Will the Fed Get This Detail Wrong Too?

Consumers keep shopping… do we really need loads of rate cuts if shoppers are so healthy? … what if the Fed’s neutral rate is wrong? … Eric Fry’s “Road to AGI” is here

The reports of my death are greatly exaggerated.

So said Mark Twain in 1897…

And the US consumer in 2024.

Now, we’ve spilled plenty of ink here in the Digest profiling the deteriorating financial condition of the average American. So, why the change?

Well, since I’m feeling literary, let’s answer with a Ralph Waldo Emerson quote:

What you do speaks so loudly I cannot hear what you are saying.

US consumers have been “saying” that they’re near-tapped-out for months via various economic reports and surveys. For example, although today’s latest release of the Consumer Sentiment Report from the University of Michigan shows a slight rebound in consumer sentiment, this is the first positive reading in five months.

Separately, the way the economy “feels” to many Americans is so bad that a survey by Affirm finds roughly 3 out of 5 people believe we’re in a recession.

But what are US consumers actually “doing?”

Well, they’re shopping.

Spending in July blew past expectations

Let’s go to The Wall Street Journal:

American households boosted their retail spending last month, with strong vehicle sales helping to drive a higher-than-expected reading for last month.

Retail sales—a measure of spending at stores, online and in restaurants—rose a seasonally adjusted 1% in July from the month before, the Commerce Department said Thursday.

That was a strong pickup from June, when sales were revised down to a 0.2% decrease.

Economists surveyed by The Wall Street Journal had expected retail sales to rise just 0.3% in July.

Now, we need to do a quick recalculation to address those “strong vehicle sales.” This number was artificially inflated by a rebound in auto sales following the cyberattack on software systems that dealerships endured earlier this summer.

Excluding vehicles sales, retail sales climbed 0.4% not 1%. While that’s far more modest, it’s still higher than the forecast of 0.3%.

Here’s the quick take from legendary investor Louis Navellier, from yesterday’s Flash Alert podcast Growth Investor:

When we look at retail sales, fully 11 of the 14 categories surveyed were up. So, it’s pretty robust. Consumers have spending.

Louis adds a noteworthy point, saying a detractor might argue that retail sales on the year are flat if net out inflation. While that’s true, the pushback would be “well, flat sales are still evidence that the US shopper isn’t rolling over. After all, ‘flat’ isn’t ‘negative’.”

The second news headline illustrating the resilient US shopper comes courtesy of Walmart’s earnings release yesterday

Here’s Wall Street Journal:

US consumers might be spending carefully, but they are still flocking to Walmart stores. The country’s largest retailer posted strong sales in its latest quarter, and executives said they don’t see signs of fraying demand.

As businesses and investors are searching for clues about consumer demand, Walmart said Thursday that its US comparable sales, which measures both stores and e-commerce, rose 4.2% in the three-month period ended July 26, a faster pace than in the previous two quarters…

So far, so good.

Now, the pushback would be that these numbers reflect what’s already happened. And perhaps a beleaguered shopper could be on the cusp of tapping out as the end of the year comes into better view.

Fortunately, that’s not what we find. Back to the WSJ:

Executives said shoppers are gravitating to deals as well as the convenience of online order pickup and delivery, which led to customer gains, especially among higher-income shoppers.

In a sign of confidence, they raised their sales and profit targets for the remainder of the fiscal year…

“We continue to believe that customers are discerning, they are choiceful, they are focusing on essentials versus discretionary items, but we have not seen any incremental fraying of consumer health,” said Walmart Chief Financial Officer John David Rainey.

So, where does this leave the Fed on interest rate cuts?

The market is 100% convinced that the Federal Reserve will cut rates in September. The only question is whether it will be 25 basis points or 50 basis points.

Now, the strength of the US consumer already opens the door to debate about how many rate-cuts we really need. But let’s take it one step further.

If we look at what’s happening with interest rate futures over the next 12 months, then we see a growing conflict between “more cuts” and “fewer cuts” as well as “soft landing” versus “hard landing.”

Let’s go to analyst Charles-Henry Monchau at Syz Goup:

Interest rate futures are now pricing in 8 Fed rate cuts over the next 12 months, the most since the 2008 Financial Crisis.

Market expectations have sharply shifted over the last week towards more cuts in anticipation of economic weakness.

Over the last 60 years, every time the market expected 200 basis points of rate cuts, a recession in the US followed within several months.

This year alone, the market anticipates a 100 bps decline in rates with a 49% chance of a 50 bps cut in September. This is up from just one 25 bps reduction expected in 2024 back in April.

Now, the bullish pushback to this is “no, this degree of cuts isn’t to stave off a recession, it’s to bring the fed funds rate into better alignment with the neutral rate.”

To make sure we’re all on the same page, the “neutral rate” is the rate that, theoretically, neither speeds up nor slows down the economy

If the economy were growing at the exact speed the Fed members desired, then they’d set the fed funds rate to this neutral rate so as not to interfere with that ideal economic growth rate.

Now, here’s the challenge…

The Fed estimates this neutral rate after running various analyzes and making economic observations. So, it’s not a perfect, constant number where you can have certainty you’re right. More on that in a moment.

First, here’s MarketWatch with where the neutral rate might be today:

Fed officials lowered their estimate of the neutral rate to as low as 2.5% after the pandemic.

They have raised their estimate to 2.8% this year and Powell suggested it could go even higher.

“Clearly, the neutral interest rate must have moved up, at least in the short term,” Powell said Wednesday.

Some Wall Street forecasters say the neutral rate is likely over 3%.

So, bulls are likely to argue that eight quarter-point cuts over the next year (reducing the fed funds rate to 3.25% – 3.50%) would simply move the fed funds rate into better alignment with the neutral rate.

But to that, bears would scoff, “Do you really trust the ‘inflation-is-transitory’ Fed’s assessment of where the neutral rate is?”

What if the Fed has it wrong…again?

Earlier this week in the Digestwe featured commentary from former Treasury Secretary Larry Summers. Frankly, his predictions about inflation’s path over the last 12 months have been far more accurate than those of any fed members.

Here’s MarketWatch with Summers’s take on the neutral rate:

Summers added that the Fed is underestimating the long-term level of interest rates, known as the neutral rate, that will be necessary to keep prices from rising too quickly.

“My best guess is (the Fed) is badly wrong that the neutral interest rate is 2.5%,” he said. “My guess is that the neutral rate is 4.5%.” Fed officials raised their estimate of the neutral rate to 2.8% earlier (last) month.

Clearly, if the Fed slashes rates to 3.25% – 3.50% over the next 12 months while the neutral rate sits all the way up at 4.5%, that’s going to play out as a stimulus for the economy.

And that would reignite inflation.

To be clear, this isn’t a small differential. It’s not a “rounding error” mistake. The Fed ballparking a 2.8% neutral rate when Summers pegs 4.5% is an eye-catching difference. Someone is way off base.

Sure, it could be Summers. But if we look at analysis and predictions over the last 12-18 months, it’s been the Fed – not Summers – who has been wrong.

We’ll find out soon enough.

For now, this changes nothing when it comes to action steps in your portfolio

As we regularly say, mind your stop-losses, use appropriate position sizes, and maintain a diversified, balanced portfolio. But with those protections in place, keep riding your positions for however high they’ll take you.

But pay attention to what’s happening here…

The markets are exploding higher based on a handful of assumptions that are anything but set in stone:

• A soft landing is coming…
• We’ll get loads of rate cuts over the next year…
• The correct neutral rate is a low neutral rate…
• The attempt at normalizing the fed funds rate to the neutral rate won’t goose inflation…

That is quite the rosy outlook.

Let’s hope it plays out that way. Just make sure you’ll know what to do in your portfolio if it doesn’t.

Before we sign off…

In yesterday’s Digestwe explained how our macro expert Eric Fry has been putting the finishing touches on a summary presentation of his research into AGI, or “Artificial General Intelligence.” Well, after months of preparation, it’s here and it’s time to mark your calendar.

Next Thursday, August 22nd at 1 pm ET, Eric will host The Road to AGI. It’s about what happens when AI technology surpasses human intelligence – an existential line in the sand that’s coming much faster than most people realize. The event is open and free for anyone to attend, but we ask that you register ahead of time to reserve your spot.

We’ll bring you more details next week, but here’s Eric with a preview to take us out today:

If you set yourself up correctly right now, you have the potential to build more wealth than you ever imagined possible — all thanks to the world-defining power of AGI.

There is no other topic more important to focus on right now…

I promise you an event you will not soon forget. I’ll deliver a three-part “future-proof” blueprint to everyone in attendance. Plus, I’m bringing a brand-new stock idea for The Road to AGI that I’m so excited to share with you. Again, this is ALL FREE for attendees.

Have a good evening,

Jeff Remsburg