Employment Cost Index Up - Bad News for Inflation?

The Labor Department reported today that the Employment Cost Index rose 1% (or more than 4% annualized) in the third quarter and 3.3% for the latest twelve months.

Many, including myself, view the ECI as the "super core" inflation measure since employment is the predominant cost of doing business in our service-based economy. When the ECI runs above the CPI, as it is doing now, it has to raise concerns of further acceleration of the consumer price index as businesses raise prices to offset rising costs. The implications for Fed policy, interest rates and the stock market if the ECI continues to track above the CPI are not positive, in our view.

Before you panic, however, there is another key figure due out later this week - productivity. This measure of output per man-hour is a critical offset to the ECI. Simply put, if productivity grows at least as rapidly as the ECI, the chances of accelerating inflation are lessened and the pressure for the Fed to act is reduced.

Stay tuned!

Will the election matter to the market?

With the midterm elections less than two weeks away, investors are debating the impact of potential changes to the make-up of both the House of Representatives and the Senate. The direction of the economy, taxes, government spending, the war in Iraq, all have the potential to see major changes in 2007 and beyond. But for the stock market, does it really matter what happens on November 7th?

It seems not. According to the folks at FTN Midwest Securities, the stock market has risen an average of 19% in the year following midterm elections. And since 1959, every post midterm year has been positive, even with changes in control of the Congress.

So have fun debating politics - and (it seems) don't worry about your portfolio.

One caveat: Past performance is never a guarantee of future results.

GDP Growth Slows to 1.6%

The GDP report this morning surprised investors to the downside at only +1.6% versus expectations of more than 2% growth in the third quarter. The plunge in residential investment carved about 1% off the GDP result. On a positive note, the rate of inflation as measured by the personal consumption expenditure index slowed sequentially and consumer spending rose nicely.

What do these results mean to us?

• Inflation looks to be under control, allowing the Fed to stand pat on interest rates for the time being.
• Growth in the economy, ex-housing, looks fine - consumer spending rose 3.1% for example. But we wonder how long the overall economy can continue to grow when such an important component, housing, is in freefall.
• Slowing GDP growth will ultimately impact corporate earnings growth. We've enjoyed a string of double digit profit growth quarters - this can't continue forever (unfortunately) so stocks could be vulnerable after the strong gains since last summer.

The good news is that our economy is diverse enough to absorb the shock of a collapse in housing and still grow. As a result, we think the risk of a recession is fairly low. However, the likelihood of subpar growth for the next several quarters has increased and investors will need to get used to slower earnings growth as we head into the new year.

Oh, and don't forget, these numbers are subject to revision and may be better (or worse) than today's report!

Commodities Trend Break!

Take a look at this chart of the CRB index of commodity prices. After a period of steady increases, the CRB has recently experienced a noticeable (if not significant) break in that upward trend. Of course, oil is an important component of the CRB so much of the index's price erosion is due to the recent decline in energy prices.

Our take? Ultimately, commodity prices are driven by the forces of supply and demand. So perhaps the trend break reflects some slowing in economic activity. The good news, to the extent the CRB reflects inflationary pressures in the economy, its recent fall is further evidence that inflation has at the very least stabilized for the time being.

Inflation's Not So Scary After All

Yesterday, markets were startled by an unexpectedly high core PPI report (see our last post). So, we held our breath waiting for more bad news from the CPI report today.

It didn't happen. In fact, the CPI actually fell more than expected thanks to gas prices. And the core CPI (excluding gas and food) rose 0.2% as expected.

So, what do we make of these numbers? While the core rate is still above the Fed's "comfort level" it doesn't look to us like there is a big risk of acceleration of the core rate of inflation. And as a result, we suspect the Fed will stand pat for awhile longer - good news for equity investors.

Inflation Scare!!!

Halloween is just a few weeks away, so it seems appropriate that investors got a real inflation scare today. 

First the good news.  The Produce Price Index fell a whopping 1.3% last month.  Needless to say, the collapse of gasoline prices caused much of the overall drop in producer prices.

Now for the scary part!  Core PPI (excluding food and energy) rose 0.6% in September or about 3X what the economists were expecting.  All of the increase was to be found in finished goods (autos for example).  Both crude goods (ie. raw materials) and intermediate goods prices declined in September.

Bottom line?  I'm not willing to read much into these numbers, as I am wondering if the finished goods increase reflects hikes in raw and intermediate goods in prior months. 

But watch out - tomorrow is the CPI!

Bonds Better Than Stocks in 3rd Quarter

The third quarter was great for stocks with the S&P500 rising more than 5% between June 30, 2006, and September 30, 2006. But bonds did better! Look at the chart to the right. It compares the performance (price only) of the SPY, an S&P500 Index ETF and the TLT, a long bond ETF (click on the link for more info on ETF's). Long bonds rose in value over the period as interest rates fell, thanks to the end of Fed tightening, signs of a slowing economy, and lower energy prices. (Remember that there is an inverse relationship between interest rates and bond prices.)

Perhaps, the upward move in bonds (interest rates down) has had as much to do with a strong stock market as earnings reports, investor sentiment and the like. At the very least, falling interest rates (rising bonds) made stocks more competitive, particularly after their sharp correction from early May.

Please note the recent change in trend I have circled. The stock market continues to head higher while bonds have reversed trend and are falling in value. Interest rates have backed up a bit. While we don't believe this "trend-break" portends any serious problems for the stock market, it may raise the likelihood of a pause or short correction of the stock market's advance.

Since we're a bit bullish, we'd take advantage of any near term weakness in the market.