Here Comes the Reflation Trade

Data dependence is all well and good as long as the economic data revisions do not cause your policy to go astray. At turning points in the monetary policy tightening cycle, it is not unusual for economic indicators (such as employment and inflation) to point in conflicting and confusing directions that muddies the outlook. The U.S. is definitely in one of those periods right now. For that reason alone, I would have been an advocate for a smaller quarter-point rate cut from the Fed in September to help reduce the chance of a policy misstep.

Add major data revisions to the mix, and the whole economic and inflation narrative can change altogether, increasing the complexity of correctly calibrating the right policy response. Just last Friday, the August Personal Income and Spending report had major revisions. Prior to that release, we were tracking the increasing disconnect between growth in real personal spending and real personal income. The July report had shown yearly growth in income (ex. transfer receipts) slowing to a tepid 1.6%, even as spending continued to rise at a 2.7% pace. As a result, the personal saving rate had sunk to an anemic 2.9%, less than half of pre-pandemic levels. The logical conclusion being that spending is likely to slow appreciably in the months ahead as it aligns with incomes to stabilize the savings rate. That is a pretty good reason for the Fed to cut rates aggressively to try and counter any major damage to the labor market.

But after the August report’s income revisions, that narrative appears more like one of those generative AI hallucinations. Over the past year, real income has actually been running a bit ahead of spending, up a robust 3.1%, with real spending up a healthy 2.9% (Chart 1). Instead of a weak 2.9% savings rate, the August rate now clocks in at a relatively respectable 4.8%. In short, the upwardly revised personal income data suggest a much more modest pull-back in consumer spending may be in the cards, especially if widespread layoffs are held at bay.

We are also monitoring another sharp jump in commodity futures prices over the last three weeks with some trepidation (Chart 2). The short-lived East Coast ports strike this week and widening war in the Middle East certainly contributed to the move, but is goods demand picking up too? A broad commodity futures price index has increased by more than 10% over the past three weeks. Even more troubling is that it is not coming from any one sector, but a broad cross-section of commodities from metals, gasoline, oil, grains, meats, coffee, and sugar, just to name a few (Chart 3).

U.S. economic surprises continue to turn more positive, financial conditions have loosened since the Fed cut interest rates, mortgage purchase applications are up 10% over the past month, and U.S. equity prices remain near record levels. The ISM Services index for September was the best since February 2023, and far exceeded all analysts’ forecasts with both new orders and prices paid soaring. Next week’s CPI and PPI reports for September are both still expected to be relatively tame, improving on a month-on-month basis. But PPI final demand (both the core and headline measures) could worsen on a year-on-year basis due to unfavorable base effects. Include the conflicting signals coming from prices paid indexes for service business and manufacturers, and there’s plenty to keep the Fed and markets guessing.

Regional Economy: Pockets of Strength Spread

The second revision of yearly U.S. real GDP growth for Q2 shaved a tenth from the initial estimate, but it was still a sturdy 3.0% y/y. With the figure, fresh GDP data by industry and state were released. Typically, a ranking of real gross state product (GSP) growth would reveal a swath (or two) of strength across a group of proximate states. Growth rates ranked in the Top 10 or Top 20 would be clustered, say, in the southwest region or the southeast area, or along either coast.

Individual state economic outperformance is partly explained by industrial structure; that is, relative to the national average, having a larger economic exposure to the fastest growing industries (and a smaller exposure to the slowest growing ones). On top of this, a state’s industry growth could beat the national industry’s pace. Contiguous states often (but not always) have comparable industrial structures, giving birth to a bundle of states outperforming the national norm if there’s the right mix of industries posting stronger-than-average growth. As an illustration, imagine how the Plains region south to the Gulf of Mexico would stand out if both the agriculture and the oil & gas sectors were booming (this also has occurred before). Thanks to strong performances in a variety of industries, particularly the tech sector, California has again ranked among the top 10 fastest growing states (it was in the 18^th spot last year).

Note that population growth can also partly explain state economic outperformance. Basically, the bigger the better as far as GSP growth is concerned. And, sometimes, there are comparable demographic themes among nearby states.

It is rare to see more than one or two separate clusters of economic outperformance because the less proximate states become, the more disparate their industrial structures potentially become. And, arithmetically, there is a limit to how many industries can grow faster than the national average. This makes the 2024Q2 map of ranked real GSP growth so compelling (Chart 1 based on the rankings in Table 1). There are five separate pockets of strength scattered across the country, not just one or two larger swaths.

The five clusters (with their GSP growth rankings) are:

• South Carolina (1), North Carolina (4), Florida (6), Georgia (12), and Virginia (17) in the southeast region.
• Utah (2), Idaho (3), Washington (5), California (9), and Nevada (13) in the west region.
• Indiana (7), Wisconsin (14), and Ohio (20) in the midwest region.
• Louisiana (8), Texas (11), and Arkansas (16) in the south-central region.
• Rhode Island (10), Maine (15), New Hampshire (18), and Massachusetts (19) in the northeast region.

Such a result means that the current mix of leading industries contains some sectors that are more ubiquitous in terms of states having significant economic exposure to them. Quarterly real GDP data are available for the 22 major sectors (Table 2).

In 2024Q2, nine industries grew faster than the national average but the first five were particularly strong (all topping 5% y/y). The combination of retail trade, nondurable goods manufacturing, construction, agriculture (et al.) and information account for less than a quarter of the economy, but they contributed more than half of overall output growth. The fastest growing retail trade industry would be a prime example of a more ubiquitous sector… every state has at least its fair share of consumers and stores. Nondurable goods manufacturing is also diverse, both in the products it makes and where the production takes place. Both these sectors, at this midyear point, appear on track to post among the best full-year (average) growth rates in 25 years of available data. This is allowing more disperse state economies to outperform.

Below is a brief summary of what’s driving outperformance over the past year in the five clusters of strength.

Southeast (SC, NC, FL, GA, VA)

South Carolina led all states in economic growth at 4.9% y/y, with both North Carolina and Florida topping 4.0% (at 4.4% and 4.2% respectively). Retail trade was the largest growth contributor in Florida and to Georgia’s 3.5% and Virginia’s 3.0%, and the second largest contributor in the Carolinas. Nondurable manufacturing was the leading industry in South Carolina (e.g. food products), and it was finance and insurance in North Carolina. South Carolina also led all states in population growth at 1.8% y/y, followed closely by Florida at 1.7%, with the region having two others (North Carolina and Georgia) in the Top 10 (Chart 2). Strong population growth not only supports retail trade, but lifts activity in real estate and rental, health care, and construction. In South Carolina, for example, these were the next largest contributors to growth (3^rd, 4^th and 5^th, respectively).

West (UT, ID, WA, CA, NV)

Apart from Idaho, retail trade was the second-largest contributor to growth in the other four states, but their largest drivers mostly differed. In Utah, the government sector barely edged out retail in contributing to the 4.8% y/y total. In both Washington and California, the information industry was the largest contributor, and it was accommodation and food services in Nevada. These three states grew 4.9%, 4.2% and 3.9%, respectively. A (temporary) rebound in agriculture output was the dominant driver for Idaho’s 4.8% total, pushing down the next ones in line, which were (in order): health care, construction, and retail trade. For both Utah and Idaho, their silver- and bronze-medal-winning GSP performances were aided by Top 10 population growth (Chart 2 again) and all the sectors that ride on its coattail. (Think government services and health care, retail trade, construction, along with real estate and rental.) Finally, when information is a leading industry, the vigor tends to spill over into professional, scientific and technical services, which was the case in Washington and California.

Midwest (IN, WI, OH)

Indiana is the state most exposed to total manufacturing, and the booming nondurable segment was the leading industry contributing to its 4.0% y/y growth; it actually accounted for about half of it (with pharmaceuticals a key element). Even durable manufacturing managed to eke out some growth despite contracting slightly on a nationwide basis. The state is garnering support from investments in the clean energy space (EVs, batteries). Retail trade was the second largest contributor to growth in Indiana, but it was top line in driving Wisconsin’s 3.3% and Ohio’s 2.9% gains. For Wisconsin, rebounding agricultural output was next in line, followed by nondurable manufacturing (with food products a large segment). Nondurable manufacturing was second for Ohio (with plastics and rubber products an important part).

South Central (LA, TX, AR)

Nondurable manufacturing was the dominant driver of Louisiana’s 4.0% y/y growth and Texas’ 3.9%, with petroleum products greasing the gains. For the former state, this industry contributed around half the total, with retail trade following construction as the next largest contributors. Despite a pullback in mining output nationally, domestic crude oil production hit a record high in 2024Q2 (and in Q3) which pushed mining output’s contribution to Texas’ growth just behind retail trade. The Lone Star state also scored third in population growth (1.6% y/y officially) which provided a lift to the typically affected industries, particularly construction. The latter was already booming with the state garnering the largest slice of announced investments related to the Biden Administration’s industrial polices promoting investment in semiconductors and clean energy. Arkansas’ 3.2% growth was led by retail trade and nondurable manufacturing. Food products were a big part of the latter.

Northeast (RI, ME, NH, MA)

Rhode Island was the only state in the Top 10 or 20 growth rankings that didn’t have retail trade or nondurable manufacturing as the first- or second-largest contributor to growth. The leading industry for the Ocean State’s 3.9% y/y result (which matched much larger California and Texas) was finance & insurance, followed by health care & social assistance (retail was 3^rd). In Maine, finance & insurance was also a major growth driver, second only to retail trade in promoting 3.3% growth. For New Hampshire’s 3.0%, professional, scientific & technical services was the second-largest contributor behind retail. Massachusetts’ 2.9% growth was led by the information sector with professional, scientific & technical services (not surprisingly) in tow, just behind retail trade.

In the Top 20 ranking, the final four states (VA, NH, MA, OH) posted growth rates at or a bit below the 3.0% national average. They would have still topped the U.S. median pace of 2.6%. The average metric was skewed higher by the fastest growth rates being posted by more of America’s largest states. Nearly 40% of average growth was driven by just three states: Florida (4^th largest state economy), California (#1) and Texas (#2). Given this skew, our map of state growth rankings shows a massive middling middle. Seventeen other states (not in the Top 20) posted growth in the 2% range, which is still a respectable result. Only 13 states were below the 2% mark.

In conclusion, U.S. economic growth was robust over the past year, pushed by very strong growth among a group of states that were dispersed across the country. The dispersion reflected the fact that ubiquitous industries such as retail trade and nondurable manufacturing were the leading sectors. This also allowed a majority of states to still post respectable growth rates.

Ports Strike: The Needle and the (Potential) Damage Done

After a three-day strike, dockworkers along the East and Gulf Coasts returned to their jobs after reaching a deal that raises wages 62% over six years. The ports will remain open until at least January 15, while both sides discuss other issues, including the thorny topic of automation. The strike highlighted a couple of upside risks to the inflation outlook. The first is that many unionized workers are trying to catch up to the previous inflation spike by seeking wage increases well above current inflation. This can add stickiness to inflation, especially if productivity growth slows. The upturn in average hourly earnings in September might be Exhibit-A. The second risk is to supply chains. While the New York Fed’s global measure suggests supplies are flowing normally, a lengthy port strike could throw a serious wrench into the works.

The ports strike also highlights a key vulnerability to the U.S. economy’s apparent invincibility. There is still an outside chance of talks breaking down after January 15. The resulting turbulence would imply a rougher landing, depending on the duration of the shutdown. Dock closures disrupt the transportation, manufacturing, and retail sectors by halting the maritime trade of goods, parts, and supplies. The 36 ports at risk handle more than half of the country’s import and export volumes. Highly impacted industries include food, automobiles and parts, machinery, construction materials, and chemicals, though few industries would be untarnished if parts and supplies are severely delayed. However, exports of oil and LNG from the Gulf Coast would be little impacted as their dockworkers are not members of the International Longshoremen’s Association. While some ships can be rerouted to the West Coast, that’s an expensive option resulting in lengthy delays. As transportation and food costs rise and shortages worsen, inflation would catch a second wind.

Estimates of the economic cost of an East and Gulf coast ports strike are wide-ranging. The National Association of Manufacturers pegs it at up to $5 billion per day. By contrast, the Conference Board sees a lesser $0.54 billion daily hit if the strike lasts a week. These estimates are equivalent to 0.7% of annualized nominal GDP at the low end and 6.2% at the high end. A complicating factor is that much of the economic cost would be recovered (apart from the rotting food) after the strike ends, though it could take months to clear the backlog. In two earlier port strikes, the economy slowed meaningfully due to a widening trade deficit, before bouncing back once the walkout ended. During the 45-day strike that ran to mid-November 1977 along the East and Gulf Coasts, real GDP stalled in the fourth quarter, even as consumer and business spending remained strong, partly due to plunging exports and less inventory investment. During the much shorter 11-day walkout in October 2002 on the West Coast, real GDP came to a crawl before picking up moderately, largely due to wide swings in exports.

Should the strike resume after January 15 and is short-lived, it would have a modest impact on our growth outlook. Many retailers would stockpile goods before the threat unfolded, keeping shelves full for a couple of weeks. The knife would come out, however, if a strike lasted several weeks.