioning its attention from the micro (e.g., earnings releases) to the macro (e.g., jobs, inflation, growth, etc.). With recessionary concerns and fears of too much tightening remaining consequential risks, the upcoming Consumer Confidence (August 30), ISM Manufacturing (September 1), employment (September 2), and CPI (September 13) reports could lead to some interim volatility. 

September slowdown

While we place more emphasis on the fundamentals, it is worth noting that the August through September time period has historically been the weakest two-month time period for the equity market. In fact, the S&P 500 has declined ~0.5% on average since 1950 while all other rolling two-month returns are positive. What doesn’t help is that trading volumes are historically depressed during this vacation-laden period so any moves are exacerbated. In addition, midterm election years like the one we are in now have historically compounded the pressure on the markets prior to the election. The good news is that from a historical perspective, both seasonal patterns tend to reverse themselves in the form of a post-midterm election and year-end rally (e.g., November/December). Let’s hope that these patterns repeat themselves this year – especially if inflationary pressures recede as we expect.

The bottom line

The equity market notched an impressive rally after the major indices entered bear market territory, but investors may have gotten ahead of themselves as the S&P 500 soared above our 2022 year-end target of 4,180. Moving forward, positive earnings growth, decelerating inflation, the conclusion of the midterm elections, and positive seasonal factors should help support equity prices by year end. As a result, if weakness in the equity market were to persist, long-term investors could look for buying opportunities should the S&P 500 fall below the 4,000 level. Assuming long-term interest rates are at or near a peak, valuations for equities remain attractive at current levels.

All expressions of opinion reflect the judgment of the author(s) and the Investment Strategy Group, but not necessarily those of Raymond James & Associates, and are subject to change. This information should not be construed as a recommendation. The foregoing content is subject to change at any time without notice. Content provided herein is for informational purposes only. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Economic and market conditions are subject to change. Investing involves risks including the possible loss of capital. Material is provided for informational purposes only and does not constitute a recommendation. Diversification and asset allocation do not ensure a profit or protect against a loss. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Diversification and asset allocation do not ensure a profit or protect against a loss.

The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 7.8 trillion benchmarked to the index, with index assets comprising approximately USD 2.2 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

Who should you choose to execute your estate?

ESTATE & GIVING

When selecting a personal representative to carry out the terms of your will, consider the role's many responsibilities.

Selecting a personal representative for your estate, also known as an executor, is no easy task. While it’s an honor to be chosen as an executor, it’s also a demanding commitment consisting of more than two dozen responsibilities and liabilities. For instance, an executor can be held personally liable for improperly spending estate or trust assets or for allowing insurance coverage on the assets to lapse.

Considering the many responsibilities of an executor, it’s important to take several factors into account when determining who’s right for the role. If you’re in the process of choosing your executor, you’ll want to consider the following.

Trust is key. It might seem obvious, but it’s essential that your executor be someone you trust. Not only will they be held legally liable for any corrupt behavior, but you’ll also be putting your legacy intentions in their hands and relying on them to handle important legal documents, such as annual tax returns, honestly and appropriately.

Responsible parties only. Your executor should be a responsible individual who is able to fulfill the time commitment and duties of their role, as well as manage the inherent legal liabilities. For example, if an executor fails to pay taxes or file tax returns in a timely manner, it can throw a wrench in tax-minimization strategies and expose your estate to interest charges and penalties. That’s why it’s crucial to choose someone you can rely on.

Ban biases. Your first choice for an executor may be a family member or friend. Keep in mind, however, that the person you choose should be able to act in an impartial way. If the beneficiaries of your estate believe that your executor has ulterior motives and harbors bias (or can’t be impartial), it can cause unnecessary tensions and legal battles.

Set yourself and your executor up for success

After choosing your executor, you’ll want to take certain steps to help set them – and yourself – up for success.

Establish realistic expectations. Once you decide on an executor, it’s important to sit down with them and explain why you consider them the best person for the position. You’ll want to relay the level of commitment involved and give them time to decide whether they can accept the responsibilities accompanying the role. You’ll also want to have a second person in mind in case your first choice is unable or unwilling to accept the role.

Determine their digital access. It’s important that your executor have access to the digital documents they need to carry out their duties. This can include email or online bank accounts. Without the right passwords or credentials, it can be highly challenging to access digital assets. For instance, Google may provide the contents of a deceased user’s account if the family produces proof of death, but Yahoo accounts require a court order to access accounts without a password. To help prevent unnecessary headaches, you’ll want to provide your executor with the proper digital access. Fortunately, you have different options for how to store and share your information securely, such as with the help of an online tool like Everplans.

A final note

So, who is the most appropriate person to appoint as a personal representative? A digital sleuth with accounting acumen and the skills of a diplomat? Most of us don’t have that person on speed dial. Thankfully, there are several ways to help ensure that your estate is settled properly.

If it’s impartiality and expertise you’re looking for, a corporate personal representative might be an appropriate choice. For instance, a corporate executor can offer their guidance and experience to help ensure assets are distributed according to your wishes, reduce unnecessary expenses, and achieve the most efficient and accurate settlement of your estate with the lowest costs possible. Alternatively, you could appoint both a corporation and an individual to serve as co-executors, or name a corporation as agent for the personal representative, offering an assist to this important role.

Being named a personal representative is an honor, but there’s a reason that it’s often a paid position: It’s a job unto itself. If you want to choose the best fit for the role, it’s important to understand the realities of the position and know the steps you can take to help ensure your estate ends up in the right hands.

Raymond James and its advisors do not offer legal advice. You should discuss any legal matters with the appropriate professional. Raymond James is not affiliated with Everplans.

Biden’s Student-Loan Fiasco

First Trust MMO

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

The Dow Jones Industrial Average fell more than 1,000 points on Friday, caused apparently by Fed Chairman Jerome Powell’s attempt to use a brief speech to channel the ghost of Paul Volcker. Obviously, this was part of the market’s worries, but the stage was set when the Biden Administration announced a student loan forgiveness program last week. The more we learn about this, the worse it looks.

The executive order would send an already very bad student loan system – a system designed more to create jobs for academics then to really help students – into overdrive, generating huge costs for taxpayers, soaring college prices, and a massive shift in resources toward the already bloated college sector, which already generates negative marginal value-added for both students and our country.

The Biden Administration says the changes would cost $240 billion in the next ten years. The Committee for a Responsible Federal Budget says $440 - 600 billion. A budget model from Wharton says $1 trillion. But even that $1 trillion figure might be way too low.

The key is that, as bad as it is, the cancellation of some student debt that already exists is only a small part of the policy change. The much bigger change, and the one that the market has finally begun to absorb, is limiting future payments on debts to 5% of income, but only after the borrower’s income rises above roughly $30,000 per year. For example, if someone makes $70,000 per year, then no matter how much they borrow they’re limited to paying $2,000 per year (5% of the extra $40,000). After twenty years, any remaining debt would simply disappear. Think about the perverse incentives!

For the vast majority of students, choosing this “income based repayment” system would be a no brainer. And once they pick it, they wouldn’t care at all whether their college charges $35,000 per year (tuition, room, board, and fees), $85,000, or even $150,000. In fact, students would have an incentive to pick the priciest college with the best amenities they could find and pay for it all with federal loan money, because their repayments are capped. If you always wanted Rodney Dangerfield’s dorm room from the movie Back to School, you’re in luck!

Meanwhile, students would have the incentive to take out loans greater than what they need because they can turn the excess into cash for “living expenses.” Then they could use it to buy crypto, throw parties, or pretty much anything else. Who cares?!? The government would limit their future repayments.

And here’s what might be the worst part: colleges would have an incentive to enroll students even if they have horrible future job and earning prospects. By enrolling people no matter how poorly prepared they are, a college can charge whatever they want and get huge checks from the federal government. And the unprepared students won’t care because they really don’t have to pay it back. In effect, colleges could create massive and perfectly legal money-laundering schemes.

We are not legal experts and do not know whether the new proposal will be implemented fully. But, if it is, watch out: college costs are poised to skyrocket and academia is courting a political backlash of enormous proportions. Meanwhile, the market is attempting to digest just how far from economic reality politicians have become. The political allocation of capital is a recipe for economic disaster.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance.

Distorted

First Trust MMO

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

One thing we must remember when looking at economic data, is that everything is distorted. The US (in fact, much of the world) panicked in 2020. COVID caused governments around the world to implement unprecedented policies. The US borrowed, printed, and spent its way through the lockdowns. We believe, and we don’t think it’s hard to understand, that the economic bill for these policies, is soon coming due.

We don’t expect a recession like in 2020, or a repeat of the Great Recession in 2008-09, but the unemployment rate will eventually go up, job growth will go negative, industrial production will fall, and so will corporate profits. At that point we won’t have a big debate about whether we’re in a recession; everyone will know it.

In the meantime, before a real recession sets in sometime in 2023 or early 2024, many people will believe the recession is already here. Especially, as the shift away from goods and toward services gathers steam.

Right before COVID started, in February 2020, “real” (inflation-adjusted) consumer spending on services was 64% of all real consumer spending. With the economy locked down, services fell to 59% of spending by March 2021. That five-percentage point decline represented roughly $700 billion of spending. Consumers have clawed some of that back with services now up to 62% of total spending, with big recoveries in health care, recreation, travel, restaurants, bars, and hotels. And, we expect this trend to continue.

Yes, companies like Peloton and Carvana, where investors apparently projected COVID-related trends to persist, have gotten hammered. Some look at layoffs at these companies, and others in similar straights, as a sign that recession is already here. But these aren’t macro-related developments; they are a realignment of economic activity from a distorted world to a more normal one.

Another distortion from COVID policies was a big drop in labor force participation, which is the share of adults who are either working or looking for work. The participation rate was 63.4% in 2020 but now, even though the unemployment rate is back down to the pre-COVID low of 3.5%, participation is only 62.1%.

Part of the problem might be inflation. “Real” hourly earnings are lower than they were pre-COVID. So fewer people might be participating, despite low unemployment, because they (correctly) realize the real value of work is less than it used to be. Another problem is that big-box stores and Amazon stayed open, while many small businesses in certain states were closed. Whether this represents a permanent shift in employment and productivity, or a temporary one, remains unclear.

Yet another shift is in housing. Home prices soared during COVID, with the national Case-Shiller home price index up a total of 41.4% rate in the past 27 months (through May 2022). That’s the fastest increase for any 27-month period on record, even faster than during the “housing bubble” of the 2000s. Meanwhile, with the government preventing landlords from evicting tenants, rent payments grew unusually slowly during the first eighteen months of COVID.

But now rent payments are catching up. Expect a major transition in the next few years, with rents continuing to grow rapidly while home price gains slow to a trickle by late this year and then home prices remain roughly unchanged in the following few years.

What a fiasco. More employment at large firms, less at small firms. More renters, fewer owners. Lower inflation adjusted incomes. Distorted economic data. The costs of the lockdowns, one of the biggest policy mistakes in US history, are absolutely immense.

Voters will react, and at least one house of Congress is likely to go the opposition party this November, meaning legislative gridlock for the next two years as the nation sorts all of this out.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Silly Season

First Trust – MMO

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

With less than three months left before the 2022 midterm elections, it is officially silly season when it comes to interpreting economic reports. For many analysts it’s pretty much all politics all the time, with data seen through a political lens first, and with real unbiased economic analysis coming maybe second, if ever.

It started off with those saying we’re in a recession because, at least based on the most recent reports, real GDP declined in both of the first and second quarters of the year. Never mind that the unemployment rate has dropped 0.4 percentage points so far this year. Never mind that payrolls are up an average of 471,000 per month, while industrial production is up at a 5.2% annual rate over the first six months of the year. Never mind that “real” (inflationadjusted) gross domestic income was up in the first quarter (we’re still waiting for Q2 data) and has just as good of a track record as real GDP.

Ultimately, those claiming a recession started already wanted to score political points against the President and no other reports besides GDP would stand between them and that goal. Our view is that a recession is coming, that monetary policy will have to get unusually tight for the Federal Reserve to bring inflation back down to its 2.0% target. In turn, tighter money should induce a recession. But that takes time and the recession hasn’t started yet.

And now it’s the President and his side of the political aisle who are abusing economic reports for their own political ends. It is entirely true that the consumer price index was unchanged in July, the first month without an increase since May 2020. Fair enough. But to use that to suggest the inflation problem is going away is nonsense on stilts.

Energy prices surged 7.5% in June and then dropped 4.6% in July. That’s it. That’s really all you need to know about inflation in the past two months. As a result, overall consumer prices soared 1.3% in June and then were unchanged in July. But a new trend this doesn’t make. Looking at both June and July, combined, consumer prices rose at an annualized 8.1% rate. That is no different at all than the 8.1% annualized increase in April and May, before the extra surge in energy prices in June then the drop in July.

If you look at the unchanged CPI in July and think the Federal Reserve is nearly done, you’re in for a big surprise. The Fed isn’t close to done. Yes, if you follow consumer prices on a year-ago comparison basis, the inflation rate likely peaked at 9.1% in June. But getting from 9.1% down to the 5 – 6% range by sometime next year is the relatively easy part. Getting from there back down near the Fed’s 2.0% target is the hard part. Rents have been increasing rapidly around the country and we don’t see that ending anytime soon, which will make it very tough for the Fed to reach its stated goal.

You’re also deluding yourself if you think the officially-called “Inflation Reduction Act” is actually going to reduce inflation. Inflation is a monetary phenomenon; the bill isn’t going to have any noticeable impact at all.

The bottom line is that, for now, the economy continues to grow and inflation remains a very serious problem. In the meantime, investors need to set aside their personal political preferences and follow economic reports as they are, not as they want them to be because of the political spin their side gets to put on them.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James. All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Still No Recession

First Trust - Monday Morning Outlook

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

To many investors, this week’s GDP report is more important than usual. The reason is that real GDP declined in the first quarter and might have declined again in Q2. If so, this could mean two straight quarters of negative growth, which is the rule of thumb definition many use for a recession.

We think these investors are paying too much attention to the GDP numbers; the US is not in a recession, at least not yet. Industrial production rose at a 4.8% annual rate in the first quarter and at a 6.2% rate in Q2. Unemployment is lower now than at the end of 2021. Payrolls grew at a monthly rate of 539,000 in the first quarter and 375,000 in Q2. If we were already in a recession, none of this would have happened. That’s why the National Bureau of Economic Research, the “official” arbiter of recessions, uses a wide range of data when assessing whether the economy is shrinking.

In addition, it’s important to recognize that once a year the government goes back and revises all the GDP data for the past several years. That happens in July, including with the report arriving this Thursday. Given the strength in jobs and industrial production, it wouldn’t surprise us at all if Q1 is eventually revised positive.

In the meantime, we are forecasting growth at a +0.5% annual rate in Q2. Here’s how we get there.

Consumption: “Real” (inflation-adjusted) retail sales outside the auto sector grew at a 2.2% annual rate, and it looks like real services spending should be up at a solid pace, as well. However, car and light truck sales fell at a 19.7% rate. Putting it all together, we estimate real consumer spending on goods and services, combined, increased at a modest 1.2% rate, adding 0.8 points to the real GDP growth rate (1.2 times the consumption share of GDP, which is 68%, equals 0.8).

Business Investment: We estimate a 5.5% annual growth rate for business equipment investment, a 7.5% gain in intellectual property, but a 4.0% decline in commercial construction. Combined, business investment looks like it grew at a 4.4% rate, which would add 0.6 points to real GDP growth. (4.4 times the 14% business investment share of GDP equals 0.6).

Home Building: Residential construction looks like it contracted at a 4.0% annual rate. Mortgage rates should eventually become a headwind, but, for now, it looks like an increase in spending on construction was more than accounted for by inflation in construction costs. A decline at a 4.0% rate would subtract 0.2 points from real GDP growth. (-4.0 times the 5% residential construction share of GDP equals -0.2).

Government: Remember, only direct government purchases of goods and services (and not transfer payments like unemployment insurance) count when calculating GDP. We estimate these purchases – which represents a 17% share of GDP – were roughly unchanged, which means zero effect on real GDP.

Trade: Exports have surged through May while imports, after spiking late in the first quarter, have remained roughly flat so far in Q2. That means a smaller trade deficit. At present, we’re projecting net exports will add 1.0 point to real GDP growth, although a report on the trade deficit in June, which arrives on July 27, may alter that forecast.

Inventories: Inventories look like they grew at a slower pace in the second quarter than they did in Q1, suggesting a drag of about 1.7 points on the growth rate of real GDP. However, just like with trade, a report out July 27 may alter this forecast.

Add it all up, and we get 0.5% annual real GDP growth for the second quarter. Monetary policy will eventually tighten enough to cause a recession, but that recession hasn’t started yet.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Refocusing the Fed

First Trust Monday Morning Outlook

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

If you follow the financial press, the conventional wisdom has come to the simple conclusion that the way to fight inflation is raising interest rates. Unfortunately, this is just not true. Yes, raising rates may slow the economy, but that alone won’t fix inflation.

Starting in 2009, for seven years the Federal Reserve held the federal funds rate at zero and yet inflation never accelerated. So, if seven years of zero percent interest rates didn’t cause inflation, why would the last two years do it? Even though everyone talks about interest rates, it is really money supply growth that matters. We follow M2 because that is what Milton Friedman told us to follow. M2 is currency in circulation plus all deposits in all banks

(checking, saving, money markets, CDs).

If M2 rises by 10%, we would expect a 10% increase in overall spending. Some of that would be soaked up by real increases in output, but the rest would go to inflation.

From February 2020 – December of 2021, M2 grew at an 18% annual rate. No wonder inflation has climbed to 9%. Raising interest rates, by itself, will not stop this inflation. The way to stop it is by slowing growth in M2 to a low enough rate, for long enough, to allow the economy to absorb the excess money.

That is exactly what happened in the early 1980s when Paul Volcker altered the focus of the Federal Reserve toward money. Prior to Volcker, in the 1970s, the Fed would talk about what level of the federal funds rate it was aiming for, and people started to believe it was the level of rates that mattered. But this was never the case. The Fed consistently held rates lower than a free market (and the level of inflation) suggested it should, because that’s what politicians wanted. In order to do that, it would add more money to the system than real growth required, causing inflation.

In the late 1970’s, Paul Volcker turned this approach on its head. He understood (because of Friedman) that it was money supply growth that mattered. So, he targeted money growth and let interest rates go wherever they may. Some people believe he tightened money too much, and with interest rates spiking well above inflation, close to 20%, this may have been the case.

But it is also why inflation fell. He kept money tight until it was all absorbed and inflation was tamed. It was slower money supply growth, not higher rates that stopped inflation. At the same time, Ronald Reagan cut regulations, tax rates and slowed government spending. This let real economic output accelerate, also helping absorb some of the excess money of the 1970s.

So, if we learned that lesson once, why do we have to learn it again? Part of the answer is that the Fed shifted from a “scarce reserve” policy to an “abundant reserve” policy in 2008. This is what Quantitative Easing (QE) was all about. Under the old “scarce reserve” model the Fed bought bonds from the banking system to increase the money supply and this brought interest rates down. When it sold bonds to banks, the opposite happened. The reason this worked so well is that banks had few, if any, excess reserves. Banks used every dollar created.

Think of it this way. At the end of 2007, the Fed’s balance sheet (basically bank reserves) totaled roughly $850 billion. The M2 money supply (all deposits in all banks) equaled roughly $8 trillion. Banks held roughly $1 in reserves for every $9 in deposits. The “money multiplier” – how many dollars of M2 circulated relative to reserves held at the Fed – was about 9.

But this all changed in 2008. With QE 1, 2 & 3, and then more QE during 2020/21 the Fed increased its balance sheet ten-fold. The Fed’s balance sheet is now roughly $9 trillion, while M2 has grown to $22 trillion. In other words, banks only have about $2.5 of M2 per $1 of reserves, not $9. The Money Multiplier has collapsed, while excess reserves have soared. The Fed has grown tremendously relative to the economy and the banking system. Why? We could speculate on that…after all, some politicians want to nationalize the banking system. But the “how” is equally important.

Back in the 1970s, one of the Fed’s tools was to use reserve requirements to manage money. If the Fed raised reserve requirements it could slow down money creation. Today, with so many excess reserves in the system ($3.3 trillion at last count), the Fed and other banking regulators have layered regulations on banks, pushing required capital ratios from 4%, to 6%, to 10%, or higher. “Reserve requirements” have been replaced by direct regulation on how much capital a bank must hold.

This is why the 2008-2014 QE did not create inflation. The Fed grew its balance sheet, but it also increased capital requirements which kept the banks from multiplying those

new reserves.

The pandemic response was different. The Fed monetized Treasury debt (created new money to buy bonds). At the same time the Treasury and Congress used banks (through PPP loans and direct deposit stimulus checks) to distribute “stimulus” and the Fed eased liquidity rules to allow this to happen. M2 growth exploded. In fact, it has grown 41% since February 2020.

So, how does this get reversed? Once the Fed allows more M2 to be created, it can’t destroy it. All those deposits are owned by someone – you, me, your employer, or the Treasury. The Fed can’t take them away – they are private property.

There are only three ways to limit money supply growth under the “abundant reserve” model. First, by paying banks interest on their reserves at a high enough rate to keep them from lending. But this approach means that at a 3.5% rate, the Fed will be paying private banks roughly $120 billion per year. This may or may not stop them from lending, but it will certainly not make politicians, like Elizabeth Warren, very happy.

Second, the Fed can raise capital requirements, as it is already doing. Last week, JPMorgan was forced to raise its Tier 1 capital ratio to 12.5% from 11.2%. Jamie Dimon, the CEO of JPMorgan said these rules were “capricious” and “arbitrary.” He is correct. They have nothing to do with the banks themselves and have everything to do with slowing money supply growth. At some point, however, this becomes ridiculous. Banks are better capitalized and have more liquidity than they probably ever have.

The third way has little to do with the Fed. If the Treasury ran a surplus, like it did in April, it could reduce its debt and allow the Fed to let bonds mature. But this is unlikely to last. The US has what appears to be a permanent budget deficit and that is unlikely to change under current leadership.

We are not saying that raising interest rates won’t cause a recession. What we are saying is no country in the world has ever had massive inflation problems under the new “abundant reserve” policy model. We are in uncharted territory. Raising rates alone is an untested tool to slow or stop M2 growth.

Some people say that the velocity of money is falling and so we don’t need to worry about M2 as much. Slower velocity will help get inflation back down and keep it there. Slower velocity means every dollar boosts economic activity by less than it used to. But this is a feature of the abundant reserve model, not a bug. As the Fed grows its balance sheet, bank balance sheets grow as well, but this money is not allowed to circulate because of higher and higher capital requirements. That’s why velocity has fallen. Velocity itself has not changed, money has.

The thing that worries us the most is that the Fed will keep growing its balance sheet and government’s power by regulating banks to the point where capital requirements hit

ridiculously high levels.

And this brings us back to Paul Volcker and Ronald Reagan. By slowing the growth of money, Volcker took the Fed out of the business of juicing the economy. By cutting tax rates and reducing regulations, Reagan revived the private sector. This ended stagflation and led to a boom in the economy.

How do we end the current trajectory and fix our problems all over again? Our answer would be to shrink the size of the Fed’s balance sheet by massive amounts. It is way too big, and it is regulating banks in an extraordinary and unprecedented fashion. And while we sound like a broken record, shrink the size and scope of the federal government as well!

Putting these two policies together, just like the US did in the early 1980s, will end the stagflation we haven’t seen since the 1970s.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James. All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Mortgage Reset Alarmism Is Off the Mark

First Trust Monday Morning Outlook

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

Some investors think the US is already in a recession. As we wrote two weeks ago and as recent data have confirmed, we don’t think that’s the case.

Industrial production is up at a rapid pace so far this year, while payrolls have expanded at a monthly pace of 457,000 and the unemployment rate has dropped to 3.6% from 3.9%. Real gross domestic income (Real GDI), a companion to real GDP that is just as accurate, but which arrives a month later, rose at a 1.8% annualized rate in Q1.

Nonetheless, the recession story is out there and some claim adjustable-rate mortgage resets are going to knock the economic legs out from under consumers. The idea is that with the Fed raising rates rapidly, as the rate on adjustable mortgages reset, homeowners are going to have to make higher payments, which means less money to spend on other goods and services.

Let’s start off by noting the most basic problem with this theory, which is that even if mortgage resets increase some families’ payments, the holders of those mortgages will get the extra payments and their purchasing power will increase. On net, purchasing power should remain unchanged.

But, to be cautious, let’s indulge the reset theory by pretending the extra payments are money that just disappears, with no one on the other side of the transaction. Even then, our calculations show the theory doesn’t add up.

Households have about $12 trillion in mortgage debt, according to the Federal Reserve, so, yes, the top-line number sounds scary. But, according to the Federal Housing Finance Agency, only 3.7% of these loans are adjustable, or about $450 billion. Now let’s say that one-third of these mortgages reset every year. That’s $150 billion worth of mortgages resetting. Still a big number, still potentially scary.

But when we calculate how much a reset would change the payments on these loans the problem suddenly gets much smaller. An extra two percentage points in interest on $150 billion in debt is $3 billion.

Obviously, the people making these extra $3 billion in payments won’t like it. But the extra payments equal only 0.018% of annualized consumer spending. That’s not a typo. Not 1%, not 0.1%, but only 0.018%. Which means that even if all of the $450 billion in adjustable-rate mortgages reset upward by two percentage points at the same time, we’d be talking about 0.05% of annual consumer spending.

The bottom line is that we think a recession is eventually on the way because monetary policy will have to get tight enough to wrestle inflation back down and that should be tight enough to cause a recession starting in late 2023 or beyond. But those rate hikes won’t work like they did in 2006-07 when nearly half of all mortgages were adjustable in ‘05. The mortgage reset story makes superficial sense. But when you work through the actual numbers, it’s not something to worry about.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

How About More Freedom?

First Trust Monday Morning Outlook

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist 

As we celebrate 246 years of national independence, our country is now more than two years into an economic recovery from the two-month COVID Lockdown Depression.  Although the economy has improved dramatically from the complete lockdown bottom in April 2020, it’s still feeling lingering pain from policy mistakes made to address the pandemic.

First the good news.   The unemployment rate is down to 3.6%, very close to where it was before COVID started.  Manufacturing production is 3.8% above where it was pre-COVID.  The problem is that a smaller share of workers are participating in the labor force and the number of jobs still hasn’t fully recovered.  Meanwhile, inflation is running at the fastest pace in forty years.

In our view, we are still suffering from three major policy mistakes.  First, running an overly loose monetary policy.  Second, handing out too many government checks, which allowed American consumers to borrow from future production and spend more in the past two years than they would have if no pandemic had ever occurred.  And third, shutting down many parts of the economy through government mandates at multiple levels.

That last part, the shutdowns, is key because here we are about eighteen months after vaccines were introduced and supply chains are still a mess.  We think much of this represents lingering pain from shutdowns that broke relationships among firms and within firms.  This makes it much tougher for companies to keep up with demand that was temporary and artificially boosted by government stimulus checks.

Markets are extremely robust under normal circumstances.  War, hurricanes, drought, power failures are all disruptive, but markets absorb them and move on.  But, by taking the unprecedented path of shutting down large parts of the economy, government made the recovery process extremely hard.  Markets only work when information (the pricing system) is allowed to function.  It hasn’t functioned properly for over two years now.

The Atlanta Federal Reserve’s GDP Now model is now projecting that real GDP declined at a 2.1% annual rate in the second quarter.  We think that’s way too pessimistic and not consistent with continued increases in industrial production and job growth, both of which are signaling continued economic growth.

Nevertheless, the Atlanta Fed’s model is picking up the cost of the shutdowns and we think the lesson for future policymakers should be obvious: let’s not shutdown the US economy again.  People are much smarter than policymakers think; workers, customers, and private business, all by themselves, without mandates and extra rules, could figure out when to step back from certain high-risk activities and when they don’t have to.

Fortunately, some business leaders are starting to push back against political leaders who think they know how to run the US economy all by themselves.  For example, a recent comment from a consortium of oil companies urged that the author of a White House statement on energy take a basic course in economics.  Another example: Jeff Bezos openly disagreeing with the White House on inflation.

In a sense, the answers to our problems were all around us this past weekend, in all the celebrations of America and in all our connections with family and friends.  The answer is us.  What we need is more of all of us thinking things through on our own, figuring things out, with fewer Washington rules, mandates, and regulations getting in between.  Freedom works.        

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

We’re Not Already in a Recession

First Trust Monday Morning Outlook

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Andrew Opdyke, CFA – Senior Economist

Bryce Gill – Economist

Real GDP declined at a 1.5% annual rate in the first quarter and, as of Friday, the Atlanta Fed’s “GDP Now” model projects zero growth in Q2.

We still think real GDP will turn out to be positive in the second quarter, but if you take the Atlanta GDP Now model at face value, it superficially appears that the odds of having two consecutive quarters of negative growth are close to 50%. That’s important, because two consecutive quarters of negative growth is a rule of thumb that many people use for a recession.

We believe a recession is coming but the US is clearly not in one yet. In the first five months of the year, manufacturing production is up at a 6.6% annual rate, nonfarm payrolls are up at an average monthly pace of 488,000, and the unemployment rate has dropped to 3.6% from 3.9%. Meanwhile, in April, both “real” (inflation adjusted) consumer spending and real personal income (Excluding transfers) were at record highs. If this is a recession, we could use more recessions.

It’s also important to recognize that real gross domestic income (real GDI), an alternative measure of economic output, rose at a 2.1% annual rate in the first quarter. The public pays very little attention to GDI because the government usually takes an additional month to report that data, after GDP is initially released. But, over time, GDI is just as accurate as GDP in describing the performance of the economy.

We’re not saying everything is fine with the US economy. Obviously, inflation is taking a huge bite out of people’s earnings. But the debate about whether we’re in a recession should be about real economic pain, not academic-style semantics or whether we fit some technical definition. That’s the reason the official arbiter of recessions, the National Bureau of Economic Research, weighs jobs, manufacturing, and real incomes, when assessing whether we’re in a recession, not just real GDP.

We suspect that some of this debate is political, with some champing at the bit to claim there’s a recession because they know it hurts the party of the incumbent president in a mid-term election year.

 Again, we expect a recession, with a lag, after monetary policy gets tight. And tight it must get in order to wrestle inflation back down toward the Federal Reserve’s 2.0% target. But that means a recession starting in late 2023 or in 2024, not now.

Even more unlikely is the notion that the US is on the cutting edge of a recession like the one in 2008-09. Bank capital is well above regulatory requirements and we don’t have a mark-to-market accounting rule that will generate a “Fire sale” in bank assets. Nor are we about to have a government lockdown of the private sector, like in 2020.

When it comes, the recession will cause economic pain for many. Recessions always do. But we expect something like the recessions in 1990-91 or 2001, when the unemployment rate went up about 2.0 to 2.5 percentage points, not like the soaring unemployment of the Great Recession or the 2020 Lockdown.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James. All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Unprecedented

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

Strider Elass - Senior Economist

Andrew Opdyke, CFA - Senior Economist

Bryce Gill - Economist

At least a couple of major retailer stocks got clobbered last week as investors sold on reports that they missed earnings estimates.

What’s surprising to us is that the fate of these individual companies was such a surprise to so many investors. Inflation is obviously a problem – retailers often run on very thin margins – but a problem of which investors should have already been well aware.

What we really think is going on is both investors and corporate management are having a hard time understanding the real economic impact of “unprecedented” policies. As a result, normal macroeconomic analysis isn’t as helpful.

Yes, unemployment is very low. Yes, real GDP is up a solid 3.6% from a year ago. But the economy has been deeply influenced the past couple of years by a massive

increase in government spending, COVID-related shutdowns of normal business activity, and a huge increase in the money supply. In turn, the economy is deeply distorted versus where it was before COVID.

Retail sales are up 28.8% versus where they were in February 2020, an incredible surge over twenty-six months. For comparison, retail sales were only up 6.7% in the twenty-six months before COVID started. In other words, retail sales increased roughly 4x the normal pace because of pandemic spending and money printing. That can’t last.

But many firms apparently believed this COVID-era trend would continue, as if it were some sort of new normal. Part of the recent misses in earnings may reflect a generational shift, with a whole new cohort of managers who didn’t have jobs of any significance during the inflationary and Keynesian-dominated 1970s. They saw rising earnings earlier in the pandemic and thought they were brilliant when they were just lucky they were working in the sectors that were temporarily helped by money printing and redistribution. That goes for some retailers and some home exercise equipment and technology companies, as well.

While the government was throwing massive aid at the economy, both fiscal and monetary, government regulations were shutting down competition in certain sectors, particularly small businesses.

But the extra checks stopped in the spring of 2021 and now monetary policy has (finally!) gone into reverse. And so managers who figured they had the golden touch are now finding out their touch isn’t as golden as they thought, and investors are reassessing.

The good news is that while the tide is moving away from some businesses that were helped during COVID, the tide is moving toward some businesses that were substantially hindered by COVID. Goods are hurting while services are still getting back toward normal.

This is consistent with our view that the US is not heading for a recession in 2022. Goods slow down, but services pick up. In turn, it also means stocks should move substantially higher from current levels before the next recession begins, but with different sectors taking the lead versus the COVID era.

Since early 2020, the US has experienced the shortest and sharpest economic Depression/Lockdown in (at least) modern history, paired with an enormous expansion in government spending that is now receding. No one knows for sure how the whole process will play out, but the business winners and losers of the next couple of years are very likely to look a lot different than the last few.

Date/Time (CST) U.S. Economic Data Consensus First Trust Actual Previous

5-24 / 9:00 am New Home Sales – Apr 0.750 Mil 0.761 Mil 0.763 Mil

5-25 / 7:30 am Durable Goods – Apr +0.6% -0.1% +1.1%

7:30 am Durable Goods (Ex-Trans) – Apr +0.5% +0.1% +1.4%

5-26 / 7:30 am Initial Claims May 21 215K 209K 218K

7:30 am Q1 GDP Preliminary Report -1.3% -1.3% -1.4%

7:30 am Q1 GDP Chain Price Index 8.0% 8.0% 8.0%

5-27 / 7:30 am Personal Income – Apr +0.5% +0.5% +0.5%

7:30 am Personal Spending – Apr +0.7% +0.8% +1.1%

9:00 am U. Mich Consumer Sentiment- May 59.1 59.5 59.1

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James. All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Whipping Inflation

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

Strider Elass - Senior Economist

Andrew Opdyke, CFA - Senior Economist

Bryce Gill - Economist

Ultimately, inflation is always and everywhere a monetary phenomenon, as the late great economist Milton Friedman used to say. And so the key to reducing the inflation we’re experiencing today –the highest inflation in forty years – is the Federal Reserve raising short-term interest rates, like it will do on Wednesday, as well as pursuing an aggressive course of Quantitative Tightening.

But the central importance of monetary policy doesn’t mean other policies cant play any role at all wrestling inflation under control. Central banks don’t just exist on the blackboards of academic macroeconomists; they exist in the real world where other officials adopt policies that sometimes make central banks’ jobs easier and sometimes make them harder.

One key issue is the size of government, both spending and regulation. When the federal government spends money like a drunken sailor, as it did during COVID lockdowns, a central bank policy that sets short-term interest rates at essentially zero is going to generate a larger increase in the money supply and, in turn, a larger increase in inflation, than would otherwise be the case. Think of extra government spending as monetary kindling. It doesn’t create fire by itself, but it does make it easier to spread.

So, one way to help the Fed more easily achieve its goal of reducing inflation would be for Congress and the President to find ways to reduce spending. Entitlements, discretionary spending, you name it. No, we’re not being naïve; we know this isn’t happening in 2022. But if it did, inflation would be easier to fight.

In addition, regulations that stifle economic growth could be trimmed, particularly in the energy sector, where the government has directed resources toward politically-favored but relatively inefficient “renewables,” like wind and solar, while stifling development of nuclear power, for example. A world with cheaper, more abundant, energy supplies is one in which real economic growth is faster, which means less of the increase in the money supply winds up generating inflation.

Another area ripe for regulatory reform would be the Jones Act, which dates back to 1920 and requires ships carrying goods between US ports be built, owned, and manned, by American firms. No one is talking about letting North Korea, Russia, or Cuba run these ships. But there are plenty of US allies who could qualify and who could help reduce shipping costs.

Big picture: policymakers should commit to making sure the public knows another COVID-related lockdown is not in the cards, by admitting it was a massive mistake to lock things down in the first place.

Last, but never least, policymakers should consider cutting tax rates to boost work and investment, which, as always, help boost the economy and make inflation easier to control.

Yes, monetary policy is the key ingredient for reducing inflation, but getting other policy oars rowing the right direction can make the Fed’s job easier.

Date/Time (CST)        U.S. Economic Data                              Consensus          First Trust            Actual Previous

5-2 / 9:00 am             ISM Index -Apr                                         57.6                      58.0                       55.4       57.1

9:00 am                        Construction Spending - Mar              +0.8%                    +0.4%                    +0.1%    +0.5%

5-3 / 9:00 am             Factory Order -Mar                                +1.2%                   +1.4%                                    -0.5%

afternoon                    Total Car/Truck Sales -Apr                  14.1 Mil                14.5 Mil                                13.3Mil

afternoon                    Domestic Car/Truck Sales -Apr          10.8 Mil                11.3 Mil                                10.4Mil

5-4 / 7:30 am             Int’l Trade Balance –Mar                     -$107.1Bil            -$107.9Bil                         -$89.2Bil

9:00 am                        ISM Non Mfg Index-Apr                      58.5                       58.9                                       58.3

5-5 / 7:30 am             Initial Claims -April 30                            180K                      180K                                      180K

7:30 am                        Q1 Non-Farm Productivity                   -5.0%                     -7.4%                                     +6.6%

7:30 am                        Q1 Unit Labor Costs                               +10.0%                 +12.5%                                 +0.9%

5-6 / 7:30 am             Non-Farm Payrolls -Apr                         391K                      380K                                      431K

7:30 am                        Private Payrolls -Apr                               395K                      390K                                      426K

7:30 am                        Manufacturing Payrolls -Apr               34K                        20K                                        38K

7:30 am                        Unemployment Rate -Apr                    3.5%                      3.5%                                      3.6%

7:30 am                        Average Hourly Earnings -Apr             +0.4%                    +0.4%                                    +0.4%

7:30 am                        Average Weekly Hours -Apr                34.7                       34.6                                       34.6

9:00 am                        Consumer Credit -Mar                           $25.0Bil                $25.0Bil                              $41.8Bil

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James. All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Slower Growth in Q1

First Trust Monday Morning Outlook

Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
Date: 4/18/2022

Real GDP, in the US, grew 5.5% in 2021, the fastest growth for any calendar year since the Reagan Boom in the mid-1980s. In spite of this, for the two years ending Q4-2021, real GDP grew just 1.6% annually, which is below its pre-shutdown trend.

Because of the shutdown and government actions growth has been uneven. Goods consumption is up 7.5% at an annual rate in the past two years, while services consumption has declined 0.4%. Thanks to a boom in investment during the second half of 2021, investment (including inventories and home building) is up an annualized 5.9% during the past two years.

These uneven growth rates will start to balance out during 2022 and beyond. And in the first quarter of this year, we are tracking a real GDP growth rate of 1.5%, although our forecast may change based on reports to be released in the next week and a half. The bottom line is that this is a far cry from the stellar growth of 2021, but not a recession, either. We expect growth will be a little faster in the second quarter, but, again, not nearly as fast as in 2021.

Right now, the US economy is a battle between forces boosting growth and forces dragging it down. What's supporting growth? First, continued re-opening from COVID-19. Americans are still in the process of returning to normal, but we're not completely there yet.

Second, monetary policy is still very loose. Even if the Federal Reserve raises rates by 2.25 percentage points this year, real interest rates will still be negative and monetary policy will not be tight.

Third, tax rates remain relatively low and are likely to stay that way. Major transformational legislation seems unlikely.

Meanwhile, the economy also faces some headwinds. The Russia-Ukraine War and lockdowns in China are further disruptions to supply chains and the Biden Administration is ramping up regulation, adding to business costs.

Put it all together, positives and negatives, and we're forecasting about 2.5% real GDP growth this year (Q4/Q4), with slower growth in 2023-24 as monetary policy gets tight and the benefits of getting the economy back open eventually run out.

In the meantime, here's how we get to our 1.5% real GDP growth forecast for the first quarter.

Consumption: Car and light truck sales jumped at a 44.2% annual rate in Q1 while "real" (inflation-adjusted) retail sales outside the auto sector rose at a 5.3% rate, and it looks like real services spending should be up at a solid pace, as well. Putting it all together, we estimate real consumer spending on goods and services, combined, increased at a moderate 3.8% annual rate, adding 2.6 points to the real GDP growth rate (3.8 times the consumption share of GDP, which is 68%, equals 2.6).

Business Investment: We estimate an 11.0% growth rate for business equipment investment in the first quarter, with commercial construction unchanged, and investment in intellectual property rising at a typically strong rate. Combined, business investment looks like it grew at an 8.0% annual rate, which would add 1.0 points to real GDP growth. (8.0 times the 13% business investment share of GDP equals 1.0).

Home Building: Residential construction looks like it accelerated to a 6.0% annual rate in the first quarter, with demand for new housing and improvements remaining strong. A growth rate of 6.0% would add 0.3 points to real GDP growth. (6.0 times the 5% residential construction share of GDP equals 0.3).

Government: Remember, only direct government purchases of goods and services (and not transfer payments like unemployment insurance) count when calculating GDP. We estimate federal purchases shrank at a 0.6% annual rate in Q1, which would subtract 0.1 point from real GDP growth. (-0.6 times the 17% government purchase share of GDP equals -0.1).

Trade: Imports have continued to soar in the first quarter while exports have not grown as quickly. As a result, the trade deficit is likely to expand significantly, which will be a temporary drag on real GDP growth in the US. At present, we're projecting that the increase in imports relative to exports will subtract 2.3 points from real GDP growth in Q1, although a report on the trade deficit in March, which arrives on April 27, may alter that forecast.

Inventories: Inventories look like they grew at almost exactly the same pace in the first quarter that they did in the last quarter of 2021. If we're right, that would mean inventories have zero net impact on GDP in Q1.

Add it all up, and we get a 1.5% annualized real GDP growth for the first quarter. Look for continued growth in 2022 but not nearly as fast as in 2021.

Date/Time(CST)    U.S. Economic Data            Consensus            First Trust       Actual     Previous
4-19 / 7:30 am      Housing Starts – Mar          1.740 Mil               1.739 Mil                               1.769 Mil
4-20 / 9:00 am     Existing Home Sales – Mar 5.780 Mil              5.630 Mil                               6.020 Mil
4-21 / 7:30 am      Initial Claims – Apr              16 180K                 175K                                       185K
7:30 am                 Philly Fed Survey – Apr       21.4                         24.1                                        27.4

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James. All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Housing: Heartburn, Not a Heart Attack

First Trust Monday Morning Outlook

Brian S. Wesbury, Chief Economist

April 11, 2022

When interest rates go up, many analysts start to worry about recessions. That’s not wrong to do, after all Federal Reserve rate cycles are important. Lately, the market has settled on expectations for a total of about 2.25% or more of interest rate hikes this year. The result is a jump in many longer-term yields. The 10-year Treasury yield is 2.77%, while the typical 30-year mortgage has climbed from 3.2% in December, according to Bankrate.com, to 5.1% recently.

So, some analysts think that a housing bust is likely, which would drag down the entire economy. We certainly agree that higher mortgage rates will be a headwind for the housing market in the year ahead. But what we see is some heartburn, not a heart attack.

While 5% mortgage rates are high relative to where they were, home prices should still rise 5 - 10% this year, meaning home prices either keep up with or exceed borrowing costs. Real mortgage rates (the rate minus inflation) are still negative.

Negative real rates are also why we are not yet worried about an inverted yield curve from the 2-year Treasury to the 10- year. In the past, when inverted yield curves preceded recessions, real interest rates were positive, not negative.

Now, back to housing…It is true that national home prices have soared in the past couple of years. However, so have construction costs. The Census Bureau’s price-index for singlefamily homes under construction, which does not include the rising cost of land, is up around 25% from two years ago. For 2022, we expect mortgage rates to help slow national average home price increases versus 2020-21, but for prices to still go up in the 5 - 10% range.

By contrast, rents should accelerate for several reasons: (1) general price inflation, (2) the end of the eviction moratorium, (3) higher mortgage rates shifting demand toward renting, and (4) the fact that home prices are already high relative to rents.

Home sales are a different story. Higher mortgage rates make it likely that fewer existing homes should sell in 2022 than in 2021. But this is not the end of the world. Existing homes don’t reflect new construction and add only slightly to GDP (via brokers’ commissions, for example). Existing home sales slowed in 2018 and 2019 and the economy did fine. New home sales should be roughly flat to slightly down this year, but new home sales also fell in 2021 and real GDP grew 5.5%. Again, not the end of the world.

What really matters for the economy is how higher mortgage rates affect the pace of home construction. There, again, we see some heartburn, but no calamity and no collapse. Builders started 1.605 million homes last year and we expect total housing starts to exceed that in 2022. However, starts for the full year will probably lag the 1.713 million annual pace of January and February.

But starts are not the whole story when it comes to home construction. The total amount of construction can rise as builders move toward completing homes they began months ago. And remember: home building includes not only single-family homes but also multi-family units, which captures building designed for people who want to rent.

The US has underbuilt homes for the past decade. Higher mortgage rates don’t change that, although they may shift around the share of the population that rents versus owning. Monetary policy is now getting less loose; that’s going to lead to some indigestion. The real problems won’t start until policy actually gets tight. And for that we have longer to wait.

Date/Time (CST) U.S. Economic Data Consensus First Trust Actual Previous

4-12 / 7:30 am CPI – Mar +1.2% +1.1% +0.8%

7:30 am “Core” CPI – Mar +0.5% +0.5% +0.5%

4-13 / 7:30 am PPI – Mar +1.1% +1.1% +0.8%

7:30 am “Core” PPI – Mar +0.5% +0.7% +0.2%

4-14 / 7:30 am Initial Claims – Apr 9 171K 167K 166K

7:30 am Retail Sales – Mar +0.6% +1.0% +0.3%

7:30 am Retail Sales Ex-Auto – Mar +1.0% +0.9% +0.2%

7:30 am Import Prices – Mar +2.3% +1.5% +1.4%

7:30 am Export Prices – Mar +2.2% +1.5% +3.0%

9:00 am Business Inventories – Feb +1.3% +1.4% +1.1%

9:00 am U. Mich Consumer Sentiment- Apr 59.0 59.4 59.4

4-15 / 7:30 am Empire State Mfg Survey - Apr 1.0 12.2 -11.8

8:15 am Industrial Production – Mar +0.4% +0.3% +0.5%

8:15 am Capacity Utilization – Mar 77.8% 77.8% 77.6%

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Geopolitics Only One Factor in Rising Oil Prices

Markets and Investing

April 7, 2022

Underlying oil market fundamentals – good ol’ supply and demand – are as bullish as they have been over the past decade, says Pavel Molchanov, Managing Director and Energy Analyst for Raymond James Equity Research.

For our readers with investments in the oil value chain, the fact that oil prices reached fourteen-year highs in the early spring of 2022 helps explain the Energy sector’s outperformance year-to-date, building on its gains from 2021, when it had been the best sector in the S&P 500. On the other hand, the oil market rally is also contributing to the global economy’s inflationary spiral, with consumers as well as businesses feeling the pain of high prices at the fuel pump. Whether we like it or not, high oil prices are here to stay. We forecast that West Texas Intermediate (WTI) crude will average $100/barrel (Bbl.) in 2022, with only a modest cool-off to $90/Bbl. in 2023. For some perspective, as recently as December 2021, WTI was in the low $70s. Brent crude, the global benchmark, should remain a few dollars above WTI.

Geopolitics and the oil market

There is no disputing the fact that geopolitical factors played a major role in the oil market rally of recent months. The prime example is the crisis that culminated in Russia’s invasion of Ukraine. Why does this matter for the oil market? Because Russia produces approximately 11 million barrels per day, or 11% of the world’s oil supply – on par with the U.S. and Saudi Arabia – of which7.5 million barrels per day (bpd) is exported, including 4 million bpd that is sold into European countries.

Russia’s natural gas production – three-quarters of which goes to Europe – is even more of a geopolitical hot potato. Thus far during the war, oil and gas pipelines have continued to operate normally. Also thus far, sanctions have had only a peripheral effect on Russia’s energy sector. Germany has made it crystal clear that the Nord Stream 2 gas pipeline – an $11 billion project owned by the Russian gas giant Gazprom – will be blocked from operating for the foreseeable future. The U.S. has imposed an embargo on Russian oil, and the U.K. and Poland plan to do so by year-end 2022, but unless the rest of Europe follows suit, it won’t mean much in practical terms. Separate and distinct from Russia/Ukraine, other geopolitical hotspots that contribute to high oil prices include Libya (the plan to hold a presidential election has broken down); Yemen (the Houthi rebels continue to fire missiles into neighboring countries); and Iran (progress in negotiations toward a new nuclear agreement is uneven, at best).

Supply and demand fundamentals

It is equally true that the underlying oil market fundamentals —good ol’ supply and demand — are as bullish as they have been over the past decade. Our global oil market model points to inventories declining by approximately 2 million bpd in 2022.When inventories are declining, by definition it means that demand is outstripping supply. Demand in 2022 is back to the pre-COVID peak of 100 million bpd. Meanwhile, OPEC has remained very consistent with its roadmap of gradually bringing production back to pre-COVID levels by September 2022. Capital spending by the world’s oil and gas companies is finally recovering from the ultra-austere levels of 2020-2021, but the industry’s commitment to capital discipline is firmly in place. Management teams are accommodating long-standing shareholder demands for less production growth and instead more emphasis on dividends and share repurchases. Even for those companies that are willing to substantially increase capital spending, it will take time for drilling activity to provide a meaningful boost to supply. For North American shale, production uplift will remain muted until2023. For oil-producing regions with mostly long lead time projects, such as Brazil and West Africa, it will take even longer.

Energy transition

The oil industry may be tempted to celebrate that good times are back again, and indeed it is the case that profitability and free cash flow metrics are currently very strong. But high oil prices on a prolonged basis will carry an unavoidable side effect: accelerating the energy transition, away from fossil fuels. Government policies vis-à-vis climate change (such as carbon taxes and petroleum phase-outs) are already pointing consumers and businesses toward low- and zero-emission alternatives. Oil prices at fourteen-year highs are compounding the effect of climate policies, as the economics of electric vehicles look more attractive than they did just a few years ago. As it relates to Europe specifically, there is also the geopolitical urgency of shifting away from Russian oil. The war has dramatically raised the issue of energy security on the agenda across Europe. Germany, whose new coalition government includes the Green Party, is taking the lead: targeting 15 million electric vehicles (EVs) on the road by 2030, which is approximately equivalent to what the entire world currently has. EVs in Germany had a market share of 26% in 2021 (among light-duty auto sales) – the highest of any G20 economy. By comparison, the U.S. was at only5%. If Germany reaches its 2030 EV target, it would have the effect of erasing the need to buy Russian oil ever again.

Taking a global perspective, we forecast light-duty EV market share increasing from 8% in 2021 to 25% in 2025 and 50% in2030. Alongside the demand boost from high fuel prices, expansion of consumer appetite for EVs is being driven by the declining cost of lithium-ion batteries, longer range of those batteries, and a broader array of model choices across the price spectrum. Interestingly, though, the adoption curve is progressing more rapidly in buses as compared to the car market. China is the standout leader in electric buses, though Europe and the U.S. are moving in the same direction. Electrification of trucks is at a very early stage, but if it follows the trajectory of buses, this will imply rapid transformation of truck fleets into the second half of this decade. It is worth noting that sustaining rapid growth in EV sales will require an equally aggressive buildout of charging infrastructure, especially the DC ultra-fast chargers that can make it as convenient as filling up a conventional car at a fuel station, i.e., a mere five to ten minutes.

Read the full Investment Strategy Quarterly here.

All expressions of opinion reflect the judgment the author, the Investment Strategy Committee, or the Chief Investment Office and are subject to change. Past performance may not be indicative of future results. There is no assurance any of the trends mentioned will continue or forecasts will occur. The performance mentioned does not include fees and charges which would reduce an investor’s return. Dividends are not guaranteed and will fluctuate. Investing involves risk including the possible loss of capital. Asset allocation and diversification do not guarantee a profit nor protect against loss. Investing in certain sectors may involve additional risks and may not be appropriate for all investors. The indexes mentioned are unmanaged and an investment cannot be made directly into them. The S&P 500 is an unmanaged index of 500 widely held securities.

We Are All Keynesians Now

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

April 4, 2022

Intellectuals and politicians often try to verbally summarize or justify conventional thinking in pithy ways. Milton Friedman (in 1965) and Richard Nixon (in 1971) both said different versions of the phrase “we are all Keynesians now.”

John Maynard Keynes, one of the most famous economists of all time, supported deficit spending and government manipulation of economic activity. Friedman and Nixon were describing the thoughts behind the implementation of Great Society redistribution programs and an inflationary monetary policy designed to offset the cost of those programs.

If economic policy was Keynesian in the 1960s and 1970s, as policymakers stopped believing in free markets, we are certainly all Keynesians now. COVID spending and monetary policy are a clear continuation of this economic thinking.

It all began in 2008, when the Bush and Obama Administration combined spent $1.5 trillion of taxpayer money to “rescue” the economy and the Federal Reserve started Quantitative Easing. That blueprint of policy response to the Panic of 2008 was used to respond to COVID shutdowns. This time the Federal Government borrowed at least $5 trillion to spend and the Fed increased its balance sheet by over $4.5 trillion.

As a result of the Keynesian policies of the 1970s, the U.S. experienced stagflation (slow growth and high inflation) – with both unemployment and inflation peaking in the double digits. Right now, inflation is 7.9% and the unemployment rate is 3.6%. So while inflation is clearly here, signs of stagflation are harder to find.

That doesn’t mean economic growth isn’t being impacted. There are multiple forces to analyze and untangle to understand everything that lockdowns and government largesse have done.

First, the US economy was artificially boosted by borrowing money and distributing it through PPP loans and pandemic benefits. Case in point, retail sales are up 25.2% between February 2020 and February 2022, while industrial production is up just 2.3%, and the US has 1.6 million fewer jobs than it did pre-lockdown. The good news is that unlike the Great Society programs, the spending done in response to the Financial Crisis and COVID-19 are not all permanent increases in entitlements. Some of our COVID response spending is likely to be permanent, but not all of it.

Second, the M2 money supply has increased more than 40% since February 2020, as the Fed renewed QE and monetized deficit spending. In other words, a great deal of that spending was paid for out of thin air.

The impact of these policies was like giving morphine to an accident victim. The economy was dramatically damaged by the lockdowns, but the morphine masked the pain. All that painkiller stimulus boosted sales and profits. This year, without new spending legislation and as the Fed starts to reverse course, the economy will lose its morphine drip.

On the surface, this suggests that the economy could be in trouble…and with the 2-year Treasury yield now above the 10- year Treasury yield (an inverted yield curve), many think the US faces a recession this year.

But this ignores the impact of the third factor in play – the reopening of the economy. It is clear, at least to us, that very generous pandemic unemployment benefits had a massive impact on employment. In fact, the “Great Resignation” (people just dropping out of the workforce) had a lot to do with these benefits. While it was never the case, many thought the Build Back Better spending bill would keep the checks coming. Now that BBB appears dead, those people are heading back to work. In the first three months of 2022, 1.69 million jobs have been filled. This year will likely total 4 million jobs, or more.

So, even though the Fed will be lifting rates and Keynesian deficits will be smaller, the economy will expand in 2022 and profits should continue to rise. Unfortunately, our forecast is that real GDP growth will remain under 3%, while inflation remains over 5%. This is reminiscent of the 1970s, and once the reopening from lockdowns is over, the full impact of these policies will be felt.

The inversion in the yield curve suggests the bond market thinks that if the Fed lifts short-term rates to 3% or so, it will be forced to cut rates again. This may be true, but we think inflation will prove a more persistent problem than the Fed or the bond market have priced in.

The US is now stuck in a Keynesian dilemma of its own making. The way out is to cut spending, cut tax rates, cut regulation, and tighten money enough to stop inflation. Because in the end, Keynesian policies don’t create wealth…free and open markets do.

Date/Time (CST) U.S. Economic Data Consensus First Trust Actual Previous

4-4 / 9:00 am Factory Orders – Feb -0.6% -0.2% -0.5% +1.4%

4-5 / 7:30 am Int’l Trade Balance – Feb -$88.5 Bil -$88.6 Bil -$89.7 Bil

9:00 am ISM Non Mfg Index – Mar 58.5 58.5 56.5

4-7 / 7:30 am Initial Claims – Apr 2 200K 198K 202K

2:00 pm Consumer Credit– Feb $18.2 Bil $20.0 Bil $6.8 Bil

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