Action and Reaction

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by Shawn Narancich, CFA
Executive Vice President

With just a couple of weeks left to go in the second quarter, investors wanting for a lack of earnings news found plenty of economic reports and central bank meetings to freshen up their views of the macroeconomy. Amid quieter trade in stock and bond markets that saw key equity indices and long-term interest rates finish the week close to where they began, inflation and retail sales data portrayed a U.S. economy that is increasingly robust. Despite the saber rattling of trade talks and the on-again, off-again nature of tariff threats, the tailwind from tax reform and robust employment levels indicate that domestic GDP growth could be as high as 4 percent in the second quarter.

The retail sales report for May provided evidence that a cold wet winter depressing economic activity in Q1 has given way to more robust spending this spring. Driven by strong levels of home improvement sales (likely boosted by delayed lawn and garden spending), month-to-month retail sales rose at twice the 0.4 percent rate economists predicted. Strong retail sales should come as no surprise given the economic backdrop — U.S. consumers are, for the most part, gainfully employed and enjoying higher after-tax incomes. Boosted by higher gasoline prices, the headline CPI Index for May also came in on the high side of expectations at +2.8 percent year-over-year, representing the highest rate of U.S. inflation since February 2012. More relevant for the Fed is the core personal consumption price deflator, which is now hovering just above the central bank’s 2 percent target.

All of which brings us to the confluence of several central bank meetings that took place this week. In keeping with expectations, the Fed raised short term rates by a quarter of a point again, reaching a targeted range of 1.75 – 2.0 percent for overnight bank lending. Of more consequence to Fed observers is the so-called “dot plot” of policymakers’ expectations for future rate hikes, which showed a majority now anticipate a total of four rate hikes this year, up from three previously. Two have already occurred, so that means the FOMC now expects another couple of rate increases before year-end. The Fed’s interest rate policy has served to reduce the differential between short- and long-term interest rates. This flattening of the yield curve indicates that monetary policy is beginning to approach a neutral state of affairs, i.e. one that is neither stimulative nor restrictive.

While the Fed is normalizing interest rate policy domestically, foreign central banks are still nursing their respective economies through more tentative expansions. In Europe, where economic growth has slowed in the first half of 2018, ECB chief Mario Draghi announced this week the central bank’s plan to eliminate its program of quantitative easing in December, while continuing to keep negative deposit rates in place until at least the middle of 2019. In Japan, an economy still battling to keep economic growth in the plus column, the central bank there announced that short-term rates would remain unchanged amid a continuance of its quantitative easing program.

With global economic conditions and central bank policies diverging, investors have witnessed the result not only in interest rate differentials, but in exchange rates as well. Since bottoming in late January, the trade-weighted dollar has risen by over 7 percent as capital avails itself of higher rates in the U.S. A weaker dollar was a tailwind for corporate earnings in 2017, as multi-national companies benefitted from translating foreign earnings into additional dollar-based profit. The staying power of a recently stronger dollar will depend in part on how economic growth and monetary policy play out around the world.

Our Takeaways for the Week

  • A heavy dose of economic data and central bank meetings left stocks and bonds relatively unchanged
  • Whether a resurgent U.S. dollar continues its rebound will depend in part on the degree to which the U.S. economy excels