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Tapering in September--Not So Fast

A poor August employment report may remove tapering from the agenda for now, but investors should be careful what they wish for.

Robert Johnson, CFA, 08/24/2013

Markets bounced up and down most of the week with little change by week's end. Europe's economic data looked better, while news out of China and the U.S. was mixed.

The news at the beginning of the week was good enough to convince market participants that the tapering of the Federal Reserve's bond-buying program was at hand. Even the Fed minutes released on Wednesday seemed to suggest that the economy was on the path that the Fed anticipated when it announced that its tapering program might end soon after its June meeting (though that was before a patch of soft economic numbers was released). The 10-year U.S. Treasury bond soared above 2.9% before backing down on Friday. Tapering threats also continued to hit emerging markets hard. Investors have begun to pull funds out of emerging-markets countries, which has depressed many currencies (notably India and Brazil), in turn causing a spike in inflation and slower growth in those regions.

However, the real news this week was a round of continuing bad bulletins from the corporate sector. More weakness was reported in both the tech and retail sectors, along with major layoffs beginning at mortgage processors. Even the previously strong housing sector seemed to be taking a pause.

I've always said it is best to watch consumer spending to determine the direction of the economy, and the news there is not getting any better. This week teen retailers--including Abercrombie and Fitch ANF--and Sears Holdings SHLD joined the growing list of poor-performing retailers that now extends to Wal-Mart WMT, Macy's M, Target TGT, and Kohl's KSS. While many attribute the poor results to improved auto and housing markets that are sucking cash out of consumers' wallets, I am not buying it. Housing, which was actually much stronger at the beginning of the year, didn't seem to be much of a drag back then. Consumption data next week, which includes all the data from individual stores and also services, will shed more light on the consumers' situation through July.

I believe the softening is real and that even my conservative 2% GDP growth rate for 2013 forecast may be at risk. However, I will wait to see the July consumption numbers, the August auto sales report, and August employment data before I make a move. My caution flag has been up since this spring, and this week's announcements seem to indicate the U.S. economy has taken a turn for the worse. While a lot of people are excited about Europe and stronger manufacturing data, it is the consumer and maybe housing that are driving the ship, and those numbers have not been pretty. While the market might be temporarily excited by the push-off in the tapering program that may ensue if the economy slows as I surmise, investors will eventually realize the economic weakness isn't so fun after all.

Fed Minutes Fail to Shed Much Light
The basic gist of the Federal Reserve minutes was that the economy had improved over the previous month and was in line with what the Fed was thinking when it broached the tapering issue a month earlier. In other words, all systems were go for tapering to begin soon. However, there was little if any news on the tapering timetable or the mechanism. This caused the rates on the 10-year Treasury bond to rise above 2.9% for the first time since 2011. The U.S. has come a long way from the 1.6% rate of earlier this year, with a potential to move to 3.5%-4.0% if inflation stays in its current range. Even the normally optimistic National Association of Realtors believes that 30-year mortgages, now at 4.6% or so, could move to over 5% by year-end. There are some initial signs (new home sales) that suggest that those higher interest rates are beginning to bite.

Tapering in September--Not So Fast
First, a caveat: No matter exactly when the tapering will occur, rates will trend up to reflect the current inflation rate. Any delay in the tapering rate will just be a short-lived relief before the final deed is done. Frankly, if the buying goes on for much longer, there won't be a lot of bonds left for the Fed to buy given the shrinking budget deficit and smaller mortgage balances.

That said, the Fed's meeting of July 29-30 happened before the announcement of July's weak employment data and relatively soft housing and manufacturing data. In truth, the Fed didn't see all the large GDP revisions until its meeting was almost over. In addition, employment growth slowed noticeably in July, with most of the growth in lower-wage segments, including retail and restaurants. If the August employment report isn't any better than July's, my guess is that tapering will be off the table until the end of the year. The news flow hasn't looked great recently, with many retailers reporting soft results, the tech sector showing an unusual stumble, and mortgage bankers ramping up layoffs. One poor employment report may be enough to remove tapering from the agenda for now.

Manufacturing Data Showing Worldwide Improvement
Manufacturing is a small but important part of the U.S. economy. It can often be a major driver of the economy at the beginning of recoveries when demand increases simultaneously with the need to restock inventories.

Manufacturing in the U.S. continues to add to the economy's overall growth, but not at nearly the rate it did at the beginning of the recovery. Europe and China are more reliant on the manufacturing sector than the U.S. Europe is now benefiting from not only improved demand, but a need to restock inventories. Markets were heartened this week that August manufacturing data (along with July's data) suggests that the positive eurozone GDP growth rate reported last week will likely extend into the third quarter.

China is restructuring its economy to move from investments to more consumption, which has caused some softness in the manufacturing sector. The August numbers for China suggest some improvement. A stronger Europe should also help Chinese exports in the months ahead.

All Major Trading Blocks Displaying Better Purchasing Manager Data
Flash Purchasing Manager data from Markit suggests that the worldwide manufacturing economy is picking up steam, with all three major economic blocks now indicating expansion. The needle is now above 50 in each region, which means that more companies are seeing growth than contraction.

For August, China joined Europe and the U.S. after a tumble this summer. The expansion rate remains highest in the U.S., which is benefiting from an improved housing market, continued growth in the auto industry, and expansion of the oil and gas industries. Europe and the U.S. continue to benefit from an improving civilian aerospace sector.

In the U.S. the manufacturing PMI for August ramped up to 53.9, a decent gain versus July. Boding well for the future, the new orders portion of the index moved from 55.5 to 56.5. Most likely reflecting summer vacations and shutdowns, current output and export growth slowed slightly.

The European PMI manufacturing index increased to 50.1 from 51.3, a 26-month high. New orders also rose for the second month in a row, and both metrics came in above expectations. The news from Europe wasn't entirely positive, as the employment section of the report showed continued contraction. Europe's unemployment rate remains extremely high, especially for young people. Another modestly worrisome factor in the report is that the PMI in France, the eurozone's second-largest economy, contracted in August. Meanwhile the German economy and manufacturing sectors continue to push ahead.

China's PMI showed the largest jump for August, increasing from 47.7 to 50.1. New orders also expanded, but exports continued to show softness. Although the numbers now look better, some of that may be due to inventory restocking and some minor tweaks in government spending programs. Improving economies in Europe and the U.S. should provide some lift in the months ahead.

Existing Home Sales Get a Boost
Existing home sales data had stalled out at an annual rate of about 5.0 million units for the past several months, held back by low inventories and tight financing. In July, the single month total jumped to a 5.4 million rate compared to 5.06 million units the prior month, making it the biggest improvement of the year. Prices trended up too, which drove transaction volumes at an even faster clip. Even the statistic averaged over three months indicates a breakout.

The year-over-year unit growth rates continued to improve even if the price data isn't accelerating. In fact, it's rather surprising that the higher volumes didn't cause a decrease in the average price. Sometimes when the unit data gets hot, it's because a flood of lower priced homes hit the market. That clearly wasn't the case this time around.

Closings Jump Faster Than Pending Home Sales, Indicating a Rush to Beat Rate Increases
One of the silver linings of higher mortgage rates--and the fear of even higher rates--is that they force many fence-sitters to act quickly to beat any further increases. Even those who have an offer accepted appear to be pushing for quicker closures to ensure that their rate lock periods are not violated.

The data below show closings well ahead of initial contract signing growth, a trend that cannot be sustained for long.

Closings (existing home sales) are also benefiting from an easier appraisal environment, given the recent run in housing prices. There was a substantial period of time when closings ran well below pending sales, as many contracted sales never closed because of unacceptable appraisals. In general, the pending home sales growth rate tends to peak a month or two before existing home sales growth rates. Therefore, I will be watching next week's pending home sales growth rates very carefully.

Home Price Acceleration Takes a Pause
Home price growth has been accelerating since early 2012, and appears to have slowed at least a little in June, but that is nothing to worry about. As more inventory comes online and more homes are started, I suspect that home price growth could fall back to the 6%-7% range, hardly a recovery killer. Furthermore, if housing starts remain stalled out, prices could accelerate again because of lack of supply.

Year-over-year price changes by region seem to have narrowed their very wide spread, though the western portions of the country, as well as the regions hardest hit by the recession, are still seeing the strongest growth. Year-over-year growth ranges from 2.5% for Middle Atlantic states to 17% for the Pacific region.

Post-1990 Price Appreciation at 3.1% a Year, Barely Besting Inflation of 2.6%
On average, only homes bought between February 2005 and mid-2008 remain below their original purchase price. That window has narrowed by more than a year over the last 12 months. According to this price index, prices remain about 10% below the previous peak, after falling more than 20% from their highs.

One other interesting tidbit: price appreciation since 1990 and from 2000 are both about 3.1% on a compound annual growth rate basis. This suggests that wild swings since 2000 now largely cancel each other out, leaving home price appreciation closer to its long-term averages. Unfortunately, that rate isn't that much higher than the 2.6% inflation rate measured from 1990.

Home Inventories Don't Move Up Enough to Help Supply Issues
Home inventories currently stand at 2.3 million units, or about 5.1 months' worth of supply at the new elevated selling rate. That compares to 6.3 months of supply a year ago. Such relatively low supply will likely keep a lid on transaction unit volumes in the months ahead and keep prices relatively stable, if not increasing. Somewhere between four and six months of supply is considered normal. At 2.3 million units, the level of inventory looks a lot better than the 1.7 million units outstanding in January, but neither number is seasonally adjusted and inventories tend to peak in July. A higher raw inventory number looks appealing but doesn't tell the whole story.

New Home Sales Take a Plunge
New home sales data collapsed in August, and July's data was revised sharply lower across all regions of the country. Even adjusting for higher prices, transaction dollar growth rates were also off considerably, as shown below:

New home sales looked even worse on a single-month basis, with starts lower than any time since October. Year-over-year single-month (not averaged) new home sales were up just over 7%. As with any government data, the numbers could be revised upward at a later date. Using averaged data eliminates some of that revision risk.

New Home Sales Data Converging With Other Housing Data
For months, new home sales data had been far stronger than just about every other housing metric (with the exception of homebuilder sentiment). In the originally presented data, June's three-month averaged new home sales growth was 28%, while single-family starts grew at a much lower 20% rate, and existing home sales just 13%. New home sales data excludes custom homes and houses that builders build for themselves that are included in the single-family starts data. However, new home data also includes homes that are not even started yet and homes that are sitting unsold on builder lots. There was some hope that growth in sales of new homes not started would eventually turn up in improved starts data in the months ahead. Instead, it appears that something was wrong with the overly optimistic new home data.

One Month's Worth of Data Could be a Fluke, but Might Give the Fed Second Thoughts
Housing is at the top of the list of why everyone expects stronger economic growth in the quarters ahead. An improved housing market (along with improved equity markets) gets a lot of attention in the Fed's most recent set of minutes. And, it is the construction of single-family homes that drives economic growth, not existing home sales (which are looking a little better lately).

Lackluster home starts data and weaker new home sales may give the more optimistic Fed governors reason for pause. Certainly everyone now is trying to guess if the new home data is erroneous or if interest rates are hitting housing faster than anyone expected. A relatively equal slowing in the housing data across regions would seem to indicate that lost paperwork in one region was not the likely cause of the surprisingly weak data.

Durable Goods, GDP Second Reading, and Personal Income and Spending on the Docket
With the manufacturing economy apparently picking up steam, one could not be blamed for believing that durable goods orders should be looking pretty strong. However, that is not the case. Durable goods have been gyrating recently, primarily as Boeing BA orders go up and down. Recall that last month durable goods orders soared 3.9% in a single month. This month is expected to be payback, with the consensus forecasting a 4% decline in orders. I will keep my focus on the arcane measure that is a little more useful, namely non-defense capital goods excluding aircraft. That measure has been improving for a couple of months on a year-over-year basis and is approaching the 5% mark, its best reading since mid-2012. With a little luck, this indicator might punch through the 5% mark. However, a weak tech sector might keep a lid on further improvements.

Second-Quarter GDP Might Get a Big Bump Up
Economists are salivating over the prospect of a sharply higher estimate of second-quarter GDP growth, primarily as a result of a sharply reduced trade deficit in June. The original GDP estimate indicated growth of 1.7% with the trade deficit subtracting 0.8% from the growth rate. Now it looks as if trade will have no effect on GDP in either direction. Adding that 0.8% to the old 1.7% GDP estimate would seem to suggest growth of 2.5%, very close to the consensus estimate of 2.4%. However, I caution that some of the improvement due to improving trade data is often partially offset by changes in inventory data. Still, a revision to GDP growth to 2.0%-2.5% is in the cards. Unfortunately the new higher number for the second quarter will make growth harder to obtain in the second half of 2013.

Income and Consumption Data Could Look Soft
Personal income and consumption is likely to show little growth in July after adjusting for inflation. The income data will be hurt by poor employment and wage data for July that we have already seen. The consensus is for income growth of 0.2% before inflation and flat after an inflation adjustment. Likewise, retail sales data has been nothing special and likely means that spending didn't grow much faster than 0.3% (0.1% after inflation). However, the consumption data will include the larger services category, not just goods sold at car dealerships and retail stores. The purchasing manager data suggests that the services sector has picked up steam, so the spending data is a hard call.

Robert Johnson, CFA, is director of economic analysis with Morningstar.

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