Final July Regional Fed Manufacturing Report

The Dallas Fed manufacturing report is the last of the regional Fed readings for July. This means we can make educated guesses on how the ISM manufacturing PMI will turn out. I expect it to be weaker than June, but still show strong growth. The Dallas general activity index came in at 32.3 which beat the consensus for 32.0, but was below last month’s report of 36.5. The production index was up from 23.3 last month to 29.4. As you can see from the chart below, the 6 month expectation for general business activity increased from 35.9 to 36.2. The chart shows both indexes are elevated, but below their recent peaks.

Energy prices drove this expansion as this region has a big fracking sector. Even though other regional Fed indexes showed there have been delays in deliveries, this report showed the shipments index was up 5.3 points to 30.8. There were a few underlying weak metrics which are disappointing, considering the overall index was strong. New orders were down 6.3 points to 23.3 and the company outlook index was down 12.8 points to 20.4. Only 27.2% of firms said business is expected to improve. There was a big increase in uncertainty from 7.9 to 17. 24.5% of firms had an increase in the level of uncertainty in their outlook. I think this is related to the tariffs.

In the comments section of this report, primary metals firms asked “what President Trump will do next? Will it help them or hurt them?” A fabricated metal product manufacturing firm stated “We were able to increase our pricing due to tariffs on steel effective on June 1 but have purchased steel at the old pricing on most gauges through Sept. 30. It seems like most volume steel users would have done the same. We are having a great year. Sales are up, and margins are up. We hope we have raised our prices enough to cover the higher-cost steel arriving in the fourth quarter.”

Finally, let’s review the prices in this report to see where inflation is headed. The prices paid for raw materials index fell from 53.6 to 48.6 and the prices paid for finished goods index fell from 26.2 to 229. As you can tell, inflation is heightened, but there was a slight reprieve. That makes sense because the growth rate of new orders fell, the shipments increased, the finished goods inventories index fell, and the delivery times index fell.

Quick June PCE Preview

The June PCE report will be pivotal in determining how Fed policy reacts to the uptick in inflation in the past few months. This report unbundles what we saw in the quarterly GDP report last week. The expectation is for core PCE to be up 2% year over year and 0.2% month over month. Those are both the same as the May reading. I’m expecting it to beat estimates and solidify the chances of 2 more hikes this year. The headline price index is expected to increase 2.3% year over year and 0.1% month over month. The month over month report is 0.1% less than May and the year over year data is expected to be the same as May. I wouldn’t be surprised to see results beat this low bar since the GDP report just showed a 3% price index gain.

Consumer spending is expected to double May’s month over month growth rate, coming in at 0.4%. Personal income is expected to be the same as May, with growth coming in at 0.4% month over month. The current Fed funds futures are pricing in a 70% chance of at least 2 more hikes this year. I don’t see the connection between expecting tepid inflation in June, while also pricing in 2 more hikes. I don’t think that the data expectations match the Fed funds futures market. I think if the data matches expectations across the board, the chance of 2 more hikes occurring in 2018 will decline.

Weak German Inflation, Improved Markit Report

In Germany, the headline acceleration in inflation since 2016 is all about the increase in energy prices. The core CPI has remained remarkably flat as you can see from the chart below. The July core CPI was only 1.1% and the July headline CPI was 2.0%, falling from 2.1% in June and 2.2% in May. Both indexes fell as they follow the weakness in the overall German economy.

The July Markit reading showed reasons for optimism about a potential rebound as the composite index increased 0.4 to 55.2, which was a 5 month high. The services index fell 0.1 to 54.4 which was a 2 month low. The manufacturing PMI was up 1.4 points to 57.3 which was a 3 month high. After private sector output fell to a 20 month low in May, there has been a modest improvement in the German economy. Clearly, this improvement, which is pronounced in the manufacturing sector, isn’t showing up in the inflation data.

U.S. Cycle Versus Europe

The chart below compares a few American and European indicators in terms of where they are in the business cycle. As you can see, economic confidence, margins, the labor market, equity valuations, bank loans, the yield curve, and forward earnings are all late cycle in America. They pushed the average up to 82 which is late cycle. The average is 53 in Europe because only economic confidence, margins, the labor market, and equity valuations are signaling the economy is late cycle.

We can look at each indicator in detail another time; the point here is to show the difference between America and Europe. America is late cycle and Europe is mid cycle according to this chart. Being late cycle isn’t as bad as it seems because sometimes economies have a tough time growing quickly and generating inflation as exemplified by Europe’s weakness in the past 10 years. European policy makers wish its economy would grow as fast as America’s economy generate as much inflation and even if it means a recession will follow in a few years.