Implications:  The Fed will welcome today’s personal income and spending report showing healthy consumer activity and a breather on inflation, but we wouldn’t get too caught up on a single month’s report. PCE prices – the Federal Reserve’s preferred measure of inflation – were unchanged in May, bringing the twelve-month comparison to 2.6%.  But don’t go popping Champagne quite yet, remember that PCE prices rose by 0.3% or more in each of the prior four months, and prices are running above a 3% annualized pace this year through May.  “Core” prices, which exclude the ever-volatile food and energy categories, rose 0.1% in May and are also up 2.6% versus a year ago.  The Fed has prioritized a subset of inflation dubbed the “Supercore,” which is services only (no goods), excluding food, energy, and housing.  That measure rose 0.1% in May, is up 3.4% versus a year ago, and has remained stubbornly around 3.5% on a year-ago basis for the past seven months.  No matter which measure they choose, or how they try to spin it, inflation remains above the Fed’s target.  Transitioning to a focus on how consumers fared in May shows some positive momentum.  Personal income rose 0.5% in May and is up 4.6% in the past year.  Private-sector wages and salaries led the way, up 0.7% on the month and up 4.5% in the past year.  Unfortunately government activity continues to run hot as well, with government transfer payments rising 0.3% in May while government pay rose 0.5% and is up 8.5% in the past year, matching the largest twelve-month increase in more than three decades. We don’t think the growth in government pay – or massive government deficit spending – is sustainable or good for the US economy.  Consumer spending rose a more modest 0.2% in May, with both good and services showing gains.  When adjusting for inflation, consumption rose 0.3%.  We are closely watching the service sector as the driver of consumer activity both now and in the near future, and we expect activity to temper as higher interest rates and continued inflation pressures take their toll.  In other recent news on the manufacturing front, the Kansas City Fed Manufacturing Index, a measure of factory activity in that region, fell to -8 in June from -2 in May, following similar negative readings earlier this week from the Dallas and Richmond Feds. On the housing front, pending home sales, which are contracts on existing homes, fell 2.1% in May following a 7.7% decline in April.  Plugging these figures into our model suggests existing home sales, which are counted at closing, will drop in July, probably to the lowest level so far this year.

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In today’s Three on Thursday, we take a look at the surge taking place in net interest payments on treasury debt securities. Each year, when the U.S. incurs a deficit, it contributes to the growth of our national debt. The current outstanding federal debt has surpassed a staggering $33.6 trillion. However, what truly counts is the government’s ability to meet all the interest payments on this accumulating debt.

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Implications:   The final reading for real GDP growth in the first quarter ended up coming in as expected, revised slightly higher to a 1.4% annual rate from a prior estimate of 1.3%.  The upward revision to the overall number was mainly due to net exports (imports were revised lower), business investment (equipment and software along with structures) and government purchases. These more than offset a downward revision to consumption, mainly in services. Today we also received our second look at economy-wide corporate profits for Q1, which were revised lower, now down 1.4% from Q4 verses the 0.6% decline reported last month, but still up 6.4% from a year ago.  The government includes Federal Reserve profits in this data, and the Fed is making losses.  So, we follow profits excluding those earned (or lost) by the Fed, which are up 6.3% from a year ago.  However, profits excluding the Fed declined 1.2% in Q1, the largest drop for any quarter since Q3 2021 with domestic non-financial companies’ profits falling the most.  Plugging in non-Fed profits into our Capitalized Profits Model suggests stocks remain overvalued.  In addition to corporate profits, we also got a second look at the Q1 total for Real Gross Domestic Income, an alternative to GDP that is just as accurate.  Real GDI was revised lower to a 1.3% annual rate in Q1 and is up 1.8% versus a year ago.  Regarding monetary policy, inflation remains stubbornly high.  GDP inflation was revised slightly higher to a still elevated 3.1% annual rate in Q1 versus a prior estimate of 3.0%.  GDP prices are up 2.4% from a year ago.  Meanwhile, nominal GDP (real GDP growth plus inflation) rose at a 4.5% annual rate in Q1 and is up 5.4% from a year ago.

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Implications:  Durable goods orders inched positive in May, narrowly beating a consensus expected decline.  However, the details in today’s report – along with downward revisions to prior data – show a slowing economy.  Although orders for durables were up slightly in May they are down 1.5% from a year ago.  May orders were led higher by defense aircraft and motor vehicles and parts, up 22.6% and 0.7%, respectively, in May. That said, transportation orders are very volatile month-to-month, and orders declined 0.1% excluding the transportation sector.  Looking deeper at the details of the report shows mixed performance across the major non-transportation categories, with orders for machinery (-0.5%), primary metals (-0.4%), and electrical equipment (-0.4%) declining, while fabricated metal products (+0.3%) and computers and electronic products (+0.1%) increased.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – declined 0.5% in May. If the pace of these shipments remains unchanged in June, core shipments would decline at a 1.9% annualized rate in Q2 versus the Q1 average.  The growth in shipments has moderated significantly since surging in 2020 as PPP loans and stimulus payments flooded the system, and shipments fell into contraction in the fourth quarter of 2023 before the rebound last quarter.  We expect this trend of turbulent readings to continue as the economy feels the lagged effects of the Federal Reserve’s tightening of monetary policy.  In other recent news, initial claims for jobless benefits fell 6,000 last week (possibly held lower by the Juneteenth holiday) to 233,000, while continuing claims rose by 18,000 to 1.839 million.  The figures are consistent with continued job gains in June, but at a slowing pace.  

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Implications:  New home sales came in weaker than expected in May, posting the largest monthly decline since 2022 following back-to-back gains.  It looks like activity is stuck in low gear, with sales having normalized roughly at the same pace they were in 2019 before COVID.  Stubbornly high inflation continues to be the biggest headwind to a broader recovery, delaying widely expected rate cuts from the Federal Reserve and keeping 30-year fixed mortgage rates above 7%. Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle amounts to a 24% increase in monthly payments on a new 30-year mortgage for the median new home.  The good news for potential buyers is that the median sales price of new homes has fallen 9.3% from the peak in 2022. It does look like a small part of this decline reflects a lower price per square foot as developers cut prices.  The Census Bureau reports that from 2022 to 2023 (the most recent data available) the median price per square foot for single family homes sold fell 1.1%. While that decline is modest, it represents a stark reversal from the 45% gain from 2019 to 2022.  That said, most of the drop in median prices is likely due to the mix of homes on the market including more lower priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 200% versus the bottom in 2022. Total inventories have continued to climb higher as well, hitting a new post-pandemic high in May. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  Though not a recipe for a significant rebound, more inventories giving potential buyers a wider array of options will continue to put a floor under new home sales.  One problem with assessing housing activity is that the Federal Reserve held interest rates artificially low for more than a decade, and buyers started to believe those low rates were normal.  With rates now reflecting true economic fundamentals, the sticker shock on mortgage rates for potential buyers is very real.  However, we have had strong housing markets with rates at current levels in the past, and as long as the job market remains strong and buyers understand that the past was a mirage, it’s possible they will eventually adjust.  In other recent housing news, the Case-Shiller index increased 0.3% in April and is up 6.3% from a year ago. Meanwhile, the FHFA index ticked up 0.2% in April and is up 6.4% from a year ago.   In the manufacturing sector, the Richmond Fed index, a measure of factory activity in the mid-Atlantic, fell to -10 in June from 0 in May.  Also earlier this week, the Federal Reserve released monthly figures on the money supply showing M2 up 0.4% in May and up 0.6% in the past year.  After surging in the first two years of COVID, M2 declined from early 2022 through early 2023 and has since been close to flat.  This recent history should eventually put downward pressure on the growth rate of nominal GDP.

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Back in the early days of COVID, there was one key indicator that signaled or predicted the high inflation ahead: the M2 measure of the money supply. Unlike in the aftermath of the Financial Panic and Great Recession of 2008-09, M2 surged at an unprecedented pace in 2020-21.

So, while others looked back and said “QE doesn’t cause inflation” we didn’t.  While many said that inflation was “transitory,” we warned about inflation going higher and being more persistent.  And here we are more than four years past the onset of COVID and inflation is still lingering above the pre-COVID trend.  The Consumer Price index is up 3.3% from a year ago while core consumer prices are up 3.4%.

What we take from all of this is that many economists, investors and policymakers ignored M2 to their detriment.  As a result, they have been surprised by the surge and persistence of inflation.  You think they might have learned.

But now a new conventional wisdom has taken hold, which says the US is out of the woods on a potential recession.  This, in their view, supports a trailing price-to-earnings ratio of 24 on the S&P 500, a level that in the past has been associated with low future returns on equities.

We hope a recession doesn’t happen, but think their dismissive attitudes towards warning signs like M2 (which has declined in the past 18 months) increases the chances they get caught flat-footed by a downturn.  We know it’s not visible yet, but every once-in-a-while there’s an economic report that should make people re-think their pre-conceived notions.

That applies to home building in May.  Out of the blue, housing starts dropped 5.5%, completions fell 8.4%, and permits for future construction declined 3.8%.

Housing starts and permits are now sitting at the lowest levels since the early days of COVID, even as the flow of immigration remains elevated.  Whether you support or oppose high levels of immigration, where are all the newcomers going to live if we aren’t building more housing?  And isn’t one of the arguments in support of high immigration that industries like home construction need cheap labor to build more homes?

In the meantime, retail sales surprised to the downside in May, eking out only a 0.1% gain for the month, but including revisions to prior months were actually 0.3% lower.  Retail activity is roughly unchanged since the end of last year, which means after adjusting for inflation, consumers are buying fewer goods.  Car sales rose slightly in May, but are down from last December and even down from June 2023.

In addition there’s an early sign that the labor market may have some trouble ahead: initial claims for unemployment insurance averaged 211,000 per week in the fourth quarter of 2023, as well as the first quarter of 2024.  But initial claims have averaged about 240,000 in the past two weeks.  Hopefully this is just some seasonal variation and claims will go back down soon, but it is worth watching closely in the weeks ahead.  (One caveat is Thursday’s initial claims report will include Juneteenth, a relatively new holiday which may confuse seasonal adjustments.)  

None of this means a recession has already started.  Industrial production surged 0.9% in May, which is not a recessionary number at all.  The Atlanta Fed GDP Model is back up to tracking 3.0% annualized growth in Q2, while we are tracking 2.0%.  And private payrolls continue to average over 200,000 jobs added per month, even if gains appear to have been led by part-time positions.

It's also important to recognize that fiscal policy has never been this “loose” (the deficit so high) when the unemployment rate has been so low.  But with the interest burden on the federal debt as a share of GDP suddenly shooting up to the highest since the 1980-90s, the days of using the budget to try to artificially boost growth should soon come to an end.

There’s no guarantee of a recession in the year ahead, but the risk shouldn’t be casually dismissed.  Not paying attention to M2 has cost investors more than once already.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  There wasn’t much to get excited about in today’s report on existing home sales, with activity falling 0.7% in May, the third decline in a row. It looks like the housing market remains stuck in low gear due to affordability. First, sales are still facing headwinds from mortgage rates that remain above 7%. Second, home prices are rising again (hitting a new high in May) with the median price of an existing home up 5.8% from a year ago.  Assuming a 20% down payment, the rise in mortgage rates since the Federal Reserve began its current tightening cycle in March 2022 amounts to a 43% increase in monthly payments on a new 30-year mortgage for the median existing home.  Eventually, the housing market can adapt to these increases but continued volatility in financing costs will cause some indigestion. Notably, sales of homes priced at $1 million and above have risen 22.6% in the past year versus a decline of 2.8% for all existing home sales. This demonstrates that, at least at the higher end of the market, both buyers and sellers are adjusting to the new reality of higher rates. That said, outside the most expensive segment many existing homeowners are 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 18.5% in the past year.  That said, the months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) was 3.7 in May, well 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.

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In today’s Three on Thursday, we test claims made by a prominent U.S. Senator in a recent media interview by examining trends in government spending and revenues as well as the share of taxes the rich have been paying. 

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Implications:  If you want to know why home prices have remained elevated and rising in most places and rents are still heading up in much of the country, it’s really very easy: we are building too few homes while lax enforcement of immigration laws mean rapid population growth.  We think government rules and regulations are likely the major hurdle for builders in much of the country.  However, 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.  Housing starts missed consensus expectations in May by a wide margin and fell to the slowest pace since the worst of the COVID pandemic.  This was not due to builders focusing their efforts on completing projects they had already started, as completions fell 8.4% in May.  The total number of homes under construction is down 5.1% so far this year, the kind of drop usually associated with a housing bust or a recession.  Looking at the details of the report, the drop in activity in May was broad based, with both single-family and multi-family as well as three out of four major regions contributing.  Building permits showed similar weakness in May, falling to the lowest level since June 2020. An ongoing theme has been the split between single-family and multi-family development.  Over the past year, the number of single-family starts is down 1.7% while multi-unit starts are down 49.5%.  Permits for single-family homes are up 3.4% while multi-unit home permits are down 28.8%.  Fitting the pattern, the NAHB Housing Index, a measure of homebuilder sentiment, fell to 43 in June from 45 in May.  A reading below 50 signals a greater number of builders view conditions as poor versus good.  No matter how you slice it, 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, which is why we think government rules and regulations are likely a major problem.  However, there are some tailwinds for housing, as well.  For example, many owners of existing homes are hesitant to list their homes and give up fixed sub-3% mortgage rates, so many prospective buyers will 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.  In employment news this morning, initial claims for jobless benefits fell 5,000 last week at 238,000, while continuing claims rose by 15,000 to 1.828 million.  The figures are consistent with continued job gains in June, but slower than the recent pace.  Finally, on the manufacturing front, the Philadelphia Fed Index (a measure of factory sentiment in that region) fell to +1.3 in June from +4.5 in May.

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Implications:  Industrial production surprised to the upside in May, due to gains in every major category, matching the largest overall monthly gain since early 2023.  Manufacturing was the biggest positive contributor, rising 0.9%.  Looking at the details, auto production rose 0.6% while non-auto manufacturing (which we think of as a “core” version of industrial production) posted a gain of 0.9% in May. One bright spot recently in manufacturing has been the production of high-tech equipment, which is up 8.2% in the past year, the strongest growth of any major category, likely the result of investment in AI as well as the reshoring of semiconductor production. That said, activity here has begun to slow recently, with May posting a gain of just 0.1%. This signals that the initial burst of activity due to the CHIPS Act may finally be wearing off.  The mining sector was also a tailwind in May, with activity increasing 0.3%.  Gains in the production of oil and gas more than offset a slowdown in the drilling of new wells.  Finally, the utilities sector (which is volatile and largely dependent on weather) was also a source of strength in May, rising 1.7%.  In other news this morning, the Empire State Index, a measure of New York factory sentiment, rose to a still weak reading of -6.0 in June from -15.6 in May.

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