The Fed Keeps a Watchful Eye as U.S. Economy Continues to Improve

The Fed’s “Beige Book” painted a beige—or is it Goldilocks?—picture of the economy, as most districts reported economic activity growing at a modest/moderate pace, employment generally rising, and wage pressures still generally well-contained. Nothing suggested cause for the Fed to change its plans or guidance.

  • Indeed, in her speech last week, Fed Chairwoman Janet Yellen said that she thinks the U.S. is at least 2 years away (maybe more) from reaching full employment and that inflation pressures remain subdued, so tightening policy any time soon would probably be premature.
  • With that said, her speech wasn’t all that dovish. She didn’t make new promises or push the envelope; rather, she reiterated that Fed policy remains data-dependent and the Fed “must always be prepared to respond” to rising inflation.
  • Somewhat worryingly (for those who worry about these things), she stressed the mandate of maximizing employment and acknowledged the responsibility to constrain inflation, but made no mention of preventing asset price bubbles in things like stocks, houses, or things that yield 5%.

Business and Consumer Activity Rebounding
Early in the week, the Empire State (NY Fed) survey disappointed, slipping from 5.6 to 1.3 on weak new orders. Later in the week, the Philadelphia (Mid-Atlantic) Fed index surprised on the upside, rising from 9.0 to 16.6 on strong new orders. The market’s reaction suggests Philadelphia trumps New York.

  • Industrial production was up 1.2% in February and rose another 0.7% in March. Capacity utilization rose from 78.8% to 79.2%. Both are at cycle highs.
  • Earnings are coming in OK…guidance is no worse than expected. So far, so good.
  • The consumer came out of hibernation in March, as retail sales rose a solid 1.1%; February’s increase was revised up from 0.3% to 0.7%. The retail inventory:sales ratio ticked down slightly – still high, but less of a concern than feared.

Chinese Data Continues to Suggests Softness

  • Q1 GDP was 7.4% y/y, trending down, but still above expectations/fears.
  • March industrial production, retail sales, and credit market data were somewhat disappointing.
  • Government data showed house price inflation slowing, investment in property slowing, and construction slowing.
  • Premier Li once again ruled out large-scale fiscal stimulus despite the slowing economy: reform—including reducing overcapacity—is the priority.
  • A Chinese government report said nearly 20% of China’s land is polluted and that remediation will be very expensive.

In Japan: Some Good News, but Some Challenges Remain

  • Early indications are that the Japanese sales tax increase isn’t hurting sales as much as feared.
  • Japan’s working-age population fell almost 1.5% last year — to a 32-year low —as retirees outnumbered new adults.

European Inflation and Exchange Rate Policy … a Little Verbal Jousting
Eurozone March CPI was +0.5% y/y; core was 0.7% y/y…about as expected, but well below the ECB’s mandate. A week ago, the ECB spoke about the impact of the value of the Euro on Eurozone inflation, with ECB Chair Mario Draghi saying “A strengthening of the exchange rate requires further monetary stimulus. This is an important dimension for price stability.”

Last week, France’s Economic Minister reportedly responded that exchange rate policy fell within the remit of European Council, not the ECB. Apparently though, the Finance Minister didn’t voice any objection to negative interest rates … just to the explicit setting of exchange rate policy. The real message, though, was “this is how it’s done”. Recall that the G7 accepted Japanese quantitative easing, fully expecting the Yen devaluation which followed, because its stated purpose was to end deflation. If the ECB deploys negative interest rates to lift inflation back toward the target rate, associated Euro weakness is acceptable. Targeting the exchange rate directly, however, would be impermissible.

Meanwhile, slow growth in Europe continues and developments seem encouraging.

  • Eurozone February industrial production was up 1.7% y/y — not much, but slightly better than forecasted.
  • Germany’s April ZEW Economic Sentiment Indicator was mixed.
  • France’s new Prime Minister announced cuts in spending on health care and social benefits to pay for tax cuts aimed at boosting economic growth.

Ukraine Update: A Pause … Hopes for a Peaceful Resolution Rise

  • Ukraine, Russia, the EU and the U.S. reached a “first step” agreement in Geneva—implementation would reduce tensions.
  • The key might be a national referendum on a new constitution giving significant regional autonomy to the eastern part of the country.

Last Week in The Capital Markets
Good news drove a “put the risk back on” rally in developed markets.

  • Currencies: The dollar was up about a half a percent against the Yen and Euro. It was a quiet week except for the Brazilian Real, which was notably weak, losing almost 2%.
  • Bonds: Treasury yields continued to rattle around in a trading range, rising last week on good economic news and less bad news from Ukraine. 10-year U.S. Treasury yields were up 9 basis points (bps) to 2.72%; the 10-year TIP yield rose 2 bps, to 0.52%. High yield fell 14 bps last week, back to 368.
  • Equities: The MSCI Japan Index, rebounding from the sharp week-ago drop, was up about 3%. Finance Minister Aso suggested that the Government Pension Investment Fund (GPIF) might change its portfolio allocation, sparking hopes that its buying power would push stock prices higher. The MSCI Europe Index was up roughly 1%. The MSCI Emerging Market Index, the week-ago leader, was near break-even. The S&P 500 Index returned 2.7%, with sector leadership signaling greater confidence in the U.S. economy. Energy (up 4.7%) led; Industrials (+3.6%) and Materials (+3.1%) were next-best. Utilities (+1.6%) and Telecom Services (+1.9%) lagged.
  • Commodities: WTI oil was up about 0.5%; gold was down about 1.5%.

Data Sources: The Wall Street Journal, Financial Times, Bloomberg.

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About Sam Wardwell

Sam Wardwell, CFA, is Senior Vice President and Investment Strategist at Pioneer Investments. He joined Pioneer in 2003.
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