Bad News Is Good News Again

With a fairly limited set of economic data early this week, markets took their cues from events out of Europe. European news, more related to banking issues, bond ratings, and interest rates than economic activity, certainly wasn't pretty.

Later in the week, a difficult-to-interpret U.S. retail sales report showed an outright month-to-month decline for both April and May. Even though seasonality, weather, and falling gasoline prices (and consumer prices in general) explain a lot of the retail softness, markets were unimpressed with excuses.

However, markets were cheered later in the week with both the U.S. Consumer and Producer Price indexes showing declines. I liked the inflation news because it will put more dollars in consumer pockets in the months ahead, and falling prices generally increase overall demand. Markets liked the inflation news because it means that the Federal Reserve could take additional loosening measures (maybe as early as next week's Fed Open Market Meeting) without much fear of boosting inflation.

Manufacturing data this week was mixed, but U.S. manufacturing remained stronger than most other parts of the world. News on small-business confidence and initial unemployment claims was little changed, providing no real clues to the direction of the economy. Though I will say that small businesses' confidence (small businesses are generally less dependent on China and Europe) seems to be holding up a little better than their bigger brethren. 

While it's hard to argue that there hasn't been a little economic sluggishness, the economy doesn't appear on the verge of a collapse, either--or even in a moderate decline. In general, year-over-year data doesn't look as soft as the volatile month-to-month data. The anecdotal evidence that I have seen recently is more positive than negative for the economy. The automakers are now adding third shifts to some of their manufacturing plants. Also, there is a shortage of auto carriers at the major railroads.

Furthermore,  Landstar (LSTR), an important trucker, indicated during a recent conference call that  volumes remain steady. (See more on truckers as a leading indicator in this Bloomberg piece.)

Although a lot of analysts had a more negative interpretation of this week's economic news, markets almost seemed to like the glum news by the end of the week. We seem to have entered another one of those periods when bad news is good news. The reason is that the market is hoping for yet another round of monetary easing, both in the United States and abroad.

Lower Inflation Puts More Dollars in Consumer Pockets
The best news of the week was the Consumer Price Index, which showed prices fell 0.3% from April to May, following a month of zero inflation in the prior period. On my preferred, year-over-year, three-month average basis, prices were up just 2.2%, well off the 3.8% level we saw last fall. On a single-month, May 2011 to May 2012 comparison, prices were up just 1.7%, below the Federal Reserve's 2.0% target. This has stirred hopes that some type of easing by the Federal Reserve may be just around the corner.

Year-Over-Year Inflation Slowing Dramatically

In my opinion, inflation is the single largest determinant of whether the economy will continue to recover, so this month's inflation report was music to my ears. Short-term deflation will provide a nice boost to both the consumer expenditures and income reports due to be released later this month. Deflation may also explain this month's relatively weak retail sales report. That report is not adjusted for either rising or falling prices.

Some critics of this month's CPI suggest that all of the improvement was in food- and energy-related categories. While that may be true if one just looked at the first table in the CPI report, which shows just the very broad categories, the detail tables at the back of the report suggest that there's actually a lot of both ups and downs.

Consumer Resistance to Higher Prices Is Eroding
Throughout the recovery, consumers have resisted every possible price increase. When the inflation rate for a given category accelerated, sales volumes almost surely moved down. Even with higher prices, total dollar volumes for a given category often went down because of sharply declining volumes.

This seems to be changing. Apparel prices have been up sharply the past two months, but retail sales of apparel were up dramatically in May, even exceeding the rate of clothing inflation. On the other hand, lower food prices didn't seem to do anything to stimulate grocery store demand, according to the most recent retail sales report. Relatively high new auto prices and very high used car prices haven't done much to deter consumer demand for autos, either.

I am not sure if this is a sign of a more confident consumer who is more willing to pay up for something they really want, instead of settling for second best. Or, are consumers desperate for replacement goods just as retailers and manufacturers begin to take the upper hand in their technology wars with consumers, allowing them to extract a higher price? Whichever argument holds true, one thing is clear: With the possible exception of used cars, supply constraints and production bottlenecks that are so deadly to economic recoveries are not the root causes of recent price increases in select categories.

Producer Price Index Indicates Stable Prices Ahead
While I doubt that we will have another 0.3% price decline in the near future, I do believe that other indicators, including the Producer Price Index, could mean at least a few more months of limited price increases. The price index for May was off a full 1%, compared with the Consumer Price Index decrease of 0.3%. The PPI tends to lead the Consumer Price Index by a month or two, but it also swings a lot further in each direction. Therefore, we might see another small decline in the CPI in June, but the downward move is unlikely to match the 1% month-to-month decline we had in the PPI.

Also taming the CPI deflation number for June is a smaller decline in the price of gasoline. Because of refinery cutovers for summer blends of gasoline, prices usually go up. This year they went down in May before seasonal adjustments. Combining a decent decline in prices with a large seasonal adjustment factor produced a once-in-a-lifetime type of monthly decline in gasoline prices. Unfortunately in June, gasoline prices almost always fall, so even if prices at the pump fall in June, they may not fall in the computation of the CPI because of seasonal adjustment factors.

Retail Sales, Some Slowing, Nothing Catastrophic
The retail sales report was even more difficult than usual to interpret this month, with sharp price changes (for which the report does not adjust), patent expirations in the drug industry, and more normal weather clouding the interpretation of the government data.

The comprehensive retail sales report showed that from April to May, sales declined 0.2% (2.4% annualized), and the March to April growth figure was revised down from a tiny gain to a 0.2% decrease. Even excluding volatile auto sales and gasoline, sales were still down about 0.1% in both April and May. This is the first time we have had back-to-back monthly declines since 2009.

Even the normally steady year-over-year data showed at least some modest slowing in trend. Between July 2011 and March, year-over-year growth, excluding autos and gasoline, stayed between 6.1% and 6.6% on a three-month moving average basis. However, in April, growth dropped to 5.9% and then 5.5% in May.

While it is hard to deny that there is at least some modest slowing in spending, it certainly isn't catastrophic or even statistically meaningful just yet. In recessionary environments, year-over-year sales growth often dips well below zero (at the height of the recession in 2009, this metric was down 5%).

And there are some very good reasons the sales rate has come in some. First, inflation is now down meaningfully from close to 4% to the low 2% range since retail sales growth peaked in September. None of the sales reports are adjusted for inflation or deflation. Also, warm weather this winter shifted sales of seasonal goods to the winter months and reduced the normal bounceback that is seen in the spring. Year-over-year growth at building materials fell from as high as 12% early in winter to about 6% in the most recent report. Grocery store sales have also fallen off of trend, too, as food prices have finally begun to turn down. The general downward trend in general merchandise sales can be attributed to falling gasoline prices. Some of the big wholesale clubs, which make up a substantial portion of general merchandise sales, sell gasoline, which may account for as much as 15% of sales. For example,  Costco's (COST) same-store sales growth rate has dropped from 8% to 4% since January. Excluding gasoline, same-store sales growth rates have dropped less dramatically from 8% to 6%.

For an entirely different reason, drugstore sales have been under a lot of pressure, too, according to our health-care analyst, Matthew Coffina. As major patented drugs come off patent and are replaced by cheaper generics, sales through drug stores are also declining. One major retailer noted the annual sales growth may have been reduced by as much as 2.5% just because the patent on Lipitor expired. Though not big enough to move the economic needle, Paul Swinand, our luxury goods analyst, noted the jewelry sales are off a lot as the price of diamonds and some metals have fallen substantially. Unit volumes are OK, but combined with falling prices, overall jewelry store sales are down.

I am certainly not trying to deny that there has been at least a little slowing. However, I think those who claim a slowing jobs report and European problems have caused consumer spending to swoon are seriously misinterpreting the data. And the slowing is certainly not widespread, even on a month-to-month basis. There is a fairly even distribution of gainers and losers. Furthermore, some of the biggest gains are coming in big-ticket categories, including cars and furniture. If consumers were panicking the way some experts would have you believe, these would not be the categories with the best results.

Industrial Production, More of the Same
Last month I warned that although the strong month-to-month industrial production growth of more than 1% (which annualizes to 12%) was nice to see, year-over-year growth was a more somber 5%, as it had been for the previous nine months. This week's May report showed the opposite. Month-to-month data showed a small decline (as expected) while the year-over-year, three-month moving average number was just under 5%. So again, I don't really see much change in manufacturing, neither booming nor collapsing. Auto and airliner production remain the best performers on a year-over-year basis.

Like the employment data, I believe the seasonal adjustment factors are badly distorting the month-to-month industrial production figures. It's really hard to believe auto production was down in May even as manufacturers were adding more shifts, there was a shortage of auto carrier cars at the railroads, and some car companies lost market share because they couldn't keep up with demand. This hardly seems like an environment where production would go down. Yet that's just what the government statistics are indicating.

Next Week Is Housing Data Week
Besides the Federal Open Markets Committee Statement on Wednesday (oftentimes good for a market swing), most of next week's news is housing related. The calendar this month lined up in such a way that we will get four major housing reports next week from the Federal Housing Finance Administration: builder sentiment, housing starts, existing home sales, and home prices.

The market seems to believe that most of the improvement in the housing market was weather related and is now is expecting that the winter and spring will hold flat at best and perhaps shrink modestly. Builder sentiment and existing-home sales are expected to be down a little, while starts and prices are likely to look a little better. Specifically, sentiment is expected to fall from 29 to 28 while existing-home sales are expected to fall from 4.62 million units to 4.60 million units.

A poor pending home sales report several weeks ago has clearly spooked economists. On the contrary, I believe existing home sales could show a very modest increase based on a broader reading (over several months and examining year-over-year data). Anecdotal evidence also suggests a stronger housing market, especially for quality properties. House starts, which more directly affect GDP growth, are expected to show modest growth from 717,000 units to 725,000 units based on decent permits data. However, the headline data will not tell the whole story. I will be closely checking the data for the mix of single versus multifamily homes and starts by region. Pricing data for April, due on Thursday from the Federal Housing Finance Administration, should continue to build on the February to March price growth rate of 1.8%.