Englander: "If You Take Today's Data Literally, We Are At The End Of The Business Cycle"

Authored by Steven Englander of Rafiki Capital Management,

If you take today's data literally we are at the end of the business cycle. Core inflation is picking up, the Fed's hand are tied, and demand seems to be slowing. The flattening of the yield curve suggests a inevitable sad ending, with the Fed unwilling and unable to provide stimulus and the US economy inexorably slows down. (For those of you who desperately need silver linings, it looks as the US savings rate is likely to be revised up.)

It is hard to read the inflation numbers as soft, despite all the noise in the components that pushed it up. So investors have to live with the view that price inflation may finally be moving up.

We would argue that the view of an impending business cycle end is wrong.  If we are correct that retail sales provides a distorted view of activity then we are more likely to be in a 1994 scenario than a typical end of cycle. We don't expect anything like the Fed hawkishness of 1994, but the key point is that the economy did well and even equities were pretty stable, despite the rates move. In other words activity and Fed rate hikes can coexist peacefully.  If that is the case, the business cycle is not doomed to fail soon. You may want to apply a higher discount factor to future equity earnings but you do not necessarily want to adjust the profits path sharply downward to reflect a cyclical downturn in profitability. In rates terms, the cycle end story is a flattener, the peaceful coexistence of tightening and activity is a steepener.

FX is more complicated -- my conjecture is that higher rates and end of cycle fears would doom USD. Higher rates, but the expansion carries on, is more ambiguous. The typical bond portfolio manager would be on a plane to Pyongyang, if North Korean bonds carried 50bps more risk-adjusted yield than Treasuries. The same logic would suggest that if Treasury yields are rising versus other DM economies, USD should be supported. Currently, I think the near-term USD outcome is clouded by  investor concerns on fiscal expansion and the durability of the economic pickup. But if activity is sustained and the Fed tightening not so harsh, the current universal USD negative sentiment may be overturned. (I am attending a FX conference in Miami and dollar bulls are as rare as undrunk mararitas.)

Why we are skeptical on retails sales weakness

  • ​Initial prints of retail sales tend to be low. Figure 1 shows three month averages the initial release of control retail and the most up-to-date estimate.  (We use three month averages to smooth the data and make the differences more visible.) 

  • We suspect the weather played a big role in the retail sales weakness. Much of the US was historically cold in late December and early January. The cold snap began after the December payroll survey and pretty much finished before the January survey (although I think weekly hours may have been affected). Retail sales are based on whole month sales, if no one goes to the mall when it is freezing outside.
  • Consider my US counterpart to the  Li Keqiang index. It is a geometric average of the overall ISM manufacturing and non-manufacturing indices and the NFIB small business survey. We use both the headline and the employment components so there are six elements of the index.  (The characteristic of a geometric index is that each component has the same weight at all points in time. We damp down the impact of the NFIB employment component by adding 100 to the published level.)
  • The advantage of surveys is that they look past weather related disruptions, anticipating that things will go back to normal when the  weather improves. 

  • Comparing the 'Englander' activity index with retail sales shows that the survey based indicator is much less erratic, has accelerated sharply and is close to 20 year highs -- all in contrast to the indications from retail sales.

Arithmetically, the retail data are likely to lead to sharply revised down GDP numbers, although that does not look plausible given the survey data. We would go with the surveys.