In this week’s “Three on Thursday,” we explore the current state of indebtedness and financial health of U.S. households. Each quarter, the Federal Reserve Bank of New York provides a comprehensive overview of consumer borrowing and repayment trends, drawing from a nationally representative sample of Equifax credit reports. 

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Implications:  Producer prices took a breather in February following back-to-back months of rising at an outsized pace.  While a lack of price movement in February may make headlines suggesting inflation problems have abated, one month does not make a trend.  Even with no change in prices in February, producer prices are up 3.2% in the past year, and the pace of inflation is accelerating over the past three and six-month time periods.  This certainly shouldn’t instill confidence at the Fed that inflation is under control.  It’s notable that the February reading of no change was not the result of modest price movements across categories, but rather came from large price movements in categories cancelling each other out.  For example, food prices – which tend to be volatile month-to-month – jumped 1.7% in February led by a 53.6% increase in the cost of chicken eggs.  This was offset by a 1.2% drop in energy prices – another often-volatile category – as gasoline and home heating oil costs fell.   Strip out the food and energy categories, and “core” producer prices fell 0.1% in February but are up 3.4% in the past year, a notable acceleration from the 2.1% reading for the twelve months ending February 2024.  These “core” prices were led lower by a drop in margins received by vehicle and machinery wholesalers, while margins also fell for auto parts and apparel retailers.  On the goods side, prices were led higher by tobacco products and carbon steel scrap.  Further back in the supply chain, prices rose 0.5% for intermediate demand processed goods and 1.3% for unprocessed goods.  Trade disputes, and specifically companies adapting purchasing plans as they try to make heads and tails of what may come next in this constantly shifting environment, will likely bring increased volatility to the data over the coming months. We will be focusing on the M2 measure of money, which is down from the peak in early 2022, as a guide to how inflation is likely to move as we progress through 2025.  In employment news this morning, unemployment claims fell 2,000 last week to 220,000; continuing claims declined 27,000 to 1.870 million.  These figures are consistent with continued job growth in March.

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Implications:   Inflation was less than expected in February, but likely won’t change the Federal Reserve’s path for rates.  Consumer prices rose 0.2% in February versus a consensus expected gain of 0.3%, with the twelve-month reading declining to 2.8%, not far off the 3.2% inflation in the year ending February 2024.  While the 0.2% increase in February was the smallest move in four months, keep in mind that comes out to +2.6% annualized, still above the Fed’s inflation target of 2.0%.  Looking at the details, the rise in prices was broad-based, with energy and food both matching the headline move of +0.2%.  It’s important to note these two-often volatile categories have not been what’s kept inflation from returning to the Fed’s 2.0% target.  “Core” prices, which strip out food and energy, also rose 0.2% in February, with the twelve-month reading falling to 3.1%, above headline inflation.  The main driver of core inflation has been housing rents, which continue to outpace most categories (+0.3% in February), though not as much as in the years prior.  Some analysts – including those at the Fed – have argued that housing rents have artificially boosted inflation due to the way it’s measured.  But a subset category of prices that Fed Chair Jerome Powell said back in November 2022, “may be the most important category for understanding the future evolution of core inflation” – known as the “Supercore” (which excludes food, energy, other goods, and housing rents) – has been running hotter than headline and core inflation, up 3.8% in the past year.  The good news is this measure rose 0.2% in February. Still, no matter which way you cut it, inflation continues running above the Fed’s 2.0% target.  While this month’s inflation report is an improvement, one month of data does not make a trend.  We expect the Fed to remain on hold until inflation renews its long and winding march toward 2.0%, or the economy slows substantially.

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It is true that tariffs are a tax.  It is also true that tariff policies have been volatile…on and off again…different carve outs…different countries…phone calls that change things.  All of this clearly has an impact on the market.  So, we are not surprised to see stock market volatility.

However, it isn’t all about tariffs.  Many major models of overall stock market valuation show that the market is expensive.  The so-called Buffett Indicator, which measures the market cap of the S&P 500 as a percent of GDP, says the market is overvalued.  The Shiller CAPE PE Ratio, which measures stock prices compared to trailing 10-year inflation-adjusted earnings, shows the market is overvalued.  In other words, compared to history, stock prices are on the high side.

Some argue that it’s different this time.  That AI, and technology in general are moving so fast, and so powerfully, that historical measures don’t work.  One way to deal with this is to compare stock values and earnings to a discount rate…in other words compare the stock market to the bond market.

The Fed Model, which compares the earnings yield of the S&P 500 (the inverse of the PE ratio) to the 10-year Treasury yield or to a corporate bond yield, shows that stock returns relative to bond returns are the lowest since 2000 – the dot-com bubble.

Our Capitalized Profits Model, which discounts current profits by the 10-year Treasury yield, shows the same thing.  We are overvalued relative to past relationships of earnings and interest rates.  (To view all these charts, see our latest Three on Thursday by following this link.)

However, as the saying goes, it is a market of stocks and not a stock market.  Just because these models say the market as a whole is over-valued does not mean all stocks are over-valued.  But because the S&P 500 is so top heavy, with just 10 stocks making up over 1/3rd of its total capitalization, it is hard for the other 490 stocks to offset declines in these very large cap companies.

Back on January 6th, we published our forecast for 2025.  Our expectation was for the S&P 500 to finish this year around 5,200.  We have not changed our forecast.  For the record, unless earnings grow much faster than the consensus expects (around 10% this year), or the 10-year Treasury falls to 3% or below, even at 5,200 the market would remain over-valued.

We think the policy changes that are underway will be positive for long-term growth.  Keeping tax rates low, cutting regulations, and reducing the size of the government bureaucracy will boost the underlying growth rate of the economy in the future.

Unfortunately, the US economy has been artificially boosted in recent years by massive deficits and a very loose monetary policy.  Reducing that artificial stimulus is like having morphine wear off.  We expect the economy to grow more slowly this year, which means corporate profits are unlikely to grow faster than the consensus expects.

In other words, what is good for the long-term makes the short-term look worse.  This is much like what happened with Ronald Reagan in the early 1980s.  Even though his policies led to a boom in the economy, the fix (especially for inflation) was a painful process.

So we are not surprised to see the stock market reaction of the past few weeks.  Investors have been so used to “buying the dip” because the stock market has been a one-way trade, that seeing it fall toward or into correction territory feels worse than it really is.  This compounds negative feelings and people start looking for scapegoats.

We get it.  But tariffs are just the catalyst, not the full explanation.  Don’t forget, when Reagan moved into the White House, the PE ratio of the S&P 500 was about 8.  When Donald Trump moved back into the White House it was 28.

This doesn’t mean investors should abandon stocks altogether.  The valuation models we mentioned are not meant for trading.  They are indications of value.  And when valuations are high, there are still opportunities.  To find them, we suggest reading Dave McGarel’s Market Minute.  As we said a few weeks ago, “the era of easy everything is over.”  And as McGarel says in his Market Minute, “when you break stride it’s hard to win the race.”  Clearly the market has “broken stride,” which shouldn’t be a surprise to anyone looking at heady valuations.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Payrolls continued to expand in February, but other signals from the labor market show all is not well.  Nonfarm payrolls grew 151,000 in February, narrowly missing the consensus expected 160,000. A large part of the gain came from health care and social assistance jobs, up 63,000.   Meanwhile, jobs at restaurants & bars dropped 28,000.  We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (that includes COVID lockdowns and re-openings for leisure & hospitality).  In what is probably the best news for February, this “core” measure of jobs rose 83,000, beating the 33,000 monthly average in the past year.  However, in what is probably the worst news for February, civilian employment, an alternative measure of jobs that includes small-business start-ups dropped 588,000.  As a result, and in spite of a 385,000 drop in the labor force (people who are either working or looking for work), the unemployment rate ticked up to 4.1% versus 4.0% in January.  Meanwhile, the U-6 measure of unemployment spiked upward to 8.0% from 7.5%.  That measure counts as unemployed not only those normally counted but also those working part-time who say they want full-time jobs as well as “marginally attached” workers, who are unemployed workers who still say they want a job and have looked for one in the past year.  Other details in today’s report suggested moderate economic growth, but reasons for the Federal Reserve to be cautious about cutting short-term interest rates.  Total hours worked increased 0.1% in February and are up 0.6% in the past year.  Add that gain in hours worked to the trend growth rate in productivity (output per hour) of 1.8% per year in the past decade and you get close to 2.5% economic growth.  Meanwhile, average hourly earnings rose 0.3% in February and are up 4.0% in the past year.  The Fed would probably like to see that annual gain closer to 3.5% before it’s comfortable with the path toward 2.0% inflation.  Notably, federal government payrolls (excluding the Post Office) declined 7,000 in February, the largest drop for any month since 2022.  Given the Trump Administration’s goal of reducing the federal workforce, we expect more of this in the months ahead, potentially much more.  That may cause some short-term pain for the US economy, but we expect long-term gains from reducing the size and scope of the federal government, including more jobs gains in the private sector.

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With the market volatile, we thought it would be a good time to take a look at alternative valuation models. Every major valuation metric of the S&P 500 Index is flashing warning signs. In this week’s “Three on Thursday,” we look at three key different valuation models – plus, as a bonus, our own in-house model – each offering a unique perspective on just how stretched equity prices may be.

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Implications: Imports soared to a record high in January as businesses were front running tariffs that might be put in place by the Trump Administration. The increase in imports was led by industrial supplies, mainly due to a massive increase in finished metal shapes, which can be used in the manufacturing of cars, appliances, and other equipment. This category also includes gold bars which are considered finished metal shapes. Several countries were key to the import surge all with their largest monthly increase ever recorded. Imports from Switzerland soared by $9.6 billion (mainly gold), while imports from Ireland increased by $6.2 billion, and those from Australia by $2.2 billion. The surge in imports will have a huge influence on the calculation of real GDP for the first quarter because when it comes to GDP accounting, imports are a negative. As a result of the surge, it now looks like international trade will be a roughly 3 percentage point drag on the growth rate in Q1 and overall real GDP should drop at about a 1.5% annual rate, with a rebound bounce in growth in Q2 as firms soon end the process of front running tariffs. Looking at the overall trend, total trade is up 14.7% from a year ago, with exports up 4.1% and imports up 23.1%.  There also continues to be a major shift going on in the pattern of US trade and with new tariffs that look lasting on China we expect this to continue.  China used to be the top exporter to the US.  Now the top spot is held by Mexico; China has fallen to number two with Canada nipping at her heels.  Also in today’s report, the dollar value of US petroleum exports exceeded imports once again.  This marks the 32nd consecutive month of the US being a net exporter of petroleum products. In other news this morning, initial jobless claims declined 21,000 last week to 221000, while continuing claims rose 42,000 to 1.897 million.  These figures are consistent with continued job growth in February, but at a slower pace than seen in recent years.

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Implications:  The February ISM Services report signaled continued expansion in the sector that drives two-thirds of the US economy.  The overall index beat consensus expectations and rose to 53.5 in February from a previous level of 52.8.  We do believe sentiment can move this survey so it may reflect new optimism of political change.  Fourteen out of eighteen major service industries reported growth in the month while three reported contraction.  The overall increase was led by faster growth in employment, with the index moving to the highest level since late 2021 at 53.9.  However, growth was split, with an equal number of industries (seven) reporting an increase versus a decrease in employment in February.  Notably, two of the industries to report a decrease in employment were Public Administration and Health Care & Social Assistance, both of which were lifted by government spending but likely now affected by the impact of DOGE.  As for other details, new orders picked up while business activity remained steady.   Both of these forward-looking indexes sit in expansion territory (52.2 and 54.4, respectively), but survey comments suggest things could change quickly, as they were full of concerns over tariffs and how they will affect activity if implemented.   Finally, the highest reading of any category was once again the prices index, which increased to 62.6 in February, with sixteen out of eighteen major industries paying higher prices.  Inflation was a major problem before any new tariffs and will continue to be one if the Federal Reserve does not have the resolve to let tight money suffocate the embers of inflation that remain.  As for the economy, the service sector continues to be a lifeline for growth, standing in contrast to the recent wave of weak economic data.  In other news this morning, ADP’s measure of private payrolls increased 77,000 in February versus a consensus expected 140,000. We’re estimating Friday’s official report will show a nonfarm payroll gain of 165,000 with the unemployment rate remaining steady at 4.0%.  On the autos front, cars and light trucks were sold at a 16.0 million annual rate in February, up 3.2% from January and up 2.1% from a year ago.

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Implications:  Activity in the US manufacturing sector expanded marginally for the second month in a row, but the details of the report were ugly.  Nearly all major measures of activity declined in February and sit in or are hovering near contraction territory.  The new orders index led the drop, falling to 48.6 from 55.1.  Production cooled to a reading of 50.7, while the employment index fell to 47.6; the tenth month in the last twelve below 50.  Although manufacturing was already tepid before, it appears a key reason for the drop in the index this month had to do with policy coming out of Washington.  Survey comments were full of tariff concerns, with reports of price increases from suppliers and delayed customer orders over uncertainty with how the tariffs will be implemented.  Notably, one respondent in the Computers & Electronic Products industry said that limits on U.S. government spending in key organizations like the FDA, EPA, and NIH are delaying some of their orders. We expect volatility in the data to continue in the months ahead as businesses figure out how the new policy environment changes the outlook for investment and growth.  Perhaps the worst part of the report was that inflation remains a major problem in the manufacturing sector.  Prices paid by companies rose again in February and the pace accelerated, with the index rising to 62.4. That is the highest index level since the surging inflation of 2022, a clear sign that the embers of inflation remain even as manufacturing stagnates.  We hope the Federal Reserve has the resolve to stomp the embers out, despite the short-term economic pain that may result from federal policy changes – pain that will ultimately pave the way for long-term growth. In other news this morning, construction spending declined 0.2% in January, as a large decline in homebuilding fully offset smaller increases elsewhere.

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Is the US already in recession?  Probably not.  But in the first quarter, real GDP is very likely to have a minus sign in front of it.  Yes, a negative reading for real growth!

Even before Friday there were some troubling signs.  Retail sales fell 0.9% in January while housing starts dropped 9.8%.  The personal saving rate hit a new post-COVID low in the fourth quarter, existing home sales declined 4.9% for the month and, with pending home sales (contracts on existing homes) down, February will likely be weak as well.  Meanwhile, manufacturing production slipped in January as did shipments of capital goods excluding aircraft and national defense.

In addition, in what could be an early sign of layoffs in the private sector from DOGE-related government spending cuts in Washington, initial claims for unemployment insurance jumped to 242,000, up noticeably from the 213,000 in the same week the year before.

But the real reason for a drop in real GDP was reported last Friday.  The advance report on international trade in January reported a massive surge in imports for the month, led by industrial supplies.  This is important because the primary way the government counts GDP is to add up all the things we’re buying – whether by consumers, businesses, or the government – and then to subtract out imports.  Gross Domestic “Product” is a measure of how much the US is producing, so imports don’t count.  For example, if we buy 100 mousetraps total but we imported 20 of them, then we only made 80 mousetraps in the USA.

Plugging the surge in imports into our models suggests negative growth for Q1, which was confirmed by the Atlanta Fed’s GDP Now, which is tracking -2.8% growth in Q1.

But just because we expect a negative reading in Q1 doesn’t mean a recession is here.  The data are volatile for many reasons.  For example, unusually cold winter weather plus California fires probably held down retail sales and homebuilding.

And it seems clear that the surge in imports in January reflects many importers front-running proposed tariffs by the Trump Administration – they’re bringing the goods in early to avoid higher tariffs later – which means the import surge should reverse sometime in the next few months.  If so, the drop in Real GDP in the first quarter could be followed by a temporary surge in Real GDP growth in the second quarter.    

But that still leaves the effects of what is likely to be a consistent effort by the Trump Administration to bring down government spending.  We think those efforts are a positive for future long-term economic growth, but in the short-term could deliver some pain as some consumers and businesses who have grown addicted to living off government redistribution need to adapt to a more free-market environment.

With headwinds, tailwinds, and side winds hitting all at once, the data are not very clear.  While we do expect the US to face an eventual recession, a negative Real GDP growth report for Q1 is not yet defining evidence.  It is a reason to be concerned, but we will look elsewhere for confirmation.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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