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Wednesday, October 19, 2016

Inflation and a High Pressure Economy

Financial Review

Inflation and a High Pressure Economy


DOW + 41 = 18,202
SPX + 5 = 2,144
NAS + 2 = 5,246
10 Y + .00 = 1.74%
OIL – .15 = 51.45
GOLD + .60 = 1,270.50

The consumer price index climbed 0.3% last month. The cost of shelter — rent, new homes and previously owned homes — rose at the fastest pace since May. Energy prices, mainly gas, also posted the biggest increase since early spring. The cost of food was unchanged for the month.

Over the past year, consumer prices have advanced 1.5%. The so-called core CPI, which strips out food and energy costs, gained 0.1 percent last month. That slowed the year-on-year increase in the core CPI to 2.2 percent.

Energy costs were up 2.9 percent in September as oil and gasoline prices rebounded from recent lows. Previous price declines still mean that gas costs 6.4 percent less than a year ago. So, what does this mean for the Federal Reserve? Since one of the biggest drivers of inflation is energy prices, which the Fed does not seem to control, maybe it is possible to have what Fed chair Janet Yellen described as a “high pressure economy”, in other words a tighter labor market, without igniting inflation.

Higher gas and electricity prices may push inflation closer to the Fed’s target of 2% but it is not an indication that the economy is getting healthier, rather higher energy prices serve as a tax on economic growth.

Outside of housing and energy, there’s not much inflation. Food prices have actually fallen in the past year. Prices of durable goods are down 2.3% in the past year, a continuation of a 20-year trend of falling prices. Falling prices aren’t great for retailers’ or manufacturers’ bottom line.

The other place where inflation is running hot is medical care (up 4.9%) and drug prices (up 7%) – again, not an indication of a growing economy. Meanwhile, we aren’t seeing inflation where most of us would like to see it – in our paychecks. Real or inflation-adjusted hourly wages fell 0.1% in September. Hourly pay is up just 1% in the past 12 months.

Americans who get Social Security will get a 0.3% increase in their monthly checks in 2017. The estimated average monthly benefit for all retired workers will rise to $1,360 from $1,355. Annual increases in Social Security are made every year based on changes in a component of the consumer price index known as CPI-W. Inflation has been quite low for several years largely owing to a plunge in oil prices. Grocery prices have also fallen in the past year.

The extra benefits kick in on Jan. 1. Social Security recipients got no cost-of-living adjustment in 2016 because inflation was even lower. The Social Security administration also announced that the maximum taxable earnings will rise to $127,200 from $118,500 in 2016.

The National Association of Home Builders’ index of homebuilder sentiment fell to 63 after surging to its highest in a decade in September. Any reading over 50 signals improvement. Current sales conditions dipped two points to 69, while the measure of sales expectations for the next six months rose one point to 72. The index of buyer traffic declined one point to 46. The NAHB says builders continue to see the same fundamental drivers of demand, such as a strong job market and low mortgage rates.

First-time buyers may be entering the U.S. home market in greater numbers than industry watchers had assumed. According to a survey by the real estate firm Zillow, nearly half of sales in the past year went to people who were buying their first home. Forty-seven percent of purchases in the past year went to first-time buyers. Their median age was 33.

It’s become harder to realize the dream of home ownership without a college degree. Sixty-two percent of buyers have at least a four-year college degree. Just 12 percent of homeowners in 1986 were college graduates.

Older Americans, age 65-75, are still buying homes, but they are downsizing; the median size is 1800 square feet, about 220 square feet smaller than the homes they sold. But that smaller new home still cost more. These retirement-age buyers paid a median of $250,000, nearly $30,000 more than the home they sold.

Netflix crushed earnings.  The video-streaming giant earned $0.12 a share on revenue of $2.29 billion, topping the $0.06 and $2.28 billion that were expected. Netflix added 3.2 million international subscribers, well ahead of the 2 million that analysts were looking for. The stock was up by more than 20% in after-hours action.

IBM earnings beat on the top and bottom lines. IBM earned $3.29 a share on revenue of $19.2 billion, beating the $3.24 and $19 billion that Wall Street was anticipating. The company has seen declining year-over-year revenue for 18 consecutive quarters.

Goldman Sachs reported a profit of $2.09 billion, or $4.88 a share. That compares with $1.43 billion, or $2.90 a share, in the same period last year. Sluggish trading activity across Wall Street – particularly in fixed-income, where Goldman is strongest – dragged down earnings.

UnitedHealth Group hiked its 2016 earnings forecast again after its profit swelled 23 percent to nearly $2 billion in the third quarter. UnitedHealth earned $1.97 billion in the three-month period that ended Sept. 30, up from $1.6 billion in the previous year’s quarter. Total revenue grew nearly 12 percent to $46.3 billion in the quarter. The insurer added nearly a million customers through its employer-sponsored and individual coverage. Medicare Advantage membership grew 12 percent, and total enrollment topped 48 million in the quarter.

Johnson & Johnson, the world’s largest maker of healthcare products, reported third-quarter revenue and profit just ahead of Wall Street estimates, fueled by strong sales in its prescription drugs business. J&J earned $1.68 per share on revenue of $17.8 billion. Despite solid earnings, J&J shares dropped today on news Pfizer would begin U.S. shipments of Inflectra, its biosimilar form of Remicade, by late November at a 15 percent discount to J&J’s current wholesale prices. Remicade is J&J’s biggest product, with US sales of around $5 billion.

Burberry’s second quarter comparable retail sales rose for the first time in four quarters, growing 2% and topping expectations for a 1% increase. The U.K. luxury fashion retailer was helped by the slump in the pound following the Brexit vote in June.

A federal judge in San Francisco said today that he is “strongly inclined” to approve a record-setting $10 billion proposed buyback and compensation offer from Volkswagen for 475,000 owners of polluting 2.0-liter diesel vehicles which were equipped with illegal software to defeat emissions testing. U.S. District Judge Charles Breyer said he will issue a final decision in the matter by Oct. 25.

Of the 52 S&P 500 companies that have reported results to date for the third quarter, 81 percent have reported earnings that have topped analysts' average estimate, according to Thomson Reuters. These market-beating reports have led analysts to narrow their estimates.

Now analysts estimate earnings at S&P 500 companies rose 0.2 percent in the quarter, compared with their estimate of a 0.7 percent drop at the start of the earnings season. Profits at these companies last rose in the second quarter of 2015. If the good earnings continue, the latest third quarter will be the first since 2014 in which both earnings and revenue of S&P 500 companies increased.

According to the latest research from analysts at Bank of America Merrill Lynch, investors are increasingly worried about a massive bond market pullback. Only the “EU disintegration” beat out “Crash in bond market/rising credit spreads” in terms of what money managers feel is the biggest “tail risk”: Fund managers pushed their cash balances to 5.8 percent of their portfolios in October, up from 5.5 percent last month, matching levels not seen since the aftermath of the Brexit vote.

The share of cash hasn’t been higher than that since November 2001, shortly after the terrorist attacks in the US. There is no shortage of risks on the investor horizon, according to market participants surveyed, with 18 percent fearful of a disorderly adjustment in the bond market. Elevated cash balances potentially set the stage for a stock-market rally, triggering a contrarian buy signal.

Another consideration – even though fund managers might be turning to cash, the central banks are still investing in stocks. Among the central banks with disproportionately large equity holdings are the Bank of Russia, the Bank of China, the Swiss National Bank, the Bank of Japan, the Hong Kong Monetary Authority, the Bank of Israel, the Czech Central Bank, the Bank of Denmark.

The Federal Reserve is not allowed to buy company stocks directly; however, many market observers speculate that the Fed is using indirect methods to prop up the US equity indexes. And the Fed has certainly discussed more direct investment as a possible option in the future.

There is no doubt the Fed would like to “add to their toolkit”. If the discussion ever gets to the point where the Fed starts talking to Congress about approving Federal Reserve direct stock purchases, it would set the stage for another leg higher in this increasing tired bull market.

Central banks investing in equities are not active stock pickers. Rather, central banks use exchange-listed ETFs, which passively track a major equity benchmark index. In this way, central banks remain “neutral”, not favoring one company over another or obtaining voting rights in company general assemblies.

The central banks’ choice to use ETFs explains the success of passive investing recently, as their purchases “lift all boats”. Similarly, the outperformance of expensive large cap stocks can also be attributed to central bank equity purchases, as ETFs track generally market-cap weighted indexes.

This would also offer insight into why the markets have been able to maintain and grow despite surprisingly high valuations. Central banks are not value buyers, rather they seem to be indiscriminate. And of course, this only works when central banks continue to buy.

Disney decided against buying Twitter recently partly due to concerns that the hate speech that’s rampant on the social network would undermine Disney’s family friendly image, Bloomberg reports. Another reason is that although Twitter has a market cap of almost $12 billion, it continues to lose money, which sparked opposition to the purchase among some of Disney’s largest investors.

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