While Markets Yo-Yo, Economic Fundamentals Improve

U.S. markets were spinning on yet another yo-yo this week, swinging down early in the week with news out of Cyprus (irrelevant, in my opinion) followed by a rally on Wednesday on a statement from the Fed that it was not going to tighten anytime soon after all. Then on Thursday, dismal economic news from Europe, especially in the manufacturing sector, sent investors scurrying for the exits again. Negative earnings news and forecasts out of FedEx (FDX) and Oracle (ORCL) didn't help matters either, although those weaknesses had more to do with secular trends than economic softness.

None of these headlines was particularly new or insightful. Europe's been weak forever, the Cyprus issue was well known and not a big deal, and the Fed report said nothing really groundbreaking. Nevertheless, large market swings occurred within minutes of these "news events."

Senate and House of Representatives Reach a Fiscal Compromise
One story that seemed to go unnoticed this week was the U.S. House of Representatives and the Senate coming to a final agreement to fund government operations through September. The deal included most of the sequestration cuts with some fine tuning to avoid some of the more egregious effects of the sequester.

The lack of attention was unfortunate (what's the matter--not scary enough to make a good headline?). The deal will make a sizable dent in the deficit, which now looks like it will move from its $1.4 trillion high to $0.8 trillion in fiscal year 2013 ending in September. That's a nice start.

Economic Metrics, Especially Housing, Continue to Improve
Back in the world of economics, the real estate data this week was positive with decent news on new-home starts, ever higher home prices, improved existing home sales, and a much-needed increase in inventories, although not nearly enough in some markets. The anecdotal evidence here in the Chicago area shows Realtors are in a near panic in some locations because there are so few homes for sale.

Economywide, Conference Board leading indicators remained in positive territory, and initial unemployment claims made yet another recovery low on a four-week moving-average basis. Weekly shopping center data improved this week after a three-week bottoming process that took this metric to a lackluster 1.8% growth rate in three of the past four weeks. Single-week shopping center sales growth, as reported by the ICSC, was finally back over 2% again this week. Gasoline prices were down again, too.

With continued news out of the very important real estate sector and improvement in some consumer data, I am not terribly worried about Europe, which is weaker than most people imagine. (Europe accounts for less than 3% of U.S. GDP.)

Fed in the Headlines Again
The market rallied sharply on Wednesday after the Fed released its statement indicating more of the same: low rates, and more Treasury and mortgage bond buying. More important, the vote on the policy was 11-1, which is far better than one might have guessed from the last set of released minutes. They seemed to indicate that some Fed governors were having second thoughts about a relaxed monetary policy. That talk shocked the markets in late February, and this week's statement and vote count were great reassurances to some.

Interest rate increases are still off in the distant future, at least until unemployment sinks to 6.5% (it's 7.7% currently) or inflation rises to 2.5% (1.9% currently). Piecing these together with the Fed's economic forecast, that doesn't have unemployment falling to the magic 6.5% level until sometime in 2015, indicating that rates should stay steady through then. The Fed's economic forecast with above-consensus GDP growth estimates (2.3%-2.5% for 2013 and 2.9%-3.4% for 2014) and glacially slow improvement in the unemployment rate (7.3%-7.5% for 2013, 6.7%-7.0% for 2014) don't really mesh well, as I detail in this week's video. 

Personally, I think the unemployment rate will drop to 7% by the end of this year (more jobs, more boomer retirees, students staying in school longer, homebuilder inefficiencies), and recent sharp improvements in initial unemployment claims have bolstered my confidence in this estimate. If the rate does get that low by December, the Fed will clearly have to think about taking away the punch bowl in one form or another.

My analysis remains the same as it was in February.

The Fed will stay loose until the economy is definitively improving. When it does tighten, the moves will be smaller than many fear. And if rates go up some, it will not destroy the real economy, where low rates are a relatively smaller factor in the overall decision-making process (housing and capital spending) than many believe. Rate increases could hurt speculators who have taken full advantage of the low rates--and markets where speculators are a big portion (think commodities). Bondholders won't be exactly celebrating, either.

European Situation Continues to Deteriorate
Last week I mentioned in passing that the Markit PMI reports were really moving markets, and that proved true again on Thursday when the data was released, and the U.S. stock market fell apart.

Although the headlines that day focused on the Cyprus issue (which accounts for a mere 0.2% of European GDP and 800,000 people), the real issue is continued weakness in the rest of Europe, which appears to be sinking deeper into a recession. The March flash manufacturing data for Europe was not pretty. The ECB's bullish tone early in 2013 has proved to be premature, as I suspected. The PMI data show Europe continuing to underperform the rest of the world. Only Germany has shown any sign of strength recently. France was particularly weak in the latest report.

Companies doing business in Europe will continue to share some of that pain for most of the rest of 2013. Continued weakness in Europe, however, is unlikely to do much to derail the housing-led U.S. economic recovery. That is, unless things get so bad in Europe as to wreck the entire worldwide banking/currency system, which, unfortunately, is not a zero-probability event.

Housing Data Remains Strong
Housing starts and permits for the month of February continued to look strong despite some fierce headwinds, including poor weather and increased taxes. In addition, the report included revisions to earlier months that make the housing economy look even stronger than was previously thought. For the record, housing starts in February came in at 917,000 on an annualized basis. Recall that the lowest value of this metric was just under 500,000 units, and the pre-recession high was about 2.2 million units. In 2011 starts for the full year were 608,000 before leaping to 780,000 units for 2012. Going forward, I think there will be approximately 1.0 million-1.2 million starts for all of 2013, still well below the 1.5 million units that I would consider normal given current population growth.

The table below spells out the recent trends that include a multifamily market that continues to grow faster than the single-family market. I suspect this gap will narrow some over time, though land shortages in desirable locations could keep a lid on single-family growth rates.

Permits Also Show Continued Growth
Permits, which tend to lead housing starts by a month or two, grew a bit faster and were larger than the February starts number. That should bode well for the March and April reports on housing starts.

Note that when permits are less than starts, starts almost always go down the following month and vice versa. For example, in February 2012 starts exceeded permits (by 5.8%) and the growth in starts shrank in the very next month (from 26.4% to 22.5%). In the comparison column below, the red highlighted data points represent periods when starts exceeded permits, which is not a good thing. The red data in the starts column denotes periods in which the growth rate of starts slowed, which always happened one month after months when starts exceeded permits.

Builder Sentiment Still at Greatly Improved Level, After Two-Month Hiatus in Growth
Though the headline builder sentiment number dipped from 46 in February to 44 in March, the news under the surface was much better. The index is the sum of three components: current sales, traffic, and future expectations. The current business was indeed off in March while both traffic and future expectations were up. A shortage of stuff to sell as well as poor weather probably contributed to the slower current conditions metric. Also, given how far the index has come in such a short period of time, a small pause, especially in the winter months, isn't a big deal.

The only real negative, in my opinion, was that the reports made note of supply chain bottlenecks, rising materials costs, and labor that is getting more expensive and in shorter supply. The report also talked at length about the number of firms that had gone out of business and workers who had retreated to other sectors. This means that starts might move up more slowly than widely anticipated. However, a slower pace of housing starts should mean a larger-than-expected rise in home prices, which is also a large positive for the economy.

Home Price Increases Broad, Deep, and Enduring
Indeed, a limited supply of both new and existing homes helped keep January housing prices moving up, despite cold weather and the normally slow winter/school year related influences.

The FHFA, the least volatile of the three housing metrics I track, (Case Shiller and  CoreLogic are the other two) managed to increase 5.8% on a year- over-year, three-month moving average basis. This metric has shown price increases every month since April 2012 and has been improving (smaller declines or increases since early 2011). On a year-over-year basis, all nine regions were up with gains ranging from 0.4% in the Mid-Atlantic States to 14.1% in the Mountain States.

Housing price increases are extremely important to the economy as they enable more refinancing, encourage employment-related mobility, and even make consumers more likely to remodel. That's before mentioning the boost to confidence that comes with increases in home prices. There is something called the wealth effect, which posits that homeowners will spend 5% or more of their housing wealth gains over the next year or two (the mechanism for this is not straightforward, but includes home equity borrowing, home sales, refinancing, and lower savings rates).

Existing Home Sales Notch Another Improvement Despite Adverse Weather in the Midwest and Northeast
Existing home sales for February came in exactly on target at 4.98 million seasonally adjusted annualized units, compared with an upwardly revised 4.94 million units the prior month. Looking at the year-over-year data--the better way of examining the numbers--unit sales were up 10.6%, and total transaction value (average price time units) was up a more impressive 21%. The monthly data clearly show some weather-related effects and might have looked even better were it not for the snowy, cold weather experienced in the Northeast and Midwest. Existing home sales in the Northeast and Midwest were down 3.1% and 1.7%, respectively, while the South (which is almost double the size of the other regions) grew by 2.6%, and the West by 0.8%.

Next Week Lots of Data, Not Much News
While there is a large number of economic releases next week, they are either old news or not terribly useful data points. The only very new or useful data point will be pending home sales. Pending home sales are a very productive indicator of future final existing home sales. Last month there was decent growth in pending home sales, and then existing home sales for February looked better in this week's announcement. A combination of poor weather and light inventories makes me believe that the pending home sales report will probably not be as good as the 4.5% growth for the prior month.

Data on New Home Sales and Case Shiller Prices on Deck
Then, with increased inventories and some more springlike weather, the next month of pending home sales data, March, should look a little better again. The new-home sales report is also due next week. This is not a very useful report because it only includes single-family "spec" and not owner-built homes. It also mixes completed homes with homes not yet started. Sales are expected to be flat at 435,000 annualized units, for what it's worth.

Case Shiller Price Indexes are also due next week, but data from CoreLogic early this month and FHFA this week have already let the cat out of the bag on home price data, and the news so far has been excellent.

Durable Orders Could Get a Small Pop
On the manufacturing side, the nearly worthless and highly complicated durable goods orders report is due. This once-useful report has been gutted by hopelessly long airliner sales cycles, more just-in-time inventory systems, and ever-changing automobile seasonality. Real strength or weakness in some categories can be gleaned from this report, but that is about the extent of its usefulness. The report is expected to show a decent 2.6% headline growth rate, about which the market still seems to care, for some reason.

Personal Income Should Show a Big Jump
The normally very worthwhile personal income report is scheduled for release during the Friday holiday. However, bonus and income acceleration and subsequent reversals, combined with the payroll tax increases and volatile inflation, make the analysis tricky. This is also one of the most revised economic series that I track, so I don't like to spend a lot of time with it until some of the bigger revision periods are over. That said, growth could be large in February, as large as 1% month to month, driven by strong employment growth data for February that we have already seen. Unfortunately, inflation growth of 0.7% for the same month will wipe out a meaningful part of those gains.

Finally, the third and last read on GDP for the fourth quarter is anticipated, and analysts are expecting yet another upward revision from 0.1% to 0.5%. The improvement is still tiny on a quarter-to-quarter basis, and the small improvement probably isn't much beyond what one would consider normal statistical error. Besides, the fourth quarter is a pretty distant speck in the rearview mirror, and economists are already more excited about the potential for a rebound in growth to 2.5% in the soon-to-end first quarter of 2013.