Falling Prices: Too Much of a Good Thing?

Overall, it was a bad week for equity markets and a better week for bonds as markets began to anticipate slower economic growth in both the U.S. and abroad.

The week got off on the wrong foot with China reporting slower-than-expected growth. (It was still 7.7% in the first quarter, down from 7.9% the prior quarter amid expectations of 8% growth.) It didn't help that a German Central Banker, who is also a governor of the European Central Bank, said it might take Europe 10 years or more to dig out of its mess. He also noted that member countries should stop counting on the Central Bank for relief.

U.S. economic numbers showed a decent housing market, modest deflation, and a stabilizing manufacturing sector. Some weekly economic data hinted at better performance ahead, as did the Fed's Beige Book, although probably not as good as the widely anticipated 3% GDP growth rate in first quarter, which will be released next Friday. That number may take some participants by surprise, but it is more likely a statistical fluke and not a true reflection of the current condition of the U.S. economy. I continue to believe that the U.S. is still trudging along at about a 2% rate of GDP growth when all the abnormalities are stripped out.

Earnings news from U.S. corporations continued to be mixed as IBM (IBM) and General Electric (GE) laid eggs, while Microsoft (MSFT) and Google (GOOG) notched acceptable performances. For a market priced at near-record highs, this mixed performance was not good enough for investors. Large variations in results seemed a bit atypical of previous earnings seasons when performance was more consistent. Such inconsistency, while good for stock-pickers, is not generally favorable news for investors.

Weekly Data Watch
In some ways, with my generally long-term view of the world, I really hate to highlight weekly data. But with many pundits claiming that we are going back in the soup again, these metrics can keep us from breathless panic attacks.

Initial unemployment claims dropped again this week after a short spike a month ago. That, coupled with a better Job Openings Report last week, convinces me that the labor market isn't evaporating. 

The weekly shopping center data showed some improvement, despite some more inclement weather. The weekly reading remained stuck at 2%, and the five-week average moved from 1.8% to 1.9%, indicating that the consumer situation may be getting a little better, just not in a hurry. When (or is it if?) the weather gets better, retail sales could get a real and unexpected pop from normal seasonal goods.

In other good news, gasoline prices fell from $3.56 a gallon last week to $3.50 and down from a spring high of near $3.90 per gallon. The Fed's Beige Book, a monthly report on subjective views on the economy, released this week, also seemed to suggest at least a modestly improving economy, and that the Armageddon suggested by the most recent labor report, and many pundits, is not at hand.

The government's inflation report showed that it continues to soften after a couple of short bouts of commodity-related inflation in both 2011 and 2012. Those spikes weren't big enough or long-lasting enough to disrupt consumer spending in a big way. The reading for March showed a 0.2% decline from February and was just 1.5% above year-ago levels. Things look almost as good when examining the data on a year-over-year, three-month moving average basis. For some context, remember that measured this way, the average rate of inflation calculated has been 3.7% since 1950. An inflation rate of 4% or higher generally pushes the economy into a recession. So the economy is clearly in the safety zone right now.

The outlook for inflation both short-term and long-term is good as well. Short-term gasoline prices have continued to fall in March, and food prices also seem to be falling back in the short term. Extensive rains in the Midwest this week and recent Agriculture Department data suggest continued downward pressures in food prices in the months ahead (as long as the farmers can get into their fields).

Also, continued tightening in fiscal policy as well as a near-record output gap (actual GDP versus the potential given the supply of labor and capital at normal productivity levels) bode well for inflation over the intermediate term. A greater recognition of these inflation facts may be part of what is weighing on recent gold prices.

Prices Not in a Free Fall, Either
While I generally consider falling prices a good thing for consumers, it can be a sign of economic weakness. Certainly a slowing in China and Europe has kept a lid on commodity-related prices, and energy prices are a huge piece of the recent positive inflation readings both in the U.S. and throughout the world. But is the U.S. having too much of a good thing, and moving into the deflationary world of Japan? I think not. First, this month's inflation report was not a one-way street, with several categories showing increases.

Consumers, businesses, and economists all seem to be expecting inflation in the 2%-3% range over the next five years. Unlike Japan, U.S. consumers continue to buy. While being frugal and shopping sales, consumers are not reducing purchases currently because they are afraid that prices will be even cheaper tomorrow.

Industrial Production Looked Better, but for Mostly Bad Reasons
Industrial production grew a better-than-expected 0.4% between February and March. However, the growth was almost entirely from the utility sector, as cool weather kept generating plants busy.

Autos were another continued bright spot in the report, while technology continued to show softness, and there was at least a small blip down in construction-related manufacturing. The year-over-year data for manufacturing only, excluding utilities, seems to be reaching a bottom that is relatively close to its long-term average. Barring a disaster in April, the year-over-year data could turn back up next month. Again, the recent slowing is relatively typical in most recoveries. Growth really slows after a huge inventory restocking process is completed after a recession.

Real Estate News Good but Not Great
This week there were two important pieces of real estate news: homebuilders' sentiment and housing starts. 

The homebuilders' sentiment number was down marginally while starts were far better than expectations, and there were substantial upward revisions to the February data. But the starts data was not as good as the headlines suggested. However, even with careful analysis, the data was good enough to reassure all the nervous Nellies who expected the housing data to collapse along with all the other consumer data. The markets rallied sharply on the release of the housing starts data and held their own with the lackluster sentiment data.

Builder Sentiment Data Slows Marginally
Builder sentiment as compiled by the National Association of Home Builders slipped for the second month in a row, falling from 46 to 44. Despite the decline, the composite reading is still about 57% higher than the reading a year earlier. And the reading is still very close to the recovery high of 47. The table below shows the current plateau as well as the improvement from dire levels just a year ago.

The builders cited several issues for the decline, including the lack of construction credit, consumer difficulties in obtaining mortgages, and ongoing appraisal problems as well as building costs that continue to accelerate. Interestingly, the current sales activity and traffic indicators both moved down in March while the third component, expectations for six months from now, set a new recovery high. In other words, it appears those builders are confident that the current plateau will turn into more robust growth over the summer months.

Multi-Family Data Drives Housing Start Boom
On the surface, housing start data looked stunningly good. Starts jumped to 1.04 million units on a seasonally adjusted annual rate basis, and the February data was revised from 917,000 units started to 968,000 units, a massive revision. The million-plus units started in March (the first million-plus month of the recovery) were way above expectations for just 933,000 units.

However, the big jump between February and March was almost all multi-family units. Single-family starts were actually down in March. However, I still contend that the best way to look at the data is on a year-over-year, three-month average basis, and the news here is still pretty good, with decent and modestly accelerating growth.

The recent strength in multi-family housing has brought this sector of the housing market almost back to the high of the 2000s housing boom era. In fact, on a less-than-accurate single-month rate, not averaged, the multi-family housing business is darn close to the high of the last cycle.

One other disconcerting item in the report was that permit growth did not match the growth in starts, which almost always means housing starts go down the following month. Almost all the slowdown in permits, at least on a month-to-month basis, was related to multi-family, though. Single-family home permits were basically unchanged.

 

Taking a holistic look at the data, the housing report suggests that the housing industry remains at its new and improved level compared with a year ago. However, the data doesn't seem to be racing higher, either. There is certainly no disaster or falloff indicated in the data--just modest month-to-month growth. It is hard to tell whether the plateauing is weather and seasonally related or just represents a market that has come a long way in a hurry.

Also, keep in mind that there is a silver lining to modest growth in homebuilding activity--namely, if few new units are constructed, especially on the single-family level, prices can do only one thing: go up. That in turn means more refinancings, more remodeling, more moving for employment, and higher consumer confidence. However, it means less help in employment levels in the hard-hit construction industry.

First-Read GDP for the March Quarter and Tons of Real Estate Data Due
The biggest number next week is the first GDP estimate for the first quarter. It is expected to be up a sharp 3% versus 0.4% in the December quarter. My guess is the December quarter wasn't really that weak and the March quarter wasn't that strong. The real economy probably grew about 2% in both periods with big inventory swings and government spending accounting for most of the volatility.

Shockingly, a strong consumer spending number in the March quarter is likely to be the biggest positive, yet again during the first quarter. The lack of Hurricane Sandy effects in the first quarter will be one of the biggest helps to the data set. However, consumer growth most likely tapered off in the first quarter after a relatively strong start. Overall, 3% GDP sounds a tad aggressive to me, especially given rather slow government spending, a moderating housing industry, and poor commercial construction.

Real Estate Prices Should Be Up Big and Activity Ratios Flat
FHFA pricing data is due next week, and it should be up big, based on strong  CoreLogic data. The FHFA data was up about 6.5% year on year last month and should be up even more this month, perhaps to the 7%-8% range. This will still trail the 10%-plus growth as reported by CoreLogic. Both metrics generally move in the same direction ,but the FHFA data is usually more muted in both directions, based on a different sample set.

Unfortunately, one of the reasons prices will be up is a lack of supply. Inventories of new and existing homes remain incredibly low. This will show up in some of next week's reports, with existing-home sales and new-home sales barely budging from the previous months. As always, I will also track the transaction dollar volumes that are doing considerably better than unit volumes (which are being depressed by the lack of dirt-cheap foreclosures). Existing-home sales should come in at about 5 million units, and new-home sales should be at about the 410,000 unit level, both up about 1% or 2% from the prior month.