Tariff Trifecta

Recent research finds tariffs announced on 4/2/25 increased prices of goods three ways. They directly raised the price of imported goods by 1.5 percentage points. Tariffs also raised the price of imported inputs and that raised inflation by half a percentage point. Lastly, because domestic producers faced reduced competition from imports, they raised prices, and that added 0.15 of a percentage point. Collectively, inflation was raised by 2.15 percentage points.

Employment Erosion

While only a few months of data, July lost 23,000 jobs, and May and June were revised down by 103,000 combined. Although unemployment fell to 4.1%, it was only because the labor force participation rate slid to 61.4%, which outside Covid is the lowest since 4/1976. Wage growth slowed to 3.15% Y-o-Y, lowest outside Covid since 2/20. Payroll growth is a microscopic 0.2% Y-o-Y. A rate hike would be lunacy.

Income Erosion

Since reaching $18.1 trillion in 4/25, real disposable income remained flat till 1/26 but has since slid to $18 trillion, meaning real income hasn’t risen in over a year. It’s a combination of falling wage growth and rising inflation. Ignoring government transfers, real income peaked at $16.72 trillion on 9/25 and is now $16.56 trillion. Declines rarely happen outside recessions. AI/data center spending is partly offsetting this by boosting profits. 

Warsh Wobble

New central bankers tend to make mistakes; Warsh made his first on Wednesday. His decision not to raise rates, after steadily talking tough about inflation and price stability, pushed long-term Treasury yields to multidecade highs. This is because bond markets are losing confidence in his willingness to hike rates and that’s raising long-term inflation fears. Combine that with Warsh’s deliberate anti-communications strategy and markets are somewhat perturbed. 

Claims Conundrum

Weekly first-time claims for unemployment fell 22,000, the biggest decline in three months, to a seasonally adjusted 187,000, the lowest level of new applications since September 1969. While the drop was probably due to some quirks, the consistently low level is hard to ignore. Moreover, the continued restrained supply of available workers has kept the unemployment rate low despite weak hiring and that allows the Fed to perseverate about inflation. 

Power Play

Caterpillar’s 26Q2 earnings were superb. The AI boom continues to drive demand for its engines and generators, while construction activity boosts demand for dump trucks/bulldozers/excavators. Quarterly revenue hit an all-time high, it raised full-year sales guidance, and its backlog is up 92% Y-o-Y. Cat plans to double production of turbine engines by 2030 and invest to make more generators. This is proof AI demand for power and energy is insatiable.

Policy Perversity

While the Chinese yuan is indeed undervalued, it’s not the key to reversing China’s immense trade surpluses, it’s primarily an outcome. China suppresses household consumption and is experiencing collapsing residential property values. That combination creates weak currency. The US runs large budget deficits and has insufficient savings, ergo big trade deficits. Both nations have a bad policy mix. The US needs to save more. China needs to increase domestic spending. 

Domestic Dynamism

While 26Q2 GDP growth slowed to 1.5% annualized, net exports (think imported semiconductors) subtracted a full percentage point from GDP and inventory drawdowns subtracted another 0.7%. That means final sales to private domestic purchasers rose at a rate of 3.9% in 26Q2, best since 23Q1, due to strong consumer spending and robust capex. Moreover, inflation is benign with core PCE (the Fed’s favorite measure) down 0.1% M-o-M. Hopefully this continues. 

Bullish Bias

Since 1949 there have been, including the present, 12 bull markets, defined as a rise of 20% or more. The average price return has been 191.6% and the average duration, 66.4 months. Over the same period the average return across bear markets, defined as a decline of 20% or more, has been 34.7% and the average duration, 13.6 months. Bull markets are far more lucrative than bear markets are destructive. 

Spread Swing

When financing conditions are easy and investors expect rate cuts, as was the case early this year, the search for extra income/yield by investors intensifies. Capital moves from Treasuries into investment-grade, from investment-grade to high-yield, and from stronger speculative-grade to weaker. So expected rate cuts not only reduce rates, but also rate spreads between bond types, which lowers rates still further. Since the US-Iran War this process has meaningfully reversed.

Midyear Momentum

Since 1950, 17 times including this year, the S&P 500 has been up 5%-10% at midyear. The average return during the second half of the year has been 6.6% (better than the post-1949 average of 4.9%) and the median has been 5.7% (slightly below the post-1949 median of 6.3%). Moreover, only in 2007 and 2011 (12.5% of the time) were returns negative in the second half of the year. 

Multifamily Miasma

June housing starts blew the proverbial roof off. Headline starts surged 19% M-o-M to 1.427 million annualized units. Regrettably, single-family starts slid 0.2%, continuing their slow, steady 2.5-year deterioration, while the lumpy, noisy, and volatile multifamily sector saw starts soar 76.2% M-o-M to a three year high of 532k annualized units. This will add to the rental supply overhang, which will reinforce the downtrend in the shelter components in CPI. 

Affordability Abyss

June existing home sales slipped to a disappointing 4.09 million annual rate. The combination of high rates and prices finds housing affordability consistently 30% below the average of the last several decades. The income needed to qualify for a starter home is now $93,264 but median first-time buyer income is $71,651. So far, months-of-supply of for-sale housing is barely up Y-o-Y. If it rises more, prices will start falling. 

Boomer Bonanza

Boomers, those currently between 62-80 years-old, perhaps surprisingly comprise the largest share of US home buyers at 42%. In part, it's because they (and those over 80) control $110 trillion or about 60% of all U.S. household wealth. With that money they are increasingly upsizing their homes by buying bigger ones or financing additions to existing homes. In 2016 4% upsized, it’s now 7%. 

Resilience Reinforced

June M-o-M retail sales rose solidly at 0.2% with May revised upwards, weekly first-time unemployment claims remain very low at 208,000, the July Philadelphia Fed Manufacturing Index soared to 41.4, and the Empire State Manufacturing Index jumped to 15.6. Add inflation that in May/June was listless, a Beige Book that’s decent, and Small Business Optimism that rose. All this points to continued economic resilience and no rate hike anytime soon. 

Misallocation Malaise

While AI spending is boosting wages and driving massive investment in plant and equipment, it may, paradoxically, be reducing GDP growth. This is because AI spending is probably occurring much more quickly that it should be, like the Housing Boom. Due to this temporal misallocation of capital, other projects that at the margin would help the economy more get delayed or else never happen. AI is too much too soon. 

Misallocation Malaise

While AI spending is boosting wages and driving massive investment in plant and equipment, it may, paradoxically, be reducing GDP growth. This is because AI spending is probably occurring much more quickly that it should be, like the Housing Boom. Due to this temporal misallocation of capital, other projects that at the margin would help the economy more get delayed or else never happen. AI is too much too soon. 

Longevity Liabilities

Rising longevity puts pressure on Social Security and Medicare, but unequally. Life expectancy for the average 66-year-old increased 2.4 years between 1992-1994 and 2016-2018. Moreover, time spent with severe health limitations fell 30%. Applying 2017 mortality/morbidity patterns to a hypothetical 66-year-old finds public outlays rising $53,400, $42,500 coming from Social Security and $10,800 from Medicare. Longer lives increase expected lifetime Social Security spending by 14%, but Medicare spending by 6%. 

Petrol Paradox

While the US is, by far, the world’s largest oil producer, with domestic daily production approaching 13.8 million bbl/day, 42% more than Saudi Arabia, domestic gasoline prices rose quickly when the Iran War began and have remained high. The reason: US gasoline prices are closely tied to global oil markets because US refineries are configured to process heavy sour crude rather than domestically produced light sweet crude, which is exported.