Business Investment Growth - Beige Book

The Fed’s Beige Book gives us great insight into why stocks have been volatile in October. The Fed used the word “tariff(s)” 51 times which is up from 41 in its previous report, making it the high of the year.

It’s worth noting the use of the word “trade” fell by about 10 to 12. The Fed used the word “concern(s)” 13 times which is the lowest since January. It was used it 10 times in January.

This implies the Fed is hawkish because it’s not worried about negative trends. I like the analysis of word usage because the Fed is extremely precise with its language.

Furthermore, we don’t know what the neutral rate is, so this analysis gives us further clarification into how hawkish policy is. Keep in mind, it’s important to look at a variety of words tested. The Fed talked less about trade, but more about tariffs.

The chart below shows the Beige Book diffusion index which measures the usage of “strength”, “strong”, “moderate”, “modest”, and “weak.”

Negative readings indicate a dovish report. Weak economies are met with dovish policy. This includes rate cuts, holding rates below the neutral rate, and QE. It also can include slowing the unwind of the balance sheet.

In the current environment, the Fed won’t cut rates, but it could slow the pace of rate hikes.

The positive readings are hawkish. Strong economics are met with rate hikes and unwinding the balance sheet.

In the past couple of years, the Fed hasn’t been using QE to react to the economy. But I wouldn’t rule it out if the economy shrinks.

As you can see, current hawkishness is the highest in the last 13 months. It’s interesting to compare the stock market’s performance from October 2017 to October 2018.

This month has a hawkish policy and worse performance than last October. Obviously, that’s not the only change since last year. Now the economy must deal with tariffs. Last year, the economy was coming into tax cuts and now the effect of the stimulus is withering away.

Business Investment Growth - Weak Core Capital Goods Orders

The September durable goods report was mixed, but the long-term trend is lower because core capital goods orders missed estimates.

New orders were up 0.8% month over month which beat estimates for a 1.5% decline. The August report was revised up 0.1% to 4.6% growth.

Excluding transportation, growth was 0.1% which missed estimates for 0.4%. The August report was revised up from 0.1% to 0.3% growth. Core capital goods orders were down 0.1%. This was below the lowest estimate on Wall Street for 0.1%. That means business investment is weakening. Consensus was 0.5% growth. August’s reading was revised from -0.5% to -0.2%.

As you can see from the chart below, the proxy for U.S. business capex growth fell to 1.86%. That's a sharp decline from August.

This is a strong indicator that growth is slowing. It is in tune with the average capex plans seen in the NY, Philly, Richmond, and Kansas City regional Fed reports.

Durable goods report is bad for Q3 GDP and the regional Fed reports signal Q4 GDP growth might be worse. There was only a marginal month over month increase in orders for primary metals. This was a declaration from the previous months. It still grew almost 20% year over year.

(Click on image to enlarge)

Good news is there was a build in unfilled orders of 0.8% and 0.9% in August and September. Tariff related pre-buying continued in metals. Their unfilled orders were up 1.1% and 1.3% in the past two months.

Inventories were up 0.7% which will help Q3 GDP growth as expected. Since shipments were up 1.3%, the inventory to shipments ratio is a lean 1.6.

This implies more inventories can be built. On a year over year basis, overall orders were up 7.9% and ex-transportation orders were up 5.9%. The economy is still growing, but core orders are decelerating.

Business Investment Growth - Good Housing Report

The housing market has been the most hotly debated topic on Wall Street. Many are blaming the October correction on its weakness.

XHB homebuilder ETF was up 2.91% on Thursday. It rallied with the overall market. Prior to that, it was down 30.18% from its January 22nd high.

Finally, we received good news on housing from the pending home sales index. The September reading was up 0.5% month over month. It beat the expectation for flat growth and met the highest estimate.

This was better than the revised decline of 1.9% in August. That index increased from 104.1 to 104.6.

Meaning, the existing home sales report should be good. The west was up 4.5% month over month as it was the strongest region.

However, it was still down 7.4% year over year. Overall pending sales were down 1% year over year.

Business Investment Growth - Weak Kansas City Fed Report

October Kansas City manufacturing report is in tune with the Richmond Fed reading which showed weakness.

Kansas City index fell from 13 to 8. These reports go against the strength seen in the Markit PMI report.

The production reading fell from 10 to 5 and the volume of new orders index fell from 15 to 7.

Also, unlike the Markit report, inflation fell. Prices received index fell from 24 to 19. And the prices paid index fell from 45 to 33. Expected capex reading fell from 36 to 14. This is in tune with the September core capital goods orders.

The report includes quotes from businesses which help us understand the weakness.

One business stated, “Margins are being reduced due to lack of labor availability, supply chain effects of tariffs both on component costs (increasing) and sales opportunities (decreasing)… make it difficult to get all components in a house in time for building products.”

This is the perfect quote to summarize the weakness in manufacturing. Businesses are being squeezed by tariffs and high labor costs. This is like the home building industry. Except that home builders also must deal with regulations on where they can build multi-family houses. And also with end market weakness as consumers feel home prices are very unaffordable.