Subdued core inflation boosts equities
By R. Mark Rogers, Senior Economist, Econoday
June 15, 2007

Last week saw a reversal of the prior week’s movement in equities. Previously, increased concern that the Fed might have to raise interest rates weighed on the markets. But last week’s favorable core inflation numbers lifted equities. Nevertheless, interest rates, due to a strong consumer sector, netted higher except on the short end.

Recap of US Markets

OIL PRICES

Crude spot oil prices surged last week – reaching levels not seen since early September of 2006. Prices started up on Monday, rising $1.21 per barrel due to short covering and to indications from OPEC that it would not be easing output ceilings soon. But prices retreated somewhat Tuesday with traders concerned that prices were too high headed into Wednesday’s EIA report on oil inventories. However, on Wednesday, crude prices jumped $0.91 per barrel on the actual inventory numbers. Gasoline inventories were reported as flat during the period when there typically is a build-up ahead of driving season. Refinery utilization was reported down – due to a number of operational problems – and indicated some supply constraint. The big surge in oil prices came on Thursday with a $1.39 per barrel spike for the day. Upward momentum continued from further worries over short U.S. supplies. Additionally, fighting in Gaza as Hamas fighters stormed and drove out its rival Fatah group reminded markets of the volatility in the Middle East and of potential supply disruptions.

The spot price per barrel for West Texas Intermediate was up sharply for the week by $3.24 per barrel to close at $68.00 per barrel.

While core inflation readings were quite favorable last week, the Fed must still be worrying to what extent higher energy prices might be feeding into the core in coming months. Should oil prices remain at these levels, consumers are likely to have to pull back spending. These issues seem to be somewhat ignored last week.

STOCKS

Equities ended the week up notably. The week started quite differently, however. Stocks were near flat on Monday except for small caps which fell. Stocks remained weak from the prior week’s sell-off with a jump in energy prices also weighing on equities. A bump up in bond rates hurt also. Tuesday saw a surge in reported retail sales for May, resulting in higher interest rates and causing equities to plunge across the board. Also, Dow component Caterpillar was up sharply after revising up its earnings and revenue projections. The Fed’s Beige Book was released Wednesday and benign commentary on inflation and the economy were seen as favorable to equities. Thursday’s low core PPI numbers helped boost equities as fears of tightening by the Fed were fading. Friday’s soft core CPI number gave a final boost to equities as talk of further Fed tightening had all but disappeared.

Last week, all major indexes were up significantly - the Dow, up 1.6 percent; the S&P 500, up 1.7 percent; the Nasdaq, up 2.1 percent; and the Russell 2000, up 1.5 percent.

Year-to-date, the Dow is up 9.4 percent; the S&P 500, up 8.1 percent; the Nasdaq, up 8.8 percent; and the Russell 2000 is up 7.7 percent.

BONDS

The yield curve is up notably except on the short end which fell significantly. Long bond rates were nudged up on Monday by hawkish inflation comments from Cleveland Federal Reserve Bank President Sandra Pianalto and also by a spike in crude oil prices. Tuesday’s robust retail sales report boosted bond rates sharply. The 10-year note and 30-year bond rates rose 10 and 11 basis points, respectively, for the day. Wednesday's benign Beige Book helped ease rates but not by as much as the retail sales numbers had pushed rates up on Tuesday. The 10-year and 30-year rates fell 4 and 7 basis points, respectively. Even though equity markets saw the soft core PPI number on Thursday as favorable, interest rates were little changed for the day as traders waited on Friday’s CPI report. Higher oil prices also supported rates. Friday’s low core CPI reading pushed rates down for the day with the biggest movement on the near end. The 3-month T-bill fell 9 basis points while the 30-year T-bond declined 5 basis points.

Net for the week the Treasury yield curve was up except for the 3-month T-bill. The near end was down quite sharply as short-term yields were not having to compete with a view that the Fed would be raising short-term rates. Yields were up as follows: 2-year T-note, up 4 basis points; 3-year, up 11 basis points; 5-year, up 16 basis points; the 10-year bond, up 20 basis points; and the 30-year bond, up 19 basis points. The 3-month T-bill fell 23 basis points.

Long bond rates have been rising sharply since early May. The 10-year note is now at its highest since 2002.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

Last week’s economic data started out getting the markets nervous over very strong retail sales but by the end of the week subdued inflation reports calmed the markets.

Consumers pump up the economy

Consumers are doing their part to keep the economy growing. In fact, markets were worried they are doing too much. Retail sales were quite robust in May, rebounding 1.4 percent, following a 0.1 percent dip in April. For the latest month, gains were led by gasoline sales but increases were widespread. Components that were particularly strong were clothing, building materials, motor vehicles, and sporting goods. No major categories declined.

Year-on-year, overall retail sales in May jumped to up 5.0 percent from up 3.1 percent in April. Excluding motor vehicles, May’s year-on-year sales increased to up 4.6 percent, compared to up 3.4 percent in April. Excluding motor vehicles and gas station sales, year-on-year sales in May were up 4.7 percent, compared to up 3.8 percent in April.

Producer prices strong overall but core remains subdued

The story line on inflation last week was that overall inflation was high – boosted by energy – while core inflation was soft. The overall PPI jumped 0.9 percent in May, following a 0.7 percent boost in April. The core rate firmed in May to a 0.2 percent increase, following no change in both March and April. Markets still saw the 0.2 percent core increase as modest since it followed two flat months.

The year-on-year rate for the overall PPI jumped to up 3.9 percent in May from up 3.2 percent in April. The year-on-year core remained unchanged at up 1.6 percent.

For the overall PPI, strength again was in energy. By special groupings, energy increased a monthly 4.1 percent in May, following a 3.4 percent boost in April.  May’s boost in energy was led by gasoline, up 10.2 percent, following an 8.2 percent increase in April. Home heating oil rose 2.3 percent in the latest month, following a 4.8 percent increase in April. Consumer food prices dipped 0.2 percent, following a 0.4 percent rise in April.

Consumer prices follow producer prices lead

As was the case for the earlier reported producer price index, consumer price inflation in May was mixed with the overall figure up sharply due to energy while the core rate was subdued. The overall consumer price index in May jumped 0.7 percent, following a 0.4 percent rise in April. The core CPI inflation rate eased with a 0.1 percent increase in May, following a 0.2 percent rise in April. The consensus had expected a 0.2 percent increase in the core rate for May.

Year-on-year, the overall CPI rose to up 2.7 percent in May, increasing from up 2.6 percent in April. The core rate declined to up 2.2 percent on a year-on-year basis in May from up 2.4 percent the month before.

Energy prices again pressured the overall CPI as expected. In the non-expenditure category for energy, prices increased 5.4 percent, following a 2.4 percent gain in April. Food price inflation slowed marginally to a 0.3 percent gain after rising 0.4 percent in April.

Import prices firm

The one inflation indicator that showed higher core readings was for import prices. Strong foreign demand in combination with high oil prices and a weak dollar may be heating up imported inflation. Overall import prices jumped 0.9 percent in May and were still up 0.5 percent when excluding the month's 2.7 percent jump in import prices of petroleum. But year-on-year rates showed less pressure, up 1.1 percent for total import prices and up 2.8 percent excluding petroleum in readings that are a bit softer than the prior month.

Export prices rose 0.1 percent in the month for a year-on-year rate of 4.3 percent. Agricultural export prices were unchanged but are still up 18.2 percent on the year. Non-agricultural export prices rose 0.2 percent in the month for a 3.4 percent year-on-year rise.

Industrial production comes in flat

Also helping the equity and bond markets at the end of last week was a soft industrial production report. Earlier in the week, retail sales were rather hot so a somewhat offsetting manufacturing number was appreciated by the markets on the belief that overall the economy was not growing too strong. Despite earlier strong readings in some of the regional surveys, industrial production showed surprisingly little life in May with no change from April. Capacity utilization slipped 2 tenths to 81.3 percent.

Manufacturing output rose only 0.1 percent in the month, a contrast with the month's strong ISM report but in line with declines in factory employment and hours. Production hours worked have not been a very reliable indicator of production in recent months – apparently as factories have tried to improve productivity with varying success. Utilities, which are very volatile month-to-month in reflection of weather changes, fell 1.3 percent in May, while mining output, the report's third component, rose 0.5 percent.

Still, manufacturing has shown improvement with three consecutive gains after declining during January and February of this year. Manufacturing output has been led by durables over the last three months.

Empire State manufacturing jumps in June

Looking to more current data, the Empire State manufacturing index rose sharply in June, to 25.8 from 8.0 in May and 3.8 in April. June's new orders are strong at 17.2, up more than 9 points, with shipments very strong at 29.8 vs. 14.1.

High energy costs and likely high costs for certain metals pushed prices paid up to 42.6 in June vs. 34.4 in May. But as usual these costs are largely being absorbed through productivity gains as prices received showed less pressure at 9.6 in June vs. 15.6 the month before.

The bottom line

Last week started off with the markets rattled by a robust retail sales report before eventually being calmed by subdued core PPI and core CPI numbers. It appears – for now – that the Fed may not be compelled to think about raising interest rates. And the Fed likely sees no urgency in cutting rates either. Nonetheless, the potential impact of higher energy prices must still be a concern both for higher inflation and for lower real growth.

Looking Ahead: Week of June 18 through June 22

Next week has rather sparse offerings of economic data. The highlight will likely be the May housing starts report to be released Tuesday morning.

Tuesday

Housing starts continued to edge up in April while permits dropped notably. Weather may have helped starts while permits may reflect continued sluggishness in housing. Housing starts in April rose 2.5 percent to a 1.528 million unit pace, following a 0.3 percent increase the prior month. However, housing permits fell 8.9 percent to a 1.429 million unit pace in April. Given the continued high supply of unsold homes, it is likely that permits are more in line with underlying conditions.

Housing starts Consensus Forecast for May 07: 1.47 million-unit rate
Range: 1.45 million to 1.59 million-unit rate

Thursday

Initial jobless claims were unchanged in the June 9 week at 311,000, right at the four-week average which rose slightly to 311,250. There were no special factors in the latest week. Jobless claims continue to indicate a tight labor market – an issue that is still of concern to the Fed and certainly will be a topic at the June 27-28 FOMC meeting.

Jobless Claims Consensus Forecast for 6/16/07: 311,000
Range: 310,000 to 315,000

The Conference Board's index of leading indicators fell 0.5 percent in April following a sharply upward revised gain of 0.6 percent in March.

Leading indicators Consensus Forecast for May 07: +0.3
Range: +0.1 to +0.5

The general business conditions component of the Philadelphia Fed's business outlook survey index rose to 4.2 in May, up from an essentially flat reading of 0.2 in April. Manufacturing has been generally more positive in the regional surveys than in the national data. On the inflation front, the Philly Fed input prices index jumped to 32.3 from 24.3 in April but much of the boost was energy related. Output prices have been stable with readings of 2.2 in May and 5.2 in April.

Philadelphia Fed survey Consensus Forecast for June 07: 7.5
Range: 5.0 to 10.0