Another week with more confusing, conflicting information about the state of the economy indicates further interest rate hikes are on the way.
The Week That Was
The July job report released last Friday shows employment continues to grow but at a slower rate. Private payroll jobs are growing at a 1 percent annual rate, compared to 2½ percent over the past year.
Service companies represent about two-thirds of the economy. July business surveys continue to show strong growth. Although the overall reading of 53 indicates moderate growth, new orders and inflation were high, with readings of 55 and 57, respectively.
Manufacturing surveys, which represent about 11 percent of the economy), indicate this sector is already in a recession. The July survey registered the 11th consecutive monthly decline for both overall activity and for new orders. July also marked the second consecutive decline for manufacturing production and employment readings and the third month for falling prices.
Higher interest rates are causing problems for small- and medium-sized businesses. Those with variable rate loans that started in the 4 percent or 5 percent range are now hitting 10 percent to 11 percent, challenging survivability. In addition, banks are tightening credit and limiting their business lending in response to regulatory actions.
Look for a further wave of business bankruptcy filings in the months ahead.
Things to Come
On Thursday the July CPI report will bring disappointing news. Oil prices in July were $76, up 9 percent from May. We expect the year-over-year total CPI to jump from 3.0 percent to 3½ percent while the core CPI will remain at 4½ percent.
The high inflation reading noted in the ISM survey of service companies and the rapid increases in wages also point to persistent inflation. With a further increase in oil prices to more than $80 in August, we should have at least two consecutive months of disappointing inflation news. Friday’s producer price report for July is also likely to suffer from the jump in oil prices.
Market Forces
Stocks moved slightly lower last week, for the first time in two months. Fitch’s rating downgrade on U.S. debt to AA+ from AAA was given as the reason.
The rating decline is understandable given the surge in federal spending and debt over the past three years and no near-term efforts to contain it.
However, more important is the latest economic news. In contrast to the previous week, July reports show the economy moving ahead at a brisk pace with inflation far from subdued.
July business surveys show the service sector remains healthy going into the third quarter. The Atlanta Fed estimates based on the latest data show Q3 real growth near 4 percent annualized. A surge in oil prices in July and August is adding to inflation.
This news raises the immediate potential for the economy and inflation to continue and to exert more upward pressure on interest rates. Without signs of a serious slowdown in the economy, the interest rate cycle still has a way to go.
As for stocks, higher interest rates compete with stocks for investors’ money. The higher interest rates go, the more it reduces the fundamental value of stocks, which tends to anticipate the next move in the economy.
The longer the economic slowdown or downturn is delayed, the greater the potential for serious pain when it finally arrives. With additional upward pressure on interest rates, we remain concerned about the prospects for stock prices.
Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 17 percent
Monetary Policy: restrictive
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