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On Being Positive About the Fed

As in... I am positive another rate hike is coming our way next week.

This past week, some of us took a personality test here at the office. My answers to the questions scored out as an ENFP-A, or an ‘Active Campaigner.’ According to the website, one of the bigger weaknesses of this type of person is being overly optimistic. That might surprise some of you, but it is directionally accurate, mostly.

However, this business can test the patience of the biggest Pollyanna amongst us. It certainly has over the last several years. We have gone from bust to boom to whatever it is we are experiencing now.

  • Are we in a recession or not?
  • Is inflation ever going back down?
  • Will the Fed continue raising the overnight lending target rate?
  • What does the economic data say?

The answer to that last question is, unfortunately, it depends. Put another way, are you a pessimist or an optimist? Half-full or half-empty?

Yesterday, the Bureau of Economic Analysis (BEA) announced the US economy grew at a 1.1% annualized rate during the 1st Quarter of 2023. This was less than the survey’s median estimate of 2.0%, or thereabouts.

Clearly, the rate hikes are slowing things down, right? If this continues, there isn’t any way we will avoid a recession, correct?

Unfortunately, it isn’t as easy as that. As I told everyone on yesterday morning’s conference call, there was something in the report for both bulls and bears. If you are inclined to think the economy was in good shape, you could pull out some data and proclaim it so. Conversely, if you are all doom and gloom, why go much past that depressing 1.1% number?

Here is the rub:

  • Businesses added $136.5 billion to their inventories during the 4th Quarter of 2022.
  • Last quarter, they drew them down around $1.6 billion.
  • That $138.2 negative swing was enough to take a whopping 2.34% off the Gross Domestic Product (GDP) equation.

That doesn’t sound so good, does it? On its face, it doesn’t. However, I have been doing this so long I know the inventory line item often serves as a counterbalance to consumer expenditures. After all, if the consumer is stronger than expected, inventories will decrease. Obviously, businesses will have to replenish them moving forward.

That isn’t necessarily a bad thing. It simply means inventories were a drag on the 1st Quarter’s GDP. Intuitively, they will add to the equation either next quarter or the one after that. Basically, over time, inventories shouldn’t add or subtract from the equation significantly. After all, today’s inventories will be tomorrow’s purchases.

In nerd-speak, they will go from the I component of the GDP equation to the C variable at some point in the not-so-distant future. In case you forgot: GDP = C + I + G + NX (net exports).

So, what happened?

It seems US consumers bought a lot of vehicles last quarter. ‘Motor vehicles and parts’ and ‘recreational goods and vehicles’ accounted for $70.2 billion of the overall $129.6 billion increases in personal consumption expenditures. That works out to be 54.2%. However, those two line items are only 10.8% of the C (consumer) variable in the equation.

Clearly, US auto makers are going to have to replenish their inventories. Given the multiplier effect the industry has throughout the economy, that has to be a good thing. It simply has to be. Right?

I have two words for you, slow down. You see, the BEA reports all of this stuff on a seasonally adjusted basis, which I have discussed here in the past. However, dealers don’t have the luxury of financing their floor plan on a seasonally adjusted basis. The bank wants its money in the here and now.

To that end, it seems auto inventories are at their highest levels in 2-years, at 1.89 million units. That works out to be a 56-day supply. However, borrowing costs are a lot higher now than they were 24-months ago, much. Trust me, there probably isn’t a dealer out there who wants to be financing, say, 90-days of inventory right now. Strike the probably.

If it seems I am talking out of both sides of my mouth, I am. There is a reason why people who do what I do for a living are infamous for saying “on the one hand, but on the other hand.” This being there is almost always more than meets the eye when it comes to analyzing economic data.

You can’t just rely on the headline number. On the flipside, you can’t let the underlying data bamboozle you either.

So, just how was it, or is it? The US economy?

Simply put, the GDP report for the 1st Quarter of 2023 was like déjà vu all over again. My apologies to Yogi Berra. There were some silver linings in the dark clouds, but the clouds were dark nonetheless.

Still, when you peel back the layers of the proverbial onion, the US economy is probably a little stronger than it should be at this point in a tightening cycle.

However, it is far from hitting on all cylinders.

At least according to the report for last quarter.

Of more concern to most of the members of our Investment Committee are:

  • Recently weak regional Fed surveys,
  • the persistently negative yield curve,
  • trailing 12-months of negative Leading Economic Indicators, a
  • a shrinking money supply and
  • core inflation data which remains higher than the Fed would like, somehow.

Whew.

To that end, the Core PCE deflator in yesterday’s GDP report was 4.9%. This was higher than it was during the 4th Quarter of 2022, 4.4%, and a mile away from the Fed’s 2% target.

For this reason, unless something dramatic happens over the weekend, the FOMC will hike the rate another 25 basis points (0.25%) next Wednesday.

This will take the upper range to 5.25%, and the Prime rate will likely follow suit to 8.25%. These are all the reasons explaining how you can have a weak headline number AND still have the Fed on pace to continue raising rates.

In the end, I guess who really can say I am something of an optimist. I am positive what the Fed is going to do next week. Just as sure as the nose on my face, it is going to shoot another 0.25% bullet at the economy.

Still, keep in mind, no matter what the Fed does and how much we agonize over it, the sun will come up in the East tomorrow. Of that, I am also optimistic.

John Norris

Chief Economist & Eternal Optimist

Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.