Government Stinginess

While the retail sales report started the week off on a highly positive note, the data was all downhill from there. Industrial production, housing starts, initial unemployment claims, and the Consumer Price Index all suggested a slowing economy.

I thought the news this week might just be bad enough to knock off even the most complacent bulls, but I was sorely mistaken as the market posted hefty increases even in the face of some pretty ugly data. However, continued rumors of more quantitative easing throughout the world seemed to keep things afloat for yet another week. On the other hand, new government reports and forecasts suggest that the fiscal noose around the U.S. economy's neck continues to tighten at an exceptionally rapid pace.

Although I am a bit worried, I don't think the economy is on the path to a major breakdown, either. In the short run, slowing world economic activity (China and Europe), continued government stinginess (and more taxes), and an auto industry that is no longer accelerating will keep a lid on further economic improvement.

However, low inflation and, I hope, a continued decent housing market will keep the U.S. economy in a growth mode. A return to more normal temperatures and fewer weather disasters would go a long way in helping the economy to find its sea legs yet again, too.  Furthermore, while not all the data is in agreement, it does seem like consumers are continuing to spend, even if that rate isn't accelerating much.

U.S. Government Forecasts Deficit to Dip Much Further Than Expected
The biggest news of the week was the federal government's follow-up to last week's highly positive monthly U.S. Treasury report. I commented last week that the larger-than-expected budget surplus for April, combined with payments from Fannie Mae and Freddie Mac, made the fiscal year federal deficit forecast of $845 billion look like a chip shot.

Indeed, on Monday the Congressional Budget Office acknowledged the inevitable and reduced the fiscal 2013 deficit estimate from $845 billion to $642 billion, substantially reducing the deficit as a percentage of GDP.

 

The current government forecast is now projecting the deficit will fall from $1,085 billion to $642 billion, a massive $443 billion, one-year reduction. Instead of being 5%-plus of GDP, the deficit is now projected to fall to 4% of GDP. The sharp reduction is a combination of higher taxes, the Fannie/Freddie paybacks, contained spending levels, a stronger-than-expected economy, and rock-bottom interest rates.

Also, in a trend worth watching, the government reduced its estimates for future health-care costs. The assumptions for health-care growth included some very large inflation forecasts, which have not materialized since the recession began. While some of that reduction in health-care inflation is recession related (fewer people have insurance and therefore put off visits to doctors and hospitals), most experts now agree that the health-care cost curve has been permanently bent.

Short-Term and Intermediate Budget Issue Defused, Maybe
The sharp improvement so early in a 10-year cycle, and the fact that some of the deficit-reduction measures were in place for less than a full year, mean potentially even better numbers in the years ahead. The cumulative 10-year budget deficit forecast was reduced a whopping $618 billion. (However, the cumulative deficit for those same 10 years is still $6.3 trillion.) Current projections have the annual deficit falling to negative 2.1% of GDP in 2015 before beginning a slow ascent to 3.5% in 2024. The short-term budget crisis is essentially solved.

Politicians Need to Hold Their Course
All of this assumes that Congress doesn't undo current laws engendered in CBO's projections. That's not a small if. Projections assume the sequester will remain in place, no new spending programs will be initiated, economic growth continues to accelerate, and interest rates don't rise for a period of time. Well, maybe the deficit improvement isn't assured after all. However, if Congress remains deadlocked, this is what will happen.

The Lower Deficit--Great Long-Term News--Could Continue to Hurt Short-Term Data
Unfortunately, lower deficits also have the effect of reducing economic growth. Falling government spending has been weighing on GDP growth by about 0.5% per year on average since 2010. In a world of meager 2% growth, that's a really big deal. It's not just spending data, either; government employment at all levels has been falling for some time, too. More than 600,000 government jobs have been lost since the recovery began. The recovery would look a lot more normal if government wasn't shrinking. Recall that government spending is about 20% of U.S. GDP. The good news is that U.S. austerity has a smaller impact than in Europe, where government spending comes closer to 40% of GDP. 

Lower Deficits Mean More Gridlock, Less Negotiation
The lower deficit numbers likely mean that Congress won't be under the gun to make any further budget compromises on either side of the aisle. The looming debt ceiling violation, originally forecast to happen relatively early in 2013, is now probably pushed all the way out until sometime this fall. Continually falling deficits and potentially even better Treasury reports ahead could move this event even further out. With a falling deficit, it might prove difficult for Republicans to argue for a lot more cuts, especially if unemployment rates aren't dropping. Regrettably, both parties will still need to deal with longer-term post-2024 deficits, which still loom large as baby boomer retirements push up Social Security and Medicare payments.

Inflation Remains Under Wraps
The Consumer Price Index for April dropped a surprisingly large 0.4%, which was greater than the forecast 0.3%. While gasoline prices were indeed the key driver, apparel prices, transportation services, and medical services were all down, too. The only category showing more than 1% inflation was natural gas, which jumped an eye-popping 4.4%.

The single-point year-over-year inflation rate increased a measly 1.1%, and even the three-month moving average dropped to 1.5%, its lowest level since 2009. Interestingly, prices are now lower than they were in October of last year. I do caution that seasonal factors are drastically amplifying some of the data, especially gasoline prices. Most years there is a huge swing in gasoline prices in the spring as refineries do maintenance and cut over to special summer fuel. However, gasoline's spring peaks have occurred in May, April, and now February, over the last three years. Yet the seasonal adjustment factors in the CPI have the spike always coming in March. So I am not going to get too carried away by this month's report. However, a falling Producer Price Index the day before suggests that inflation, though undoubtedly about to move higher as gasoline prices stabilize, is not poised to jump sharply anytime soon. That is great news for the consumer.

Retail Sales Coming in Better Than Expected
Retail sales have been exceptionally volatile lately, driven by shifting auto sales, gyrating gasoline prices, and storm-related effects.

Economists had expected a relatively negative April report and instead the U.S. economy managed a small increase after a large decline the prior month. On a month-to-month basis sales were up a meager 0.1%, but excluding gasoline and autos the metric was up an impressive 0.5%. (Gasoline sales, a big influence on the index, were down almost 5%, entirely due to falling prices.)

On a monthly basis almost every category reported higher sales with many categories growing more than 1%. However, that performance is hardly anything to write home about after March's disaster, when sales were down 0.5% month to month.

The year-over-year data points to more sluggish but stable growth rates. Adjusted for inflation, the new data looks a little better.

 

Sloppy Shopping Center Data Still a Little Scary
Weekly shopping center data has proved to be prescient this year, and the news here is less ebullient than the monthly government report.

The index, which typically runs at a 3%-4% rate, remains stuck in the low 2% range. The single-week reading of 1.1% is the worst single-week reading in several years. The weekly report was even softer than the week Hurricane Sandy struck.

I do caution that as electronic outlets such as  Amazon (AMZN) take market share from brick-and-mortar stores, the relevance of this report could quickly diminish. Whether the current weakness in this index is mix-related or reflects fundamental consumer issues is still very difficult to call.

Manufacturing Remains No Bowl of Cherries, Either
The overall industrial production figure, the broadest manufacturing metric, showed that industrial production slipped 0.5% in April. Given the poor new order report and assorted deterioration in various purchasing managers' reports across the world, the news came as no surprise. The year-over-year manufacturing data (which excludes mining and utilities) continued to fall and is now below its long-term average, as shown below.

Even Housing Data Couldn't Muster an Improvement in April
Usually, the economy can count on improved housing data, but not this month. Builder sentiment was flat again and housing starts fell month to month. Year-over-year housing data continued to improve, however.

I have been forecasting at least a small hiccup in the data for at least the last six months--and I warned investors not to panic when it happened. I am sticking to my guns on that point, although more of the housing market improvement is now likely to occur because of price appreciation, and not new home construction. The volatile starts data showed new starts dropping dramatically from 1.02 million to 0.85 million as starts of new apartment buildings slipped sharply and single-family homes just about held their own. A combination of weather and seasonal factors as well as normal volatility explains a good portion of the weaker-than-expected data. Year-over-year data looked a lot more benign than the monthly headline drop suggested.

 

And before anybody gets too excited by the big headline drop in housing starts, permits accelerated sharply, suggesting better housing starts in the months ahead. (In many jurisdictions, a permit is required before any work can begin.) Permits were up 14% month to month and 36% year over year.

New and Existing Home Sales Due Next Week Along With Durable Goods Orders
New home sales are expected to creep up a little in April from 4.92 million units to an even 5.0 million. I think that this consensus forecast could prove a little optimistic.  Pending sales growth has trailed existing home sales for three months running, which usually points to at least a small decline in growth rates.

Tight inventories and stingy mortgage lenders continue to weigh on this data set. New homes are nearly impossible to project, but the market is expecting at least a little bit of an uptick from 417,000 units to 430,000. (This metric is for single-family spec homes, which is the only reason it is so much lower than the starts number or even the single-family starts number.)

Durable goods orders have been less than stellar for some time now. Expectations are that orders will break into the black and grow 1.5% in April. It seems like at least some type of dead cat bounce is likely after March's 6.9% decline. Volatile jetliner and auto orders are making the report increasingly difficult to interpret.