Implications:  Existing home sales showed some signs of life in October, posting the largest gain in eight months. While the headline gain of 3.4% is positive news, sales activity still remains near the slowest pace since the aftermath of the 2008 Financial Crisis. One problem recently is that since Federal Reserve rate cuts began in September, 30-year fixed mortgage rates have risen back above 7%. So at least so far, the widely anticipated shot in the arm to the housing market from improved affordability hasn’t happened and buyers continue to sit on the fence. Meanwhile, home prices are rising again with the median price of an existing home up 4.0% from a year ago. While most of the housing market remains stuck in low gear, certain segments have shown signs of life. Notably, sales of homes priced at $1 million and above have risen 23.0% in the past year versus just 2.9% for all existing home sales. This demonstrates that, at least at the higher end of the market, both buyers and sellers are beginning to adjust to the new reality of higher rates. However, outside the most expensive segment many existing homeowners remain reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  This remains a major impediment to activity by limiting future existing sales (and inventories).  However, there are signs of progress with inventories rising 19.1% in the past year.  That has helped push the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) to 4.2 in September, a considerable improvement versus the past few years, but still below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.   A tight inventory of existing homes means that while the pace of sales looks like 2008, we aren’t seeing that translate to a big decline in prices.  In employment news this morning, initial jobless claims fell 6,000 last week to 213,000. Meanwhile, continuing claims rose 36,000 to 1.908 million.  These figures are consistent with continued job growth in November, but at a slower pace than earlier this year. Finally, on the manufacturing front, the Philadelphia Fed Index, a measure of factory sentiment in that region, fell to -5.5 in November from +10.3 in October.

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Implications:  Homebuilding was weak in October, but not quite as bad as it looked.  Overall housing starts missed consensus expectations and declined 3.1%, entirely due to a 6.9% drop in the single-family category.  Looking at the details, construction in the South (the region with the largest share of homebuilding in the country) led the way downward with an 8.8% decline, as homebuilders in that region delayed activity in wake of hurricanes that swept through the area.  Still, housing starts appear to be stuck in low-gear, down 4.0% from a year ago, and sit at roughly the same levels as 2019.  The same cannot be said for completions.  Despite a 4.4% drop for the month, completions were at a faster pace than any month in 2021-2023 and are up 16.8% in the past year.  With strong completion activity and tepid growth in starts, the total number of homes under construction continues to fall, now down 12.7% since the start of 2024.  That type of decline is usually associated with a housing bust or recession.  The lack of new construction is why home prices have remained elevated while rents are still heading up in much of the country: we are building too few homes while lax enforcement of immigration laws mean rapid population growth.  The home building sector seems strangely slow given our population growth and the ongoing need to scrap older homes due to disasters or for knockdowns. We think government rules and regulations are likely the major hurdle for builders in much of the country, but home construction might also be facing headwinds from a low unemployment rate (which makes it hard to find workers) as well as relatively high mortgage rates.  Notably, while mortgage rates were trending lower leading up to the first rate cut announcement from the Federal Reserve in September, these rates are up more than 50bps since then. That said, there are some tailwinds for housing construction, as well.  Many owners of existing homes are hesitant to sell and give up their fixed sub-3% mortgage rates, so prospective buyers will often need new builds.  In addition, Millennials are now the largest living generation in the US and have begun to enter the housing market in force, which represents a demographic tailwind for activity.  Putting it together, we don’t see housing as a major driver of economic growth in the near term, but we’re not expecting a housing bust like the 2000s on the way, either.  In other recent housing news, the NAHB Housing Index (a measure of homebuilder sentiment) rose to 46 in November from 43 in October.  However, a reading below 50 signals a greater number of builders view conditions as poor versus good.

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In our lifetimes, the best comparison for Trump’s election win is Ronald Reagan’s in 1980.  That election, like this one, pitted big spenders and champions of government against tax cutters and critics of government.

It is pretty clear that markets approved of both winning campaigns as they were happening.  Leading up to the election in 1980, like this year, the S&P 500 rallied as it became clearer that Reagan (like Trump) was likely to win.  The market also rallied in the days following the election because markets like tax cuts, deregulation, and restrained government.  And, at the same time, the policies the markets didn’t like – such as a tax on unrealized capital gains – were now dead.

But after being euphoric at the outcome of the election in 1980, reality set in.  Paul Volcker was fighting inflation with tight money, a recession was inevitable and tax cuts took time to pass.  The S&P 500 fell in 1981 and in the first eight months of 1982 before the Reagan bull market really started.

History doesn’t repeat itself, but at times it rhymes. And while there are similarities between today and 1981, there are also some key differences.  For example, the Federal Reserve is now cutting interest rates, not raising them.  However, there are some big differences that investors need to pay attention to.  First, in October 1980, the Price-Earnings ratio of the S&P 500 was 8.6.  In October 2024, the PE ratio was 27.  In other words, while the market may appreciate better policies, it sure looks like they are already priced in.

Moreover, while Trump is selecting his cabinet rapidly and his team has likely already done the homework needed to move fast on executive orders that can boost growth, much of the real work will take time.  It appears Congress wants to move fast, but it is still Congress and that means it’s messy.

Reagan cut tax rates across the board, Trump plans to maintain most current tax rates with some small changes, and promised to eliminate taxes on tips, social security, and overtime.  These tax cuts are welcome, but they are not true supply-side tax cuts…the ones that boost entrepreneurship and innovation.

The really powerful potential of the Trump plans will come from DOGE, the Department of Government Efficiency, where Musk and Ramaswamy plan on proposing big cuts to the fourth branch of government – the Bureaucrats.  Every regulation that they can cut, every bureaucrat that they can keep from gumming up the private sector, will boost productivity.

But in addition to cutting red tape, the US must cut the absolute size of government.  John Maynard Keynes wanted deficit spending ended after a crisis was over.  But, after both the Panic of 2008 and COVID, the US kept spending elevated.  Government spending has risen from 19.1% of GDP in 2007 to 23.4% this year.  Government is a ball and chain on the economy.  We estimate that every one percentage point increase of spending as a share of GDP reduces underlying real GDP growth by 0.2%.

Every dollar the government spends is taken from the private sector, and the government taxes and borrows nearly 5% more of GDP today than it did seventeen years ago.  From 1990 through 2007, real GDP grew 3% per year.  From 2008 through the second quarter of 2024, real GDP has only grown 2% per year.  No wonder “the economy” was the #1 factor for Americans in this election.  Two percent annual growth is stagnation.

And this shouldn’t be happening according to fans of big government.  Economists like Mark Zandi and Paul Krugman support government spending and argue that it has a positive multiplier ($1 of government spending creates more than $1 of GDP).  Add this to the fact that the US has invented unbelievably productive new technologies in the last 17 years, and the economy should be booming.  Especially with the Fed holding rates at zero for nine of those years.

But it hasn’t, and the reason is that government is just too darn big.  Cutting government spending is a double-edged sword.  Half of all job growth in the past year has been in government jobs directly, as well as healthcare which is dominated by government.  Taking away that spending will initially slow job growth, but, with a lag, eventually boost economic activity.

In other words, the Trump Administration has a chance to boost underlying economic growth rates, and that would be extremely positive for living standards and equity values over the long-term.  But initially, it may result in slower growth.  The US had a car wreck with COVID.  Easy money from the Fed and big deficits were like morphine.  The US is addicted to short-term fixes that do nothing to boost long-term growth.  Withdrawal from the pain killers hurts, but is necessary to get truly healthy.

While we are extremely positive about the long-term benefits of policy changes, like under Reagan, weaning the US from massively easy fiscal policies does not guarantee overnight success.  It will take time, and the US will come through to the other side stronger.  The entire world will benefit…with a lag.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Don’t get too worried about the recent weakness in industrial production; output has been held back by temporary factors that should mostly be behind us. The Federal Reserve estimates that the Boeing strike held down total IP growth by 0.2 percentage points in October, and the lingering effects of two hurricanes subtracted an additional 0.1 points, as well.  As a result, we should see some catch up growth going forward. Looking at the details in today’s report, the weakness was concentrated in manufacturing, with activity falling 0.5%.  Production in the volatile auto sector dropped 3.1% while non-auto manufacturing (which we think of as a “core” version of industrial production) posted a more modest decline of 0.3% in October.  The only bright spot in this “core” measure came from production in high-tech equipment which rose 0.6% in October, likely the result of investment in AI as well as the reshoring of semiconductor production.  High-tech manufacturing is up at a 10.0% annualized rate in the past three months and 7.6% in the past year, the fastest for any major category.  The mining sector was also healthy in October, rising 0.3%.  Higher production of oil and gas more than offset a decline in the drilling of new wells and the extraction of other minerals and metals.  Finally, the utilities sector (which is volatile and largely dependent on weather) also posted an increase in October, rising 0.7%.  In other manufacturing news this morning, the Empire State Index, which measures manufacturing sentiment in the New York region, surged unexpectedly to +31.2 in November from -11.9 in October.

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Implications:   Despite years of higher prices, consumers continue to buy.  Retail sales rose 0.4% in October versus a consensus expected increase of 0.3%, while prior months’ activity was revised higher, bringing the overall gain to 0.6%.  Looking at the details, eight out of thirteen major sales categories rose in October.  Overall activity was boosted by a 1.6% increase for autos.  Stripping this out, sales were up a meager 0.1%.  Taking out the two other often-volatile categories of gas stations and building materials, “core” sales (the most important group for measuring GDP) were unchanged for the month.  Within the core sales grouping, restaurants and bars led the way, rising 0.7% following an upwardly revised 1.2% jump in the previous month.  While healthy growth, the 4.3% increase in restaurant and bar sales in the last year represents a slowing from the 8.6% advance in the year ending in October 2023.  We will be watching this category closely since it is the only glimpse we get at services in the retail sales report, which suffered heavily during the COVID years but have since returned to the forefront of the US consumer.  Partially offsetting gains in October were declining sales for health & personal care stores (-1.1%) and miscellaneous store retailers (-1.6%).  As a whole, retail sales are up 2.8% on a year-to-year basis, barely keeping pace with inflation.  “Real” inflation-adjusted retail sales are up 0.3% in the past year and still down from the peak in early 2022.  This highlights the ugly ramifications of inflation: consumers are paying higher prices today but taking home fewer goods than they were two years ago.  And while the Fed cut interest rates by a quarter percentage point last week and looks likely to cut again in December, it is not at all clear that inflation problems are behind us.  Case in point, import prices rose 0.3% and export prices jumped 0.8% in October versus a consensus expected decline of 0.1% for both.  We hope they have the resolve to stomp out the embers of inflation even if economic troubles come.

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The new Trump Administration hasn’t wasted any time since last week’s election win, with new information around economic policy and staffing appointments making news on a daily basis. In our opinion, the recent announcement of a new Department of Government Efficiency or “DOGE” headed by Elon Musk (who obviously came up with this name and acronym) and Vivek Ramaswamy, has been the most important so far.

As we mentioned in Monday’s piece, both these individuals have been making the rounds on various podcasts, before and since Election Day, speaking about plans to not only cut unnecessary regulation, but also potentially move agencies out of D.C. and downsize the headcount of the Federal bureaucracy by up to 50%. For context that would be the biggest reduction in headcount since the aftermath of WW2 as the US demobilized from the war effort.  Like everything in politics there are those who oppose these ideas.  One argument in opposition is that mass layoffs in Washington put the US economy at risk for a recession. We think this worry is misplaced.

The current Federal Government workforce (excluding the military) is roughly 3.0 million. Meanwhile, total employment in the US is around 160 million. We currently have 7 million unemployed individuals bringing the unemployment rate to 4.1%, a relatively low rate historically and one that hasn’t caused the US economy to stop growing. If the “DOGE” were successful in firing 50% of Federal employees, total unemployment would rise to 8.5 million and the unemployment rate would increase to just 5.0%.

If these job losses were all in the private sector, say in construction, it would lead to less production and a potential housing shortage. But, if these job losses are in bureaucracies that often interfere with production, then growth may actually accelerate.  Don’t get us wrong, we aren’t against stop lights and speed limits, and we don’t want to wait even longer to get our tax refund. But, a lot of government can be streamlined and automated. Moreover, these bureaucrats love to add pages to the Federal Register (a good proxy for total regulation).  Today, total pages of regulation have rebounded to near a record high.

Further, the vast majority of these workers will find work in the private sector, where free markets more efficiently allocate resources. These are well educated individuals with lots of potentially valuable skills that aren’t being fully utilized. The unemployment rate for people with a college degree or higher in the US is currently just 2.5%. These former bureaucrats would be able to find new jobs relatively quickly and this reallocation of talent would be an asset to future growth and innovation. And throughout the process, generous severances packages would give workers ample coverage while they find new work.

The reality is that the government has gotten too darn big. The Competitive Enterprise Institute estimates that regulation costs the US economy roughly $2 trillion a year. Add in Federal, State and Local spending and over 50% of the US economy is at the whim of the bureaucracy. This puts a wet blanket on innovation, with companies spending countless hours, dollars, and intellectual manpower trying to comply with rules and regulations, rather than applying those resources toward new and innovative ways to improve consumers’ quality of life. One clear example of this economic distortion, the Wall Street Journal recently reported 40% of the S&P 500 by market capitalization is being investigated by the Department of Justice, while the Department of Wildlife is interfering with the launch of rockets.  The real question is if we can afford not to address this growing problem, and we find it very encouraging that leadership is finally taking the issue seriously.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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With the election now behind us, attention turns to Trump’s campaign promises, especially the pledge to reduce the size of government. One of his newly appointed advisors, Elon Musk, has proposed the ambitious goal of cutting at least $2 trillion from the federal budget, aiming to bring greater efficiency to government operations. While Musk’s track record of innovation and cost cutting suggests he might be up to the challenge, reducing nearly a third of federal spending will neither be easy or universally popular. In this edition of “Three on Thursday”, we take a broad look at federal spending. 

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Implications:  While the Fed cut interest rates by a quarter percentage point last week and looks likely to cut again in December, it is not at all clear that inflation problems are behind us.  Producer prices rose 0.2% in October, despite declines in food and energy prices, which fell 0.2% and 0.3%, respectively.  These categories have played an outsized role in the slower inflation readings of recent months, but when you strip out these historically volatile components, “core” producer prices rose 0.3% in October and are up 3.1% in the past year, an acceleration from the 2.2% reading for the twelve months ending October 2023.  Diving into the details of today’s report shows service prices led the core index higher, rising 0.3% in October and up 3.5% in the past year.  The October increase in services was broad based, with all major categories showing higher prices.  Prices for goods rose 0.1% in October and are up a modest 0.2% from a year ago.  Within goods, rising costs for steel scrap, meats, and diesel fuel more than offset an 18.1% decline in liquified petroleum gas prices.  Further back in the supply chain, prices in October rose 0.5% for intermediate demand processed goods and 4.1% for unprocessed goods, but prices in both categories are down in the past year.  The direction of inflation moving forward is very likely to be dictated by 1) the services side of the economy, which suffered heavily during the COVID shutdowns but has since returned to the forefront and 2) changes in the money supply, which, after surging in 2020-21, peaked in early 2022. Although the M2 measure of money has been rising gradually since last October, it’s still down 2.3% from the peak in April 2022.  Too little growth in the money supply means continued downward pressure on both inflation and economic growth.  We will be watching the path of M2 growth closely as the Fed continues cutting rates. A sharp resurgence in M2 growth would bring with it the risk of accelerating inflation. Does the Fed have the patience to ease at a slow and steady pace, or will they overreact to any signs of economic trouble? Only time will tell, but the stakes are high, and the Fed’s record is less than pristine.  On the labor front this morning, initial jobless claims fell 4,000 last week to 217,000. Meanwhile, continuing claims declined 11,000 to 1.873 million.  These figures are consistent with continued job growth in November, but at a slower pace than earlier this year.

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Implications:   Inflation came in as expected in October but remains stubbornly above the Federal Reserve’s 2.0% mandate, warning investors that the inflation story is not over.  Headline prices rose 0.2% in October (+3.0% annualized) while the twelve-month reading rose for the first time in six months to 2.6%.  It’s worth noting that lately inflation has been held down by declining energy prices, which were unchanged in October but are down 4.9% in the last year.  Excluding energy, prices are up 3.2% in the last year. Stripping out the often-volatile category as well as food prices (+0.2% in October) to get “core” prices shows that measure rose 0.3% in October (+3.4% annualized), while the year-ago comparison remained at 3.3%.  The main driver of core inflation has been housing rents, which rose 0.4% and have shown little to no sign of slowing.  Some analysts – including those at the Fed – have argued that housing rents have artificially boosted the inflation picture due to the way it’s measured and the lags at which those changes are reflected in the monthly reports.  But a subset category of prices the Fed used to tell investors to watch closely but no longer seems to mention – known as the “Supercore” – which excludes food, energy, other goods, and housing rents, rose 0.3% in October and are up 4.4% in the last year, worse than the 3.7% reading in the year ending in October 2023.  No matter which way you cut it, inflation is still running above the Fed’s 2.0% target, now for the 44th consecutive month.  We have said for some time that easing in inflation will come should the Fed have the resolve to let the lagged effects of tighter monetary policy do its work.  But the Fed has now cut rates a total of 75bps since September.  And yet the embers of inflation continue burning.  Since we have yet to see a significant or prolonged slowdown in growth, much less a recession, it remains to be seen whether inflation will reach 2.0% or less on a consistent basis.  This month’s report did no favors proving that.

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The Federal Reserve cut short-term rates by a quarter percentage point last week, like pretty much everyone expected.  In addition, the Fed didn’t push back hard against market expectations of another quarter-point cut in mid-December, so unless the economic or financial news changes dramatically by then, expect a repeat at the next meeting.

It's not hard to see why the Fed has been cutting rates.  The consumer price index is up 2.4% in the past year versus a 3.7% gain in the year-ending in September 2023.  Meanwhile, the PCE deflator, which the Fed uses for its official 2.0% inflation target, is only up 2.1% in the past year while it was up 3.4% in the year ending in September 2023.

However, in spite of getting into the Red Zone versus inflation, the Fed isn’t yet in the End Zone, and it looks like progress has recently stalled.  According to the Atlanta Fed, the CPI is projected to be up 2.7% in the year ending this November while PCE prices should be up 2.5%.

It's also important to recognize that a few years ago the Fed itself devised a measure it called Supercore inflation, which excludes food, energy, all other goods, and housing.  That measure of prices is still up 4.3% versus a year ago, which is probably why the Fed has stopped talking about it.

Moreover, it’s important to recognize that there’s a huge gulf between the policy implications of the Fed reaching its 2.0% inflation goal and the public’s perception of inflation no longer being a problem.  Right or wrong, for now, the public seems to think that for inflation to no longer be a problem prices would have to go back down to where they were pre-COVID.

But that’s not going to happen.  The federal government spent like drunken sailors during COVID and the Fed helped accommodate that spending by allowing the M2 measure of the money supply to soar.  M2 is off the peak it hit in early 2022, but it would take a much greater reduction than so far experienced to restore prices as they were almost five years ago.

Instead, getting to 2.0% inflation means eventually accepting not only that prices aren’t going back to where they were but they’re going to keep rising, albeit at a slower pace.

And remember, even that goal has so far remained elusive.  The embers of inflation continue burning.  And since we have yet to see a significant or prolonged slowdown in growth, much less a recession, it remains to be seen whether inflation will reach 2.0% or less on a consistent basis.

The bottom line is that the Fed’s inflation goal remains elusive.  In turn, that means don’t be surprised if the Fed pauses rate cuts early next year.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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