It's Not All About the Fed, Really

With the regular economic calendar sparse, investors seemed to focus all of their attention on either China or the varied and seemingly conflicting news out of the U.S. Federal Reserve. Bad news on these fronts drove markets down for one of their worst weekly performances of 2013. While Fed news should never be ignored, it can neither take all the credit for the improved economy, nor is it likely to kill it single-handedly, as I detail later.

Real estate news for the week was relatively good, if not terribly exciting. The housing market should still be a big contributor to the U.S. economy in 2013. Changing gears, the U.S. manufacturing news was better than expected, although Markit's flash purchasing managers' report for April slipped just a smidge. Still, the U.S. index was in growth territory, unlike indexes for China and Europe. A weakening Europe and a more competitive Japan is certainly beginning to hit home in China. The U.S. is comparatively immune from a weakening China; however, Europe and other emerging markets will not escape the effects of China's softening.

The weekly data looked a little better than usual, with the International Council of Shopping Centers' year-over-year growth rate jumping to 3.1%, its best showing since the middle of January when the payroll tax increase kicked in. Nevertheless, the five-week moving average was still a lowly 2.2% growth rate. As weak as this spring has been, I had expected a bigger pop. The economy really needs to see a 4% jump sometime in the near future--let us all hope we get it soon.

In more positive news, initial unemployment claims moved back down after last week's mini-spike, suggesting continued small improvements in the employment market.

To Taper or Not to Taper? That Is the Question.
The real news of the week (or should I say confusion of the week?) involved the Federal Reserve and whether it would tighten various monetary policies and begin tapering bond purchases.

Fed chairman Ben Bernanke's original congressional testimony seemed to focus on current economic weakness and the dangers of premature tightening. That really got the markets and the free-money crowd pumping. Then during questioning, he flubbed a query about whether some type of purchase reduction could occur by September, just four months away. He paused just a little too long and seemed to indicate that it could.

The damage was compounded by the release of minutes of an earlier Fed meeting that suggested that a "number of Fed governors" favored tapering bond purchase programs in the near future. I am not so sure I care who said what. If the economy improves from here, they will definitively tighten sometime in the next year. If it doesn't, current programs could still be expanded. The question of timing is real, but rates are definitively going higher at some point, and every long-term investor already knows that. I am not a big efficient-market guy, but that should already be priced into various equity markets. 

That said, on announcement day, bonds will get hit, and stocks are likely to have a knee-jerk reaction down but will then begin to price in an improved economy over the following several months. There won't be many places to hide when the Fed actually does raise rates or halt bond purchases, especially in the weeks surrounding the announcement. This week's strong reaction to even a vague hint of tightening provided a brief, scary preview of what lies ahead. Longer-term, holding long-term bonds without owning something that is a little economically sensitive remains a risky strategy.

The Fed Deserves Some Credit and a Round of Applause
The Fed deserves a lot of credit for jump-starting and even maintaining the U.S. economic recovery. The expansion has now completed its fourth year with inflation near record lows. The stock market has captured all of its recession losses and then some. Even the troubled housing market has doubled off the bottom as measured by housing starts. Although GDP growth has been slower than we all like, growth has been relatively consistent measured on a year-on-year basis. Furthermore, the U.S. hasn't wandered into even one quarter of economic decline in 16 quarters. That can't be said of most world economies or even most U.S. recoveries. Half of all U.S. post-World War recoveries would have already been over by now as measured by length of time before a recession hits.

Fed Nudges the Economy but Doesn't Drive It, Despite What the Market Thinks
Despite all the ups and downs this week caused by differing Fed statements on low interest rates and future bond purchases, Federal Reserve policies are not the only underpinning of a broad U.S. recovery. Perhaps world bankers haven't been quite as aggressive as U.S. bankers, but they have implemented the very same policies without nearly the same positive results. Europe's policies can be called anything but tight, yet its recession continues to deepen and intensify. Clearly, the U.S. economy has a secret ingredient absent in the rest of the world.

While the Fed has certainly nudged things along, it certainly can't fight the laws of supply and demand over the long term. Loose monetary policies were often blamed for booming commodity prices (that nearly did in the recovery) in 2011. Now with even more easing in 2013, commodities are in full retreat as supplies of crops and materials come on line only to hit a world market with even weaker demand. Long-term supply and demand trumps even the all-powerful Federal Reserve. As helpful as low interest rates have been for the housing markets, huge pent-up demand and a population that refuses to live in cramped apartments with crying babies or in their parents' basements forever are probably just as important to the housing recovery.

So If It's Not the Fed, What Is Boosting the Economy?
I think pent-up demand gets an awful lot of the credit for the continuing U.S. recovery. I have already alluded to the housing industry, which is still operating way below long-term need as suggested by population growth and needed replacements. At the almost 1-million-housing-start level, the U.S. is still well below the 1.5 million long-term demand rate and the 2.2 million rate of the last boom. (That boom happened when mortgage rates were double what they were, the population was less, and incomes were below current levels.) Housing demand had nowhere to go but up, Fed or not. The same is true of the auto industry, which was a leader both on the downside and now in the recovery.

The Fed's Biggest Boost to the Economy Happened Almost Five Years Ago
The strength of the U.S. banking system has been one of the biggest boosts to the U.S. economy. The Fed and the U.S. Treasury Department should both be credited for this major success. The recapitalization of U.S. banks and the ensuing stress tests have done an incredible job of strengthening bank balance sheets. With most of the loans and share purchase from those recapitalizations repaid, the net loss to the U.S. Treasury will end up being next to nothing. This in turn has enabled more lending that is helping strengthen the U.S. economy. Europe is still going through that painful process.

A Lot of Little Factors Add Up
There are myriad other factors that have pushed the U.S. economy along faster than most developed markets. Certainly financial duress and government strong-arming enabled many businesses to wring tremendous productivity gains out of their businesses and their employees. The U.S. auto industry is now running at just over 90% of its previous highs. Yet employment, as reported by the U.S. Bureau of Labor Statistics, has just barely edged above 70%, its previous high. The U.S. booming oil and gas sector is also an unsung hero of the recovery. After almost 30 years of decline, oil and gas production is up for five years running. And then there is the huge ramp-up in aircraft production led by  Boeing's (BA) new aircraft.

Avoiding Knee-Jerk Fiscal Policy Actions May Turn Out to Be a Positive
Believe me, gridlock is no way to run a government, but just maybe it kept the U.S. from making a few mistakes. The U.S. avoided creating a stimulus-addicted economy as exemplified by China, and an austerity-crushed economy as demonstrated by Europe. I think the U.S. Fed remains guided by memories of the damage done by Herbert Hoover's mistaken balanced budget programs (and mid-Great Depression tax hikes and spending cuts). Meanwhile, European bankers have visions of the Weimar Republic, rampant inflation, and the resultant Second World War still floating in their heads. For now it appears that avoiding mindless austerity in the middle of a recession was probably a very wise decision. It is probably equally wise that more massive stimulus programs and the resulting inflation were avoided. My main fear now is that the U.S. is inadvertently edging into the austerity camp in 2013 with the recent tax hikes, and now the sequestration.

Fed's Policies Are Not Without Some Collateral Damage
While the majority of pundits seem to recognize many of the benefits of Fed easing, real and imagined, few recognize that those very same policies are also holding back the economy. Low mortgage rates are now a major reason that banks are not being more aggressive in their lending. The spread among the cost of funds, normal expenses, and current rates is not conducive to lending even under normal conditions. Add in the fact that regulators are looking for even the smallest errors as justification for "putting" mortgages back to original lenders, the risk-adjusted returns on mortgage lending just aren't all that attractive. 

Retiree Spending Taking a Hit
Low rates are also hitting retirees hard. Historically, a lot of retirees have lived on a combination of Social Security and interest on certificates of deposit. With almost every pre-recession, high-rate CD renewed or about to be renewed (most banks don't offer CDs beyond five years) the interest income contribution to retiree income and spending has been hit hard. That in turn has surely hit consumer spending.

Pension Systems Take a Blow
Pensions, especially public pensions, are being hit very hard by low interest rates. Usually pensions try to hold 40% of their assets in bonds. With those rates so low currently, plans are under a lot of pressure to reduce their income forecasts. This in turn tends to make funds look much more poorly supported. That in turn can force those entities to make larger contributions to improve the position of pension accounts, which often means current jobs must be cut in return. I think that's at least a small part of the reason that government employment remains on a downward track despite increased tax revenue.

Fence-Sitting Encouraged Here
Finally, with the Fed initially promising to keep rates low for very long periods of time, there was little reason for potential homebuyers or corporations to act quickly. With so much uncertainty in Europe, U.S. fiscal policy, and confusing new health-care rules, why act now? That is especially true if there is no interest rate penalty for waiting.

Existing Home Sales Blah; New Home Sales--Busting Out at Last?
Existing homes sales for April came in at 4.97 million units on an annualized, seasonally adjusted basis. That is just a little better than March's 4.94 million units and up about 10% from year-ago levels. Adjusted for prices, the index was up a more impressive 20% year over year. Tight lending conditions and a lack of inventory continue to weigh on this report.

 

The good news is that inventory levels are beginning to move up, and year-over-year declines in inventory levels are becoming more muted as higher prices finally entice more sellers. Part of the improvement is also likely due to normal seasonal trends.

New Home Sales, a New and Improved Trend
The new home sales report is never one of my favorites because it mixes homes that were sitting finished on a lot and homes that haven't even been started.  Nevertheless, the report included large upward revisions for many months in the past as well as an increase in the April number. Before all the revisions, it looked as if new home sales had stalled out at the 400,000 level. Now the market seems to be at 450,000 or so units and improving. Prices continue upward, too. However, the mix shift to higher-priced homes seems to have run its course for now.

 

U.S. Manufacturing Continues to Outpace the World Economy
The U.S. continues to outpace the Purchasing Manager's reports from the other two major trading regions, as it has for many months. I believe that the U.S. auto and aerospace industries continue to allow the U.S. to grow its manufacturing sector even as the rest of the world falters. The U.S. is also less dependent on exports for manufacturing growth.

Financial markets were particularly upset by the declines in China, especially as the data suggests the possibility of manufacturing contraction. No one was expecting that the Chinese data would move below 50, indicating that more firms are expecting declines than advances. Europe's reading improved, but for now that just means that the manufacturing declines are getting smaller. The U.S. registered just a tiny decline and was still in growth mode.

U.S. Durable Goods Orders Looked Good, Too
The very volatile and not very meaningful durable goods order report did sharply better than expected, increasing 3.4% month to month, driven by autos and airliners. Year-over-year orders were up 4.3%. Even excluding the transportation category, orders still increased 1.3%. Non-defense capital goods excluding aircraft improved for the second month running, increasing 1.2%.

Since capital goods have such a long life and are avoidable in the short run, improvements in this subcategory are a decent marker for business confidence. But as I have said before, this report has lost a lot of its value as more companies use just-in-time inventory systems, and volatile transportation orders push the report all over the place. So I don't get upset when the news is bad, or excited when the news is good.

Paired with the Markit data above, the U.S. manufacturing industry is neither falling apart nor providing much of a tailwind. News that  Ford (F) continues to ramp up North American production was another small plus for the manufacturing sector this week.

GDP Revisions, Personal Income, and Expenditures Report on the Docket
Reported U.S. personal income and spending will initially look a little unexciting with incomes up a seemingly paltry 0.2% and spending up an even more meager 0.1%. However, the inflation adjustment, or more correctly, the deflation adjustment, could move these figures up an additional 0.2% or 0.3%. Now these are serious improvements. On top of that, revisions to the retail sales reports and massive adjustments to the employment report should mean that prior months will also be revised sharply upward. I still watch the year-over-year data, averaged over three months, and I think those results will finally begin moving upward again with the April report.

GDP Report Could be Moved Higher for the March Quarter
The original first estimate of GDP was a bit disappointing relative to expectations, coming in at 2.5% annualized growth. Revised trade and retail sales reports had everyone hoping for a sharply marked-up report. Subsequent inventory reports have scared most economists into projecting no change in the initial GDP estimate. I am a bit more optimistic and hope that the massive revisions to the employment report, new homes sales data, and the retail sales data trickle through to the final GDP report. As such, an improvement to 2.7% seems like a possibility to me, although I confess to never getting the inventory adjustment right.

Pending Home Sales Could be Interesting
Existing home sales and pending home sales have not really lit the world on fire lately as tight inventories and still-tough lending conditions have weighed on both metrics. It will be interesting to see if the recent bump in inventories was enough to get year-over-year pending home sales out of their recent slump (year-over-year growth has declined from 13% in October to 8% currently). New home sales seem to have busted out; will existing home sales (and their precursor, pending home sales) follow suit? Stay tuned for next week's data.