William D. Johnston


Economic Commentary

The malaise in current economic conditions seems somewhat omnipresent in most media so it seems the right time to look under the hood and see not only what the current common set of facts are, but also examine what the likely scenarios are for the forward economic cycle. The Weekly Economic Index produced by the New York Federal Reserve Bank currently stands at 2.62% and while that is a steep decline from the high of 14.2% in the spring of 2021, it is a far more normalized level of economic activity from a historical perspective and reinforces a positive GDP rate. Declines in the index are due to expected influences such as declines in retail sales, steel production, tax withholding revenues, consumer confidence, rail traffic volumes, electricity output and an increase in weekly unemployment gains. Current unemployment is 3.6% and expectations for job gains to be released on July 8 are 273,000. The Federal Reserve begins their July meeting on Wednesday, July 6.

Expectations of future economic strength or weakness are important because consumer and business activity is often influenced by those expectations. If consumers are more anxious about their jobs, income and savings, they tend to spend less and save more. Even minor changes to consumption and saving habits can influence GDP growth in meaningful ways. The Consumer Confidence Index, Composite Leading Indicator Index and Business Confidence Index all indicate increasing rates of concern about the forward economic cycle though none have deteriorated to levels experienced in 2009 or March of 2020. Each of the above surveys are structured so that a reading above 100 reflects positive thoughts about the future and results below 100 reflect pessimistic views of the forward cycle which, as stated previously, reduce activity and increase savings. We like to access these results in combination with the PMI (Purchasing Managers Index) to see what correlation might be happening between consumer expectations and actual production activity. The PMI includes data and survey questions around new orders, inventory levels, production hours, supplier deliveries and employment. The survey represents 400 large employers in 19 industry sectors and is weighted to sector contributions to GDP. It has long been thought that readings below 50 represented economic cycles of contraction while readings above 50 represented cycles of expansion. The June PMI was recorded at 53, a decline of 3.1 from the May reading at 56.1 suggesting a slowing of economic expansion that began in April of 2021 but yet still positive.

As you might expect, the anecdotal comments repeated often in the survey results are concerns with energy prices, labor scarcity and ongoing logistical supply issues. I had the opportunity to travel in Eastern Europe for three weeks in June visiting Southern Germany, Austria, Slovakia and western Hungary. Each of those countries were experiencing almost identical economic conditions to those present in the United States. Each were benefiting from low unemployment and wage rate growth. All faced issues of global supply chain interruption and gas prices were slightly in excess of 2.00 Euros per liter or equivalent to about $8.50 per gallon. Inflation is both real and global. The contributors to inflation in the U.S. are the very same contributors to inflation in other countries. Ranked in order of year-over-year inflation, the contributors to increased prices are:

Energy                     34.8%

Transportation         14.6%

Non-Durable Goods 13.8%

Food                          8.8%

Shelter                        7.5%

Durable Goods            7.2%

Education                  5.4%

Services                      5.2%

Clothing                     2.2%

The largest component of price increases in the above categories was gasoline, resulting in shipping and delivery surcharges. The second largest component of price increases was energy prices that made the actual production of finished goods and raw commodity products more expensive and placed upward pressure on finished goods pricing. Also present in the component contributions to finished goods pricing was labor, reflecting the wage growth pressure due to wide spread labor shortages. The US current inflation rate is 8.3% year-over-year and when we exclude energy and food from the equation, inflation rests at 6.3% which remains 4% above the 2% target of the Federal Reserve.

The ten year treasury is currently yielding 2.80% which is a decline from the recent highs of 3.53%. Thirty year mortgage rates have declined for the past two weeks and some regions are experiencing stalled price growth in existing homes with days on market expanding. Are we seeing the beginning stages of a housing slow down? Perhaps, but yet too soon to confirm. Certainly the frantic activity level of the past near thirty months was unsustainable and eventually market forces will impact product availability to align with buyer demand. What can be said currently is that the advantage sellers experienced for the past pricing burst is eroding. How much is yet to be seen.

Significant inflationary pressure is simply the expectation of future conditions. Pricing of commodities that are required to manufacture goods can and do rise simply on the expectation that energy prices will continue to increase and the supply of commodities was already challenged prior to Russia’s invasion of Ukraine. Manufacturers also price products on the basis of assumed continuing price increases of commodities and component parts. Retailers assume energy price surcharges will continue and price on-the-shelf product to reflect expectation of future price increases. Suppliers of energy are delivering product globally and demand is exceeding supply, which is reflected in product pricing. Russia’s aggression and war raging against Ukraine has resulted in a global interruption of energy from Russia. NATO and most of the EU has remained resolute in their decision to avoid Russian energy; however, any effort by U.S. domiciled energy companies to deliver greater supplies of oil to be refined and delivered will have to be done so in a global supply chain thereby minimizing the pricing benefit of increased production. The energy component of production will be with us for some time and we should really be thinking of this disruption as very similar to the disruption of 1973 through much of 1975.