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– October 12, 2017

AIER’s Business Cycle Conditions Leading Indicators Index declined in September to a reading of 75 from 88 in the prior month. The Roughly Coincident Indicators Index remained at a perfect 100 for a seventh month while the Lagging Indicators Index rose to 58, the first increase since June 2016 (see chart below). The drop in AIER’s leading indicators was expected as the impact from Hurricanes Harvey and Irma dragged down some economic data. Going forward, there is likely to be a mix of negative and positive forces impacting economic data, but the broad spectrum of information still suggests continued economic expansion in the months and quarters ahead.

Among the leading indicators to show weakness in the latest month, real retail sales changed from a positive trend to a neutral trend. Despite the change, macro fundamentals for consumer spending remain generally favorable. A closer look at the industry shows retailers underperforming recently after a long period of outperformance.

Leading Indicators Drop on Hurricane Impacts
Seven indicators were expanding in September while four were neutral and one was declining. That compares to nine expanding, none declining, and three neutral in August. Two indicators changed direction in September, as initial claims for unemployment insurance and real retail sales both turned weaker.

Initial claims was one of the first data series to reflect the impact of Hurricanes Harvey and Irma. Weekly claims figures surged from around 236,000 to almost 300,000 in a single week. That surge was enough to tip the indicator from a favorable trend to a negative trend. Weekly data have already started to recede, dropping to 260,000 in early October. It is highly likely that this indicator will return to a favorable trend over the next couple of months.

Real retail sales has been one of the strongest and steadiest of the leading indicators, registering a long string of favorable results. However, softening auto sales over the past eight months slowed the rising trend in nominal sales. When adjusted for inflation, retail sales turned to a neutral trend in the latest month as the consumer price index surged due to a jump in energy prices related to hurricane damage. Unit auto sales surged in September as vehicles destroyed by flooding started to be replaced. However, that pace is likely to slow again. Similarly, the jump in energy prices is likely to reverse, so adjusting nominal retail sales for price changes should have less impact. With strong labor-market conditions throughout most of the country, it seems likely that nominal and real retail sales will return to positive trends in coming months.

The Coincident Indicators Index registered a perfect 100 for the seventh month, as all six of the indicators continued expanding. The seven-month run of perfect readings is the first such run since October 2014 to April 2015. All six of the coincident indicators are now showing solid expansion trends.

AIER’s Lagging Indicators Index improved in September, posting a reading of 58, matching the reading from June. Overall, three indicators are trending higher, one is now trending flat, and two are in a downward trend.

Economic Activity Growing Modestly
Second quarter real gross domestic product was revised up for a second time, now registering a 3.1 percent annual rate. Strong growth was evident in consumer spending, business investment, and exports while residential investment and government spending dipped.

Monthly data reported so far suggest third-quarter growth is likely to slow, largely due to disruptions from Hurricanes Harvey and Irma. Industrial production and retail sales showed significant weakness in August, though there are some signs that rebounds are already occurring in some areas.

The labor market is also showing mixed signals as, on the negative side, job creation slowed just a bit in August and, as already mentioned, initial claims surged. On the positive side, job openings remained at a record level and business and consumer sentiment is holding up relatively well even with storm disruptions.

The first signs for September were quite positive as unit auto sales surged on hurricane-replacement activity. Reports from the Institute for Supply Management suggested accelerating expansion in both the manufacturing sector and the nonmanufacturing sector.

Price Increases Remain Tepid on Moderate Money and Credit Growth
Energy prices surged even before Hurricanes Harvey and Irma made landfall, and reports of price gouging in impacted areas appeared in the media. The impacts have yet to flow through to price measures, but as of the August CPI report, the core CPI was up just 1.7 percent over the past year and 1.4 percent annualized over the last three months. Within the core, goods prices were down 0.9 percent for the 12 months and 1.7 percent at an annual rate over the last three months. Core services—primarily housing, hospital services, transportation (likely energy-related), and recreation—continues to be the source of price increases.

M2 money supply growth has been decelerating for almost a year, with the 12-month growth rate now at 5.3 percent, down from a recent peak of 7.6 percent in October 2016. Over the past three months, M2 been growing under 5 percent, posting a 4.5 percent pace though August.

On the bank-credit side, growth total loans and leases at commercial banks has also been decelerating, posting a 3.5 percent rate over the past year down from a 7.8 percent pace in August 2016.

Fed Policy Remains on a Path of Slow Normalization, Though Risks are on the Horizon
On September 20, the Federal Reserve announced it would begin shrinking its holdings of Treasury and mortgage-backed securities. The change in policy had been discussed extensively and was anticipated by economists and investors. Despite the lengthy lead time in preparation for the actual announcement, the process is still unprecedented. So while there was no significant market reaction to the announcement, the impact on the markets during the process is still uncertain. Given the relatively small amount of reinvestment that is being eliminated, it seems unlikely there will be a major disruption, but caution is warranted.

The Fed also released updated Summary Economic Projections suggesting an additional rate hike in 2017 is still anticipated as are three rate hikes in 2018. While there is some debate about the path of future adjustments to the fed-funds rate, in the bigger picture, the Fed remains on a historically slow path.

The more pressing issue for monetary policy is the potential for major changes at the Fed. There are already multiple openings on the board, Vice Chair Stanley Fisher has tendered his resignation, and Chair Yellen is up for reappointment in early 2018. A possible major shift in policy implementation due to a changing composition of the Fed board is a significant area of uncertainty and a major risk for markets and the economy over the medium term.

Interest Rates Remain Low Historically but Relatively High Versus Other Mature Economies
The yield on the benchmark 10-year Treasury note has ranged between 1.5 percent and 3 percent for most of the past 5 years. In times of geopolitical, financial, or economic distress, rates drifted to the bottom of the range and moved to the top of the range as stress eased. Currently, the yield is hovering slightly above 2.3 percent, close to the midpoint of the range. The combination of higher short-term rates coming from a likely Fed rate hike and marginally less demand from the Fed as reinvestment slows may provide upward pressure across the curve.

However, offsetting those pressures is the relative value of U.S. Treasuries versus sovereign bonds of other industrialized countries. A yield around 2.3 percent looks attractive compared to 0.04 percent on a Japanese government bond or 0.45 percent on a euro bond. Foreign holdings of U.S. Treasury debt have begun to rise again after dipping a bit in late 2016. Foreign holdings have grown by more than $250 billion over the first seven months of 2017.

U.S. Equities Hitting Record Highs
U.S. equities across the market-cap spectrum are hitting new highs. Prices are getting support from solid earnings growth, low inflation, and low interest rates. Valuations such as price-to-earnings ratio suggest equities are expensive, though knowing what a “fair value” is can be an extremely difficult if not impossible task. P/E multiples are high by historical comparisons, but arguments can be made about the low-rate / low-inflation environment justifying higher multiples compared to most periods in the past. Still, with valuations high by most historical measures, it would not be surprising to see excessive reactions to any news that suggests risks to the economic outlook.

Industry Review: Retail
The S&P 1500 retailing industry group has 88 companies, 29 large caps, 16 mid-caps, and 43 small caps. From 1997 through 2015, retailers in the S&P 1500 sharply outperformed the broader market, though there were some periods, typically before and early in recessions, when retailers underperformed. Since December 2015, the retailing group has also underperformed the broader market.

As is the case with many market-cap-weighted indexes, large-cap stocks tend to drive performance. The performance of the 29 large-cap retailers relative to the S&P 500 is nearly identical to the broader relative performance of the retailers for the S&P 1500. However, for both the mid-caps and the small caps, relative performance of the retailers has been much weaker. During the 2002-through-2007 expansion, mid-cap and small-cap retailers’ relative performance trailed the large-cap segment. In the current expansion, mid-cap and small-cap retail relative performance matched the large caps’ early in the expansion, but since 2013, both have significantly underperformed.

Retail sales as measured by the Department of Commerce have grown at an average yearly pace of 3.9 percent since 1997 while core retail sales, retail sales excluding motor vehicles and gasoline, have averaged 4.1 percent. Since the end of 2015, when relative performance of retailers was broadly weak, total retail-sales growth has averaged 3.5 percent while core retail sales have averaged 3.7 percent.

Consumer fundamentals such as income growth, balance sheets, and sentiment remain broadly healthy, suggesting positive support for future retail spending. However, despite support for retail spending, retailers face intense competition within the industry, particularly as consumers continue to shift preferences between online shopping and brick-and-mortar stores, and between luxury and value brands. The combination of a long period of outperformance and intense competition amid shifting consumer preferences may continue to pressure relative performance.

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