Ignore the Crazy

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

March 13, 2023

While many investors are focused on the financial troubles affecting Silicon Valley Bank (SVB) and whether those troubles will spread, there were two other major issues that hit the markets last week: the Biden budget and Fed Chief Powell hinting at raising rates by a half a percentage point rather than a quarter.

It shouldn’t be any wonder why investors are worried about the Biden budget proposal, which includes a murderer’s row of growth-destroying tax hikes. The top tax rate on capital gains and dividends would go to 44.6% versus a current 23.8% (almost double!), the top tax rate on regular income would go to 44.0%. Taxes would go up on S Corporations, small business income, and interest income. The corporate tax rate would jump to 28%; the stock buyback tax would go to 4% versus 1%.

If this proposal were passed by Congress, it would hammer the economy and the stock market. Thankfully, we believe the odds of these proposals making it into law are very slim to none.

Think about it. Nothing was stopping President Biden from making these proposals last year or the year before. Why didn’t he? Because he knew some Democrats would object, making them impossible to pass and undermining party unity. But now that Republicans control the House the Administration can pursue extreme tax hikes secure in the knowledge the plan won’t pass (and cause economic damage) while the House majority party takes the lead opposing the proposals.

As for the prospects of the Federal Reserve raising rates by half a percentage point next week, we think Powell would only open the door to that possibility if it were his intention to go through that door. However, the news about SVB, news that Powell didn’t have before his testimony last week, now makes a 50 basis point hike unlikely.

The bottom line is that in spite of investors and markets obsessing about rate hikes they need to focus on the money supply. The supply of money exploded in 2020-21 but peaked in early 2022 and has since declined at the fastest pace since the 1930s. It’s the growth in the money supply, or continued lack thereof, that will determine what happens to economic growth and inflation in the next couple of years. Obsessing about the short-term interest rates targeted by the Fed, when there is no real market for federal funds traded among banks anymore, is barking up the wrong monetary tree.

Financial markets are on tenterhooks right now. But SVB is not a systematically important bank that will, through counterparty risk, tear down the whole financial system. Instead, it’s symptomatically important, showing what happens when the Fed ignores Milton Friedman and the money supply and then claims inflation is transient when it isn’t. SVB’s managers made a huge mistake by not hedging its assets’ interest-rate risk. But it's a mistake they were seduced into making by bad monetary policy that was too loose for too long.

Expect more trouble ahead, that’s why we have been bearish on equities and the economy. But, without strict markto-market accounting in place, don’t expect a meltdown like 2008-09.

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.

What Happened to the Recession?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

March 6, 2023

In multiple ways, this is the most difficult time we have ever seen to make a forecast. “Unprecedented” actions by government – locking down the economy, printing, borrowing, and spending trillions of extra dollars – artificially boosted economic activity. Like giving morphine to an accident victim, printing and borrowing masked the pain of lockdown injuries. As these artificial actions wear off, we expect a recession to appear.

And in the fourth quarter, retail sales, industrial production and other data suggested that the economy was hitting a wall.

Then…January happened. Nonfarm payrolls, retail sales, and manufacturing production all surged.

But we think these reports overstated economic activity. The US had unusually warm January weather. In addition, seasonal adjustment factors played a key role in making the economy look better than usual, as well.

In January, the national average temperature in the “Lower 48” states was 35.2 degrees, the fourth highest for any January in the past thirty years. New home foundations could be dug, fewer plants closed due to weather, and more people could comfortably be out and about.

Normal seasonal adjustment factors also played a role. Before seasonal adjustments, nonfarm payrolls fell 2.5 million in January. After adjusting, they were reported up 517,000 for the month. Before adjusting, retail sales fell 16.2%, but after the government applied normal seasonal factors, sales were reported up 3.0%, the largest gain for any month in almost two years.

In other words, the reason the government reported that jobs and retail sales were up wasn’t that they actually rose in January relative to December, but that they fell less than they normally do.

No one is manipulating the data, nor are we trying to imply that there is anything illegitimate about seasonally adjusting economic activity. Seasonal adjustments are important. For example, agriculture follows weather patterns and holiday shopping is seasonal. If we didn’t adjust for these patterns, the economy would shrink every year in the first quarter – going back pretty much forever – with a big rebound in the second quarter every year and another surge in the fourth quarter.

And now, because of COVID, government shutdowns, and the fiscal and monetary policy response, the normal seasonal patterns of economic activity have been distorted even more. That means we are probably going to experience some months, like November and December, where activity appears unusually weak, and others, like January, where activity appears unusually strong. The best rule of thumb is to wait for at least a few months in a row of unusual strength or weakness to draw any conclusions.

The bottom line is that a yield curve this deeply inverted is a negative sign for future economic growth. Meanwhile, the M2 measure of money has slowed sharply. The growth of the M2 measure of the money supply was unusually fast through January 2022. In the past year, it is reported as falling for the first time since the 1940s, and at the fastest pace since the Great Depression. If M2 affects “real” (inflation-adjusted) economic output with a lag of a year (give or take) then that support for activity likely peaked very early this year and should dwindle sharply by year end.

We obviously hope there is no recession on the way. It’s pretty obvious that the stock market isn’t worried. But January’s economic data aren’t as clear as many might think.

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.

Hard Landing, Soft Landing, or No Landing

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

January 27, 2023

In the past few weeks, a growing chorus of economists and investors have decided that the pessimistic narrative had it wrong all along, that the US isn’t headed for a hard landing, which would mean a recession, it isn’t even headed for a soft landing, which would mean a prolonged period of low economic growth.

What they think we’re going to get is no landing at all, that the US economy reaccelerates from here and does just fine. No fuss, no muss. In turn, that means the bottom for the S&P 500 back on October 12 at 3577 was the bottom for the bear market, which is already likely over.

We wish.

Instead, we think that’s a very rosy interpretation of recent economic reports. Yes, consumer spending was reported very strong for January, even when adjusted for inflation. But this is something we predicted based on unusually warm winter weather and how the policy response to COVID, including massive fiscal stimulus, has wreaked havoc with traditional seasonal adjustments, making November and December look worse by comparison and January look better.

The problem for the “No Landing” theory is that inflation remains a major problem. The Consumer Price Index is up 6.4% from a year ago, not that much of a decline versus 7.5% in the year ending in January 2022.

The Federal Reserve is following something called “SuperCore” inflation, which is part of the PCE Deflator. That figure excludes food and energy, like the regular “core,” but also excludes all other goods as well as shelter costs (where some claim that inflation measures are misjudging rents). But SuperCore PCE prices rose at 7.4% annual rate in January, the fastest increase for any month since 2021. SuperCore PCE prices are up 4.6% in the past twelve months, barely lower than the 5.0% increase in the year ending January 2022.

Either way, this is not enough progress on inflation to satisfy the Fed, which means a higher risk of ongoing hikes in short-term interest rates, until there’s more evidence inflation is coming back down toward 2.0%.

Meanwhile, the economic morphine of government checks and loose monetary policy is wearing off. The federal government was handing out checks like candy in 2020-21 and the Fed had kept short-term rates below the pace of inflation for most of the last fifteen years.

But after surging in 2020-21, the M2 measure of the money supply hit a wall in early 2022 and declined during the past year by the most for any year since the Great Depression. The yield curve is steeply inverted and likely to get more so in the next few months, which is consistent with risk aversion among investors and in Corporate America. We expect prolonged weakness in business investment in equipment as well as commercial construction. And after surging rapidly last year, the pace of inventory accumulation should cool off, too. Combined, these should pose a big headwind for GDP growth later this year.

While some are heartened by low unemployment and recent rapid job growth, we don’t think these are hurdles to a recession. The labor market is a lagging indicator of economic performance. Meanwhile, job growth and wages are likely to slow, which means tepid gains in consumer purchasing power at the same time low-income households have run out of stimulus-induced savings.

The bottom line is that none of the recent reports has changed our forecast of a recession. Given the Fed’s reaction function and the decline in M2 that’s already happened, if we get more growth than expected in the near-term, that means more pain later on when the recession hits.

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.

Monetary Mayhem Clouds Crystal Ball

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

February 21, 2023

You can’t read or watch financial news these days without a heavy dose of speculation about what the Fed is going to do with short-term interest rates, when it’s going to do it, and how long it’s going to do it for.

There’s nothing wrong with paying some attention to this news, but what investors need to realize is that this is not your father’s (or mother’s) monetary policy and they need to focus on the money supply. (Yes, we know we’ve written about this before, but this issue is so important it warrants multiple repetitions. Expect another reminder again sometime in the next few months.)

Prior to the Financial Crisis of 2008-09, the Fed implemented monetary policy by either (a) buying Treasury securities from banks to add reserves to the banking system or (b) selling Treasury securities to banks to drain reserves from the banking system. Adding reserves would loosen monetary policy, draining reserves would tighten monetary policy.

Why would the Fed add or drain reserves? Because banks would actively trade reserves among each other on an overnight basis to meet the reserve requirements. The Fed, by adding or draining reserves, could influence the interest rate banks would charge each other to acquire those reserves and that rate was highly sensitive to Fed decisions. This was a “scarce reserve” model for monetary policy. When it was implemented carefully, it delivered persistently low inflation for multiple decades.

Then along came the Financial Crisis and that scarce reserve model was abandoned and replaced with a model based on “abundant reserves.” The Fed, through multiple rounds of Quantitative Easing, flooded the banking system with more reserves than the banks would ever need. In turn, the Fed made those reserves valuable by paying the banks an interest rate to hold them. No longer would banks scramble to acquire reserves to meet legal requirements based on the amount of deposits they held; now banks would want them only if and when the Fed paid them enough interest on those reserves, like now, when the Fed is paying banks 4.65% per annum and that figure is likely heading higher during the next few months.

What this means is that short-term rates are ultimately decreed by government edict. The market process (banks trading these reserves) no longer exists. It’s our view that investors fixated on these edicts are barking up the wrong tree. What they should be barking at is the money supply.

The M2 measure of the money supply soared in the first two years of COVID, up 40.4% from February 2020 to February 2022. But, in the last ten months of 2022, the M2 measure of money declined 2.3%. Not only have we never experienced a Fed trying to fight an inflation problem under an abundant reserve regime, we’ve never seen M2 grow so fast for so long, or decline so rapidly, at least since the Great Depression.

At present, the futures market appears to be pricing in three more rate hikes this year, 25 basis points each, with one rate cut of 25 basis points very late this year. There is nothing obviously wrong with this forecast, it sounds reasonable. But this is just a guess about how the Fed’s edicts might change. We, on the other hand, will be looking at the January M2 data out next Tuesday, which could tell us if the drop in M2 continued into 2023.

It remains to be seen how shifts in interest rate policy will influence M2 growth in the months ahead. Again, we are in an unprecedented period for policy with abundant reserves, so educated guesses, not definitive answers, are the best anyone can do. One big question is whether the lifting of rates has slowed M2 or is it just that rates are higher. That may sound redundant, but it’s not. Let’s say the Fed stops raising rates at a peak of 5.5% and then pauses rate changes. Will that peak level of rates keep putting downward pressure on M2? Or is it the hiking of rates that matters, so M2 will start growing again once the Fed stops raising rates (even though it doesn’t cut rates, either)?

This is important because monetary policy hits the economy with long and variable lags. We have already seen some weakness in production reports but are not close to feeling the full brunt of the tighter money that started last year. There is a storm headed our way, so please be prepared.

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.

January Data Get Hot

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

February 13, 2023

Markets have been volatile, with reports convincing many that the Fed is done hiking rates. But this week, we get data that may change some minds. Why? Because the economic reports for January are likely to come in hot, with inflation, retail sales, industrial production, and housing starts all potentially coming in at the fastest pace in months.

A hot inflation report for January might be a surprise to some investors, but it really shouldn’t be. The M2 measure of the money supply surged more than 40% in the two years ending in February 2022 and part of that surge is still generating extra inflation.

Analysts have been touting a 1.8% annualized rate of increase in consumer prices during the last three months of 2022, but these numbers were revised, now showing that the CPI climbed at a 3.3% annual rate in the fourth quarter. “Core” inflation, which excludes volatile food and energy prices, were previously reported as up at a relatively moderate 3.1% rate in the last three months of the year; now that’s been revised up to a 4.3% pace.

In other words, the recent trend in inflation hasn’t been as soft as some have been saying. And now, the consensus (and First Trust) expects a 0.5% increase in January. Some of this is energy, but “core” should also increase at a faster pace than many expected last year.

Retail sales should also be strong in January, for multiple reasons. First, January was unusually warm, which made it easier for consumers to be out and about. Second, auto sales were very high because of a temporary spike in fleet sales to rental companies, which are counted in retail sales. Third, costof-living adjustments for Social Security happen in January and were very large this year because of high inflation in 2021-22. And last, massive government payments during COVID look like they’ve messed up the normal Christmas seasonal pattern in retail spending, with relatively less spending in December, in turn making January look better by comparison.

We also believe housing starts will come in above consensus expectations in January, due to unusually warm January weather. It’s just easier to break ground on new housing projects when it’s warm out; in a very cold winter month, builders like to focus more on completing homes that are already close to finished. In addition, the sticker shock of higher interest rates is wearing off.

Industrial production could turn out to be an outlier. Warm January weather means households didn’t have to fire up their furnaces as much, which means utility output almost certainly plummeted for the month. However, the relative warmth also means manufacturers lost less time due to weather and so factory output should be strong. That, plus a gain in mining should boost overall industrial production for the month.

Put all these reports together and we have an economic stew that signals that a “data sensitive” Federal Reserve isn’t done hiking rates. In turn, the markets need to recalibrate expected rate hikes upward and this could cause some indigestion. Some see the recent rally in stocks as part of a bull market; we still think it’s a bear market rally and likely to fade.

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 Game Isn’t Over

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

February 6, 2023

At the beginning of the season, not many predicted that the Philadelphia Eagles would be in the Super Bowl this year. But, they had a fantastic season and are favored over the Kansas City Chiefs. Predicting this economy is equally hard. Anyone who thinks they know exactly how things will turn out is fooling themselves. COVID policies – lockdowns, massive borrowing, and money printing to pay people not to work – have never been tried before. So, what happens is still up in the air.

It seems like just yesterday that ZeroHedge – with help from the Philadelphia Fed – was trying to convince people that job growth was non-existent in the second quarter of 2022. Never mind the fact that they purposefully conflated two different measures of jobs…it just wasn’t true.

So, it must have come as a shock to those who believed that nonsense that in January, after the equivalent of 17 quarter-point Fed rate hikes, jobs data and hours worked exploded to the upside. Nonfarm payrolls rose 517,000 jobs, while revisions to prior months added an additional 71,000.

Not one economics group came even remotely close to getting this number right. And the print was especially surprising after seeing retail sales fall 4.3% and industrial production fall 5.2%, at three-month annualized rates, through December.

The difficulty of forecasting in this environment is absolutely astounding. On the one hand, the M2 measure of money has contracted in the most recent twelve months (the first time in more than sixty years), after growing over 40% in a two-year timespan. On the other hand, even with the Federal Reserve’s sharp rate hikes, the federal funds rate is still below inflation.

Using M2 growth, alone, and Milton Friedman’s lag of 6-9 months, we should be seeing the economy begin to slow, which is what retail sales, industrial production, housing, and retail auto sales have been pointing to. And so far with 256 out of the S&P 500 companies having reported, profits are down 3.1% from a year ago.

But it’s not just M2…the rebound from COVID lockdowns is over. Stores are back open, airplanes packed, and hotels filled. Now that we are back to “normal”, how much further can things go? We aren’t going to have two packed-stadium Super Bowls this year, just one. And pandemic unemployment checks and PPP loans have run their course. Yes, some state and local governments, and school districts, have money left, but not much. To our way of thinking, we should see a slump now that the drugs of all the borrowing wear off.

So, how then did jobs provide such a large upside surprise!?! Do employers really know what they are doing? Do they see something that is not showing up in the data? Or is this a delayed reaction (after all, employment is a lagging indicator) to issues with hiring during and after the pandemic.

If you couldn’t hire workers, but now they want to work, and you expect a soft landing (or even no recession at all) then you grab all the workers you can, when you can. But if there is a “hard landing” profits could be squeezed even more.

Taking all this into consideration, we don’t think the boom in nonfarm payrolls is a signal worth following. Many companies…Peloton, Bed, Bath & Beyond, Hasbro, and lots of tech stalwarts were winners when services were locked down and people with fresh stimulus funds needed tech. But now they are all in either financial trouble or are laying off workers. The losers during the lockdowns (services) have all reopened, but people aren’t going to double their use of services, especially with interest rates up and money supply down.

So, while one number from one month seemed to change a lot of people’s minds about the economy, we think we’re far from the final whistle of the game. This one isn’t over yet. Unprecedented actions on the scale that we experienced in 2020-2022 will bring unexpected results in 2023. So, while we never want to ignore a number like the January jobs report, we have to question how much is signal and how much is noise.

The economy is still absorbing the money printed during the pandemic. Inflation has not been eradicated, the Fed is highly unlikely to loosen policy anytime soon, and earnings are likely to fall as all the stimulus wears off. That’s not a recipe for a simple forecast or a soft landing. Like the Super Bowl, until the game is played no one knows exactly what will happen. Count us less bullish than conventional wisdom.

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.

Debit Limit Drama

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

January 30, 2023

The US federal budget is on an unsustainable path…but not for the reasons that most people think.

Yes, the national debt is $31 trillion, well higher than annual GDP, and only going higher. Yes, the budget deficit last year was more than a $1 trillion for the third year in a row. None of this is good.

But the real root of the fiscal problem, and our biggest concern, isn’t the debt or the deficits, it’s government overspending. If the government had an enormous debt, but spent little, the private sector could produce the country’s way out of the debt problem. And if the US had little debt, we could still have economic problems from too much government spending. Ultimately, the government funds itself by borrowing or taxing the wealth produced by private industry. If spending were high and borrowing low, taxes would have to be prohibitively high. The bottom line is that excessive spending leads to economic ills.

According to the CBO, spending on entitlements like Social Security, Medicare, Medicaid, and other health care programs will rise from 10.7% of GDP to 15.1% in the next thirty years. Meanwhile, the net interest on the national debt will almost certainly be higher than it was last year, unless and until we bring the deficit down and slow the growth in debt.

This is why the debt limit debate now going on in Washington, DC is so important. Don’t fall for the false narrative that one group of politicians wants to push the country into default. Nor, should anyone want to abolish the debt ceiling altogether. If there is a way to shine some light on overspending, why shouldn’t it be used? If debt ceiling politics can focus attention on fiscal issues, it’s done its job.

What we expect is a last-minute budget deal that includes either caps on discretionary spending for future years, some sort of commission or committee that can make proposals to reform entitlements (with expedited procedural rules so the proposals get a congressional vote), or both, as part of a bipartisan deal to raise the debt ceiling.

But let’s go down the highly unlikely path that the debt limit isn’t raised. The Treasury Department would still have enough cash flow to pay all securitized debt as it came due, as well as entitlements such as Social Security, Medicare, and Medicaid. It’s true that other programs and agencies would have to take substantial cuts to make sure those higher priority payments get made; and yes, the Biden Administration will not enjoy making that choice. But it’s still a choice that they alone get to make.

Ultimately, investors and voters need to realize that not every national debt is the same, even if they’re the same amount. The US had a debt problem after the Revolutionary War, which was a small price to pay for starting an independent country. We had a debt problem after World War II, but that was a price we paid to win a crucial war. Our current debt problem is not like those. In too many cases, politicians spend to win favor with constituents. It’s not wrong to use the debt ceiling as a way to focus attention on this problem and the endemic overspending that it creates. That’s a habit this debt limit debate needs to break.

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.

Rearview Mirror OK, Collision Ahead

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

January 23, 2023

First, the good news: we estimate that real GDP grew at a solid 2.8% annual rate in the fourth quarter. But you shouldn’t dwell on the solid GDP report that comes out Thursday. Why? Because the report shows what’s going on in the rearview mirror. Meanwhile, there’s an economic collision ahead.

Just think about the news so far for December. The ISM Manufacturing and ISM Service indexes are both below 50. Excluding the early days of COVID, both indexes haven’t been below 50, signaling at least a contraction in sentiment, since the aftermath of the 2008-09 Financial Panic.

Retail sales fell 1.1% in December after a 1.0% decline in November. Industrial production fell 0.7% in December after a 0.6% decline in November. Medium & heavy truck sales are still at a respectable level, but dropped sharply in December, down 13.5%, the second fastest drop for any month in the past twenty years. Housing starts declined, as well.

The good news is that the labor market still seems strong. Initial claims for unemployment insurance claims are still very low. But the job market is often a lagging indicator of economic health and jobless claims should be expected to be at or near a bottom very close to the peak in the business cycle.

A recession will arrive sometime in 2023. Given recent data, it would come as no surprise if we’re already in a recession and the economy shrinks in the first quarter and beyond. A surge in the M2 measure of the money supply led a rebound in economic growth from the COVID Lockdown and then a surge in inflation in 2021-22. But growth in M2 came to a halt in early 2022. Now, with a time lag, the economy is getting weaker and inflation is coming down. Buckle up, it’s going to be rough ride.

In the meantime, our calculations show economic growth at a 2.8% annual rate for the fourth quarter.

Consumption: “Real” (inflation-adjusted) retail sales outside the auto sector declined at a 2.4% annual rate in Q4. However, sales of autos and light trucks grew at a 28% rate and it looks like real services, which makes up most of consumer spending, should be up at a solid pace. Putting it all together, we estimate that real consumer spending on goods and services, combined, increased at a moderate 2.3% rate, adding 1.6 points to the real GDP growth rate (2.3 times the consumption share of GDP, which is 68%, equals 1.6).

Business Investment: We estimate a 4.1% growth rate for business investment, with gains in equipment and intellectual property more than offsetting a decline in commercial construction. A 4.1% growth rate would add 0.5 points to real GDP growth. (4.1 times the 13% business investment share of GDP equals 0.5).

Home Building: Residential construction is still absorbing the pain of much higher mortgage rates and looks like it fell at a 24.0% rate, which would subtract 1.0 points from real GDP growth. (-24.0 times the 4% residential construction share of GDP equals -1.0).

Government: Only direct government purchases of goods and services (not transfer payments) count when calculating GDP. We estimate these purchases – which represent a 17% share of GDP – were unchanged in Q4, meaning zero net impact on GDP (0.0 times the 17% government purchase share of GDP equals 0.0).

Trade: Looks like the trade deficit shrank a little in Q4, as exports declined at a slower pace than imports. We’re projecting net exports will add 0.3 points to real GDP growth.

Inventories: Inventories look like they grew faster in Q4 than in Q3, suggesting an add of about 1.4 points to the growth rate of real GDP. Look for slower inventories in 2023, which should be a significant drag on economic growth this year.

Add it all up, and we get a 2.8% annual real GDP growth for the fourth quarter. That headline sounds good. But when much of the growth is from inventories and the economy is about to get hit from slower M2, investors need to focus on the collision ahead, not the pretty scenery in the rearview mirror.

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.

Soft Landing?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

January 17, 2023

We wrote last week about the soft landing that markets now seem to expect. If the US does have a soft landing it would be because the Federal Reserve tightened enough to slow inflation, but not enough to throw the economy into recession.

In our opinion, Fed policy should not be measured using interest rates alone. The Fed held the federal funds rate at 0% from 2008 to 2015 without inflation. During COVID, the Fed held the funds rate at zero for just two years. If seven years didn’t cause inflation, how did two years?

The answer to that question is that following the financial crisis, the Fed shifted to an “abundant reserve” monetary policy and held rates at zero, but increased capital requirements and liquidity rules by enough to keep the M2 money supply in check.

During COVID, the Fed expanded reserves through Quantitative Easing again but relaxed liquidity rules; using banks to distribute pandemic loans and hand out unemployment checks. As a result, M2 peaked at 27% year-over-year growth in February 2021. This is why inflation accelerated, right on time to prove Milton Friedman correct again.

Looking at the two things the Fed can control – interest rates and the growth rate of the money supply – there is a massive divergence. The funds rate is still below inflation. Looking at just rates, monetary policy is not yet tight.

But, looking at M2, money is tight. The growth rate of M2 has slowed from 27% year-to-year in early 2021, to 12% in January 2022, to 0% in November 2022. Given that Milton Friedman told us a slowdown in M2 growth would impact economic growth with a lag of roughly six to nine months, the economy should be showing the impact. There are a few signs of slow growth (like the ISM surveys showing contraction), but gold prices are surging (up $260 per ounce in the past three months) and the jobs market hasn’t weakened materially.

Hold on, though, before thinking that M2 doesn’t matter, it is important to remember that pandemic policies were unprecedented. Shutting down most services, and only really opening them up freely in 2022, has distorted economic data. Services were held below trend for two years and are now artificially boosted – no matter what money growth does.

In addition, when the Fed started its Abundant Reserve monetary policy, the Treasury started using its Fed checking account, called the Treasury General Account (TGA) to hoard money. For decades, the TGA had an average balance of roughly $5 billion. But, lately, the TGA has held hundreds of billions and this money does not count as M2 even if it is cash held at the Fed.

Taxpayers write checks from their bank accounts. If the Treasury puts those taxes in the TGA rather than spending them, they do not return to the banking system. From the end of 2021 to November 2022, the TGA grew from $134 billion to $524 billion. In other words, M2 was reduced by $390 billion because the Treasury held cash out of the system. This has slowed reported M2 growth and just maybe money isn’t as tight as it appears.

Another sign that money may not be as tight as it appears is that loans and leases at banks are up 12% in the year ending December even though M2 has not grown.

Nonetheless, money growth has slowed rapidly. When the money supply brakes are slammed, economic growth should suffer before inflation comes down. When this happens at the same time that distortions caused by pandemic policies come to an end, a recession seems inevitable.

Our forecast for real GDP growth this year is -0.5%, with inflation remaining above 4%. In other words, a recession with higher inflation – stagflation. That’s what we expect…and it’s not a soft landing.

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.

Not Goldilocks

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

January 9, 2023

Not long after Friday’s Employment Report multiple analysts and commentators were calling it a “goldilocks” report, by which they meant it showed that the economy was neither “too hot” nor “too cold,” but instead, “just right.”

In turn, the theory goes, the Federal Reserve could stop raising short-term rates earlier and at a lower peak than previously expected, inflation would continue to cool, and the economy could pull-off an elusive “soft landing.”

The biggest headlines from the Employment Report were definitely good news. Nonfarm payrolls rose 223,000 in December, beating the consensus expected 203,000. Meanwhile, civilian employment, an alternative (although volatile) measure of jobs that includes small-business start-ups, surged 717,000. Rapid job creation helped push the unemployment rate down to 3.5%, tying the lowest level since Joe Namath was a reigning Super Bowl champion. (If you’re a Millennial or Gen Z, yes, that’s the same guy in the Medicare commercials.)

But, behind the headlines, the data were not as good. Temporary help service jobs (temps) fell 35,000 in December, the fifth straight monthly decline, to a level of temp jobs below a year ago. Why are these jobs important to watch? Because, when businesses face increased demand, the quickest way to respond is hiring temporary help. And the same thing happens in the opposite direction.

Meanwhile, the total number of hours worked in the private-sector ticked down 0.1% in December, the second consecutive monthly decline. Even though payrolls were up, total hours worked data show less work was done. Putting it all together, this is the equivalent of losing 125,000 jobs in December, not gaining jobs. Fewer temporary workers and fewer hours worked suggest some weakness in the job market. What this means is that businesses are still hiring, but their workers have less to do.

Why would businesses do that? Because finding qualified workers has been unusually difficult during the re-opening from the COVID shutdowns. In turn, many firms might be willing to keep hiring workers until it’s clear the economy is in a recession.

But this also means that if a recession happens – and we continue to think it will – more workers have to be let go.

The figure that the optimists focused on the most was the wage report, which showed a relatively moderate gain of 0.3% in average hourly earnings in December and a gain of 4.6% versus a year ago. Moderate wage growth, the conventional thinking goes, diffuses the potential for a “wage-price spiral” that keeps inflation high or even pushes it higher. But this is a basic misunderstanding of inflation dynamics. As Milton Friedman taught us, it’s loose money that causes inflation to go up. The fact that wages sometimes go up faster at the same time is also a sign of loose money, but it’s not a sign that wage growth causes inflation.

What analysts, commentators, and the markets should have spent more time chewing over was the ISM Services report, which screamed stagflation. The overall index came in at 49.6, well below consensus expectations and the first reading in contraction territory since the onset of COVID. In fact, excluding very early COVID, it was the first sub-50 reading since 2009. Meanwhile, although the prices paid index declined to 67.6 (versus 70.0 in November), that’s still higher than it ever was between mid-2011 and early-2021.

This week’s CPI report should show tame overall inflation for December itself, but that’ll largely be due to falling energy prices. The ISM report suggests inflation isn’t going back to the Fed’s 2.0% target anytime soon.

Put it all together and it looks like both the surge in M2 growth in 2020-21 (which created the inflation) and the abrupt slowdown in 2022 (which would cause slower growth) are still wending their way through the economy. If so, we should see weak economic data, soon. Further forward, if the Federal Reserve maintains slow M2 growth – an open question given the Fed’s reluctance to focus publicly on the monetary aggregates when setting policy – we could see a major slowdown in inflation in 2024. Time, and the direction of monetary policy, will tell.

Right now, it looks like Real GDP expanded at a 2.5 – 3.0% rate in the last quarter of 2022. But how fast it’s growing in the first quarter of 2023 – if at all – is anyone’s guess.

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 Housing Outlook for 2023

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

January 3, 2023

The housing sector was a huge and early beneficiary of the super-loose monetary policy of 2020-21. But, once the Fed started tightening, housing took the lead downward, as well. This isn’t a repeat of the 2006-11 housing bust, but it will drag on. Don’t expect any real recovery in housing until at least late 2023 or early 2024. Home sales and prices will continue to drag in 2023, particularly in the existing home market.

From May 2020 until June 2022, both the national Case-Shiller price index and the FHFA price index rose more than 40%. But, since June 2022, Case-Shiller is down 2.4% and the FHFA is down 1.1%. The biggest declines so far have been out West, in San Francisco, Seattle, Phoenix, San Diego, and Las Vegas. But every major metropolitan area is down in the past three months, no exceptions.

The drop in home prices should continue. Prices got too high relative to rents and need to fall more to better reflect rental values. We expect a total decline, peak-to-bottom in the 5-10% range, nothing like the 25% drop in 2006-11. Why a smaller drop this time around? First, compared to the average of the past forty years, home prices are already close to fair value when measured against construction costs. Second, there is no massive excess inventory of homes, unlike during the prior housing bust. And, unlike during the subprime-era, the vast majority of homeowners with mortgages are locked-in at extremely low fixed rates, which means they will be very reluctant to sell.

The real effect of the change in interest rates is evident in the existing home market. Sales hit a 6.65 million annual rate in January 2021, the fastest pace since 2006. But, by November 2022, sales were down to a 4.09 million annual rate, a drop of 38.5% so far. Meanwhile a decline in pending home sales in November (contracts on existing homes) signals another drop in existing home sales in December.

Existing home buyers have two major problems: first, much higher mortgage rates, which means substantially higher monthly payments. Assuming a 20% down payment, the rise in mortgage rates and home prices since December 2021 amounts to a 52% increase in monthly payments on a new 30-year mortgage for the median existing home.

Meanwhile, it’s hard to convince a current homeowner with a low fixed-rate mortgage to sell. If anything, it makes sense for them to ask for even more money if they’d have to take out a new mortgage elsewhere at a much higher rate. In other words, sellers should now want more for their homes, while buyers want to pay significantly less. This won’t change soon and so expect existing sales to be even weaker in 2023 than last year.

New home sales are also down substantially since the COVID peak, but should find a bottom sooner. The key is that with a new home, the seller is a contractor. Also, housing has been underbuilt in the previous decade. The average price of a new home will likely fall, but we need more of them. And more houses will be likely be put in rental pools.

What’s important to remember is that this business cycle isn’t normal. COVID led to a massive surge in government stimulus, both monetary and fiscal, to fight widespread and overly draconian shutdowns. Housing is rarely a bright spot in recession years and this year should be no different. But don’t expect a catastrophe like the prior bust and, once a recession is over, housing will rebound much more swiftly than after the Great Recession in 2008-09.

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.