Economic Insights - January 29 - February 2, 2018
- Inflation’s (sort of) return: Last year, economic growth was great, but rates stayed low. However, with tentative signs of inflation’s return, and positive economic momentum here to stay, the days of dull bond markets are likely over.
- The sweet spot: The global economy is in the middle of a self-sustaining expansion. Labor markets are bustling in the United States, Europe, and Japan. Manufacturing surveys are excellent. What’s not to like?
In 2016 and 2017, global growth rebounded. Economic growth started to look normal for the first time since the financial crisis. Brazil and Russia exited recession; even Greece was no longer contracting. The Eurozone, Japan, and the United States were expanding robustly.
But, there were still relics from the crisis: weak inflation and ultra-low interest rates. U.S. inflation hit a soft patch in 2017. Interest rates stayed very low. The U.S. 10-year rate started 2017 at 2.44%, and ended the year at 2.41%. The German 10-year government bond (bund) ended the year at 0.43%. Low interest rates helped spur equity markets. Returns were excellent and volatility stayed low.
However, 2018 is starting out differently. Interest rates are moving up, and with that, market volatility has returned. Last week, the U.S. 10-year Treasury rate broke through 2.8%, and is now at the highest level since early 2014. The U.S. 30-year Treasury reached 3% for the first time since early 2017. The German bund moved above 0.75%. Stock markets corrected, reacting to the sharp updraft in interest rates.
Inflation’s (sort of) return
Why did rates move up? At some point, the bond market had to start pricing in better growth. But, there are more signs that pricing pressures are coming to life. As of December, U.S. core PCE inflation was up 1.9%, on a three-month annualized basis. Pay growth remains below prior highs, but is finally trending up. Average hourly earnings (more on that below) grew 2.9% year-over-year in January, the fastest pace since June 2009. The employment cost index also hit a cycle high at the end of 2017. The Institute of Supply Management’s (ISM) Prices Paid Index reached the highest level since May 2011. Even in Europe inflation pressures are sprouting. According to Bloomberg, respondents to manufacturing surveys stated that prices were rising at the fastest rate in six-and-a-half years. However, don’t forget that overall hard inflation numbers remain very low in Europe.
In their latest policy statement, the Federal Reserve (Fed) finally acknowledged inflation’s return. The Federal Open Market Committee (FOMC) changed its language around price pressures. Gone are the days of inflation being below 2% in the “near term.” Now, the Fed expects inflation to “move up this year and stabilize around the FOMC’s 2% percent objective.” The FOMC also stated that market-based inflation measures had increased.
The bond market has finally realized that inflation isn’t dead. The disconnect between very strong economic numbers and languishing bond yields that existed last year is over. In general, better global growth prospects likely mean that higher rates are here to stay. But how much further can rates rise? U.S. pricing pressures may build up faster than expected and could put more upward pressure on yields.
Higher-than-expected inflation is certainly plausible. Tax cuts are coming at a time when the U.S. economy is already buzzing; stimulus now could tip the economy into the hot zone. Wireless-plan pricing dragged down year-over-year inflation much of last year, but is set to roll off the numbers in March.
Another catalyst for higher rates may come from abroad. Inflation data remains quite muted in Europe and Japan. Most recently, the Eurozone core CPI increased 1%, Spanish prices were up 0.7%, and Italian inflation rose only 0.8%. The Japanese core inflation rate is barely above 0. But, economies are doing well. As shown in the next section, some labor markets are downright roaring. Inflation could come back more quickly than expected going forward. The European Central Bank and Bank of Japan may then accelerate plans to normalize policy. Higher ex-U.S. rates would surely force U.S. Treasurys up even more.
The sweet spot
The global economy appears to be in a sweet spot, a self-sustaining economic expansion. Each week, evidence of a coordinated pick up in global growth mounts. Labor markets are growing briskly and manufacturers are humming. Strong labor markets are bolstering domestic demand spurring more production and trade. Companies are investing and hiring more to keep up with demand. Central banks are staying accommodative. The cycle continues.
The U.S. jobs report surprised to the upside. Headline payrolls increased by 200,000. Separately, the ADP report showed private payrolls up by 234,000 and has printed 200,000 jobs or more in five of the last six months. According to the Bureau of Labor Statistics, construction hiring popped up by 36,000. More broadly, goods-producing sectors added 57,000 jobs, after adding 55,000 and 78,000 in December and November, respectively. The services sector added 139,000 jobs led by education and health with 38,000 created. Flows into the labor force remain strong, that’s keeping payroll growth robust even as the unemployment rate stays low.
The unemployment rate picked up only slightly, from 4.095% to 4.149% as the labor force grew more quickly than the number of employed. U6, the broadest measure of unemployment, increased marginally, up to 8.2% from 8.1% last month. Temporary help, which leads broader job growth, gained only 2,000 jobs after losing the same amount in December.
As mentioned above, average hourly earnings grew at the fastest pace since 2009. There were, though, a couple caveats to that number. Pay for production and nonsupervisory workers grew only 2.4% (versus 2.9% overall wage growth), suggesting that managers’ pay may have driven the headline gains. Hours worked ticked down to 34.3 from 34.5, so weekly wages grew by only 2.6%. While wage growth should continue trending up, some of last month’s pop-up in average hourly earnings may have been noise. In general, January’s jobs report was more than strong enough to keep the Fed on track to raise rates in March.
Labor markets are solidly picking up in Europe and Japan too. Japan’s labor market is super. The job to applicant ratio is at a record high of 1.59, so for every 100 workers there are 159 jobs available! The euro area unemployment rate held constant at 8.7%, but is down one percentage point since December 2016. UK job vacancies are the highest on record at 810,000. The German unemployment rate is the lowest since reunification, and the UK unemployment rate is the lowest since 1975. Italian unemployment reached the best rate since late 2012. According to GaveKal, an independent investment-research provider, as the rest of Europe has improved, European Union (EU) migration growth into Germany has likely slowed. Gavekal shows that employment growth for non-Germans living in Germany was up 0.7% year-over-year in the third quarter of 2017, versus 10% previously.
Purchasing manager indexes (PMIs) are fantastic. The ISM manufacturing PMI was very strong, at 59.1, and the ISM services PMI rose sharply, up from 56.0 to 59.9. The Eurozone manufacturing PMI was 59.6. Germany’s PMI hovered above 60; Italy’s PMI hit 59. Japan’s PMI is at a record high. China’s Caixin PMI was unchanged at 51.5, and the NBS PMI declined slightly to 51.3. One negative: new export orders fell below 50.0 for the first time since October 2016.
This self-sustaining global economic expansion should last for a little while. It’s hard to find a negative data point out there. As mentioned above, this burst in global growth may finally be leading to a bit of inflation. Right now, that inflation is benign. But, if the United States and other countries run into capacity constraints, this boom could overheat. Until then, the sweet-spot continues.