Published on March 17th, 2017 | by Michael Drury at McVean Trading and Investments LLC0
Weekly Economic Update
To celebrate St. Patrick’s Day, I pause to honor my grandfather, Patrick Treacy — one of my three “off the boat” Irish grandparents — who was a great seanchai or storyteller. It is from him I get the gift of gab that flows forth in these weekly missives. This week’s letter concerns two ongoing trends that will shape the path of the global recovery – whether income is truly flowing from America’s elites to US consumers and whether China is exporting inflation or deflation. Despite a surge in US animal spirits, it is still not clear that we aren’t repeating the errors of the past two cycles where surging equity market valuations, which peaked in 2000 and 2007 and were near a record highs on election day, never did trickled down to Joe Six Pack – resulting in shifting control of the White House. For those of us privileged to live in the suburbs and who visit vibrant economic centers during our travels everything looks great. But is that success being shared equally enough that Joe Six Pack sees some progress?
In my hometown, Germantown, TN, there are currently three major projects planned or underway which amount to over $10,000 per resident in new retail, hotels and apartments. At that ratio, Memphis should see $14 billion and the country $3 trillion in investment – but won’t. My point is that Germantown is clearly seeing a disproportionate share of the upside as investors (and lenders empowering investors) like the best neighborhoods best. We are highly skeptical that all three projects can be profitable as there is already a plethora of underutilized retail space in town – not to mention in nearby less affluent areas. We fear that animal spirits is not enough if businesses are simply going to flood a narrow (though very economically significant) spectrum of the income distribution. There will clearly be stronger growth while the building is underway, but can an expansion be sustained when the projects – or at least the first two – are completed? We worry about 2018 and beyond.
This week’s retail sales report illustrated a microcosm of this first trend. Gasoline prices are on the rise, and they are cutting into Joe Six Pack’s ability to spend on discretionary items. When gas prices fell, the number one beneficiary was restaurant sales. As lower end households saw their monthly outlays on fuel decline, they rewarded themselves with more meals away from home. The impact was modest on white table cloth locations frequented by businesses, but substantial for fast casual eateries who benefitted as consumers traded up from fast food chains or grocery stores.
Since gas prices bottomed in November 2015, this pattern has reversed. Average consumers have not seen incomes rise as fast as gas prices have lifted inflation. The major cutback has been on fast casual restaurants and a return to food stores where prices are lower. How much minimum wage hikes have exacerbated this problem for restaurateurs will be clear later this year. While overall retail sales have soared from 1.8% in November 2015 to a hefty 5.4% in February 2017 (same quarter compared to a year ago), retail sales ex gas are only up from 4.2% to 4.7%. Almost all of this gain is due to higher sending on health care and online sales. Sales of autos and other durables were virtually unchanged at 5.5%, still far stronger than the average reflecting the wealthy’s better access to credit. This trend reversal is important because the US is still an energy importer (even if mostly from Mexico and Canada) and one of the fastest growing areas of employment over the past two years has been leisure and hospitality as Joe Six pack spent where other average Americans worked.
On the other side of the world, China announced this week that their PPI had reached 7.8% in February compared to a year ago, up from 6.9% in January. This torrid business level inflation is
unlikely to feed through to Chinese CPI as most of those prices are controlled by the Party. However, it is quite likely this inflation will flow through to exports, as they follow the rapid price driven rise in imports seen in last week’s February trade data. As we look at these two pieces of data we wonder whether they are contradictory or reinforcing. On the one hand, PPI is the series most closely correlated with Chinese nominal GDP. Because Chinese prices tend to follow real economic activity we read the surge in PPI as a sign of a booming domestic economy. China will still announce a 6.5% growth rate as prescribed by the Party in this week’s annual statement. They would no more report 9% now than they did 3% in 2014. Both numbers suggest that the market, not the Party, is in control.
The sharp narrowing of the trade gap in early 2017 suggests that commodity price increases are dampening the Chinese expansion just as collapsing import prices (and a booming surplus) cushioned the Middle Kingdom in 2014. Back then, China exported its recession to commodity producers and deflation to developed world consumers. Today we are in the reverse, and a pass-through of commodities inflation could soon show up on western shores. Chinese companies are poorly prepared to absorb any of this price shock, nor is the government likely to shield them as it tries to rein in the torrid growth. China raised interest rates another 10 basis points this week, which though timid is the second such incremental step. These baby steps are China’s way of warning local businesses that more is to come, just as they tip-toed on the way down in interest rates in late 2014.
We are perplexed by the fact that China announced very little change in both its currency and its FX reserves in January and February, while also reporting a collapsing trade deficit. When the trade surplus was exploding, China was weakening its currency to limit the negative impact on an already weak economy of being linked to the strong dollar. The massive inflow of foreign funds via the swelling trade surplus helped offset the FX reserve outflows as domestic investors moved to pay down dollar debt and horde the stronger currency. Now the yuan and FX reserves are steady despite a plunging inflow of foreign funds, suggesting domestic holders are moving rapidly back to yuan. Hmmmm… Bottom line, we expect the trade data in the first two months of 2017 significantly overstates the size, but not the direction, of the narrowing of the trade gap – and the speed and degree to which China will inevitably export inflation to the developed economies.