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Investing Specialists

U.S. Economy Looking a Little Accident Prone

The litany of misses this week included the retail sales report, higher consumer prices, and fewer housing starts.

This week, the S&P 500 squeaked out yet another small weekly gain (0.6%) even as corporate earnings were mixed and almost every major economic indicator missed the mark. The litany of misses included the retail sales report, higher consumer prices, and fewer housing starts. While the banking sector earnings reports have been quite strong, they all caution that things may not look as good in a few months as mortgage activity dries up. News out of the tech sector was not great with poor numbers or poor reactions to numbers from  Intel (INTC),  Microsoft (MSFT), and  Google (GOOG).

So what gives? Well, weaker numbers might mean that quantitative easing could continue longer than expected. Indeed, the Fed seemed to indicate it was not set to pull the rug out from under its bond-buying programs according to some prescheduled, formulaic agenda. I wonder if a negative GDP report would knock investors out of their torpor and QE obsession?

I am now quite worried about the second-quarter GDP number. Although the formal consensus remains 1.1% (already down from 1.8% in the first quarter), I noticed a number of reductions into the 0.6%-1% range last week. Then this week's data came rolling in even worse than expected, which raises at least the possibility that GDP growth could be negative in the second quarter.

From data released so far, consumption growth is highly likely to slow from 2.4% in the first quarter to 1.5% in the second quarter, and even that assumes that consumption grew modestly in June. Net export growth is likely to be more negative in the second quarter, and I still think government spending shrinkage could be almost as bad in the second quarter as it was in the first quarter. And with all the poor data coming out of tech companies this week and ongoing disappointing construction data, I am not so sure that business investment spending overall will be any help to GDP in the second quarter. That's even before all the worries about falling inventories and declining utility demand for most of the quarter.

My single-point forecast is for 0.5% GDP growth in the second quarter, but a negative number cannot be ruled out. I think there are a number of fluky items in the second quarter that could be easily reversed later in the year. So, I am still standing by my 2% full-year growth forecast despite the fact that the U.S. will be well below that in the first half. Those flukes include a cool spring, a very odd import-export report for May, June's inflation spike, and shortages in the housing industry.

Even as June data in retail sales and housing looked a little rocky, at least a few indicators may have seen their worst levels in June (purchasing manager indexes are up, year-to-year inflation-adjusted retail sales are up, and housing permit growth is now ahead of housing start growth). A shorter auto shutdown in July should also aid the third quarter, at least by a little. Even still, it feels more to me like the Fed's next move might be loosening, not tightening.

Retail Sales Miss the Mark
On a month-to-month basis, retail sales increased 0.4% in June (4.8% annualized) but disappointed Wall Street, which had hoped for a 0.9% gain. A large jump in auto sales drove both the actual gain and the expected gain. In fact, without the large increase in auto sales, retail sales would have been flat.

On the other hand, the volatile building supplies category was a big detractor, and isn't much of an indicator except of current weather conditions, in the short run. Restaurants were a very worrisome portion of the report. Restaurant sales were down 1.2% in June, which was a real shocker because the restaurant category was the biggest grower in June employment. Such divergences can't and won't remain for long. Unfortunately, the restaurant sales category is a decent indicator of consumers' moods, and this is not good news for the economy.

Year-Over-Year Retail Sales Data More Benign
The year-over-year data looks better than the volatile monthly data, and the inflation-adjusted data looks even better. So there is no need to panic over the retail sales data, although it won't be good news for the GDP calculation, which uses quarter-to-quarter and not year-on-year data.

Though I think retail will do OK in the second half, it doesn't look like a boom, either, given still-sluggish income growth, weekly shopping center data that continues to erode, climbing gasoline prices, and subpar growth in restaurant sales--a respectable leading indicator.

Inflation Spikes on Suspect Seasonal Adjustment of Gasoline Prices
This week's CPI figure made a large jump in June to 0.5% (6.0% annualized) versus expectations of 0.3% (3.6% annualized). While several important categories also spiked, gasoline accounted for two thirds of the move, or 0.3% (a 6.1% increase with a 5% weighting in the calculation).

The funny thing is that average gas prices, according to the Labor Department's own data, were unchanged. However, seasonal adjustments turned the promising flat price results into the rather stunning 6% increase. The problem with seasonal adjustment factors in fuel is that the moves aren't seasonal at all. Just in the last five years, June non-adjusted prices have ranged from negative 6.1% to 16% in a pattern that looks a lot more random than seasonal. Therefore, I am not terribly upset by this month's overall data, which could very well reverse itself in July. Unfortunately, the higher inflation rate could depress any inflation-adjusted statistics, including the GDP report, for June and the second quarter.

Again, the averaged year-over-year data doesn't look nearly as jumpy. Though I am guessing the trend in inflation is probably up from here, driven by higher gas and gasoline prices, as well as medical expenses. While inflation is likely to move higher, I think it will stay under 2% for the full year as capacity utilization remains low and unemployment remains high. Lower food inflation could be a help in the second half, too.

Health-Care Inflation Makes Its Move
As Fed chairman Ben Bernanke alluded in one of his many news conferences, medical expenses, both goods and services, made a big jump in June. The increase was due to certain payment policies and the end of the benefits of Lipitor and some other major drugs coming off patent, which is now largely complete.

Apparel was another category showing a relatively large decline. Summer heat at just the right time probably helped lift demand (and prices) at a crucial time. But as usual, a number of categories were actually still down, including used cars (which are being hurt by new car sales), natural gas, and fuel oil.

Year-over-year category data was shockingly clumped together with almost every category falling between 1% and 3%. Medical goods (the off-patent drugs mentioned earlier) and used cars were the only two categories outside of the range on the downside, and only natural gas exceeded the range on the upside.

Housing: That Sinking Feeling
Housing starts for June announced this week were clearly disappointing, and falling permit levels aren't great news for the next month or two. Overall starts dropped from 928,000 units annualized to 829,000, well below expectations of 951,000. The monthly drop was driven almost entirely by the multi-family category while the declines in single-family starts were more modest. However, on an averaged, year-over-year basis, both were off their previous sky-high growth rates. Given the strong builder sentiment report just a few days earlier, the weak data was a little surprising. Upward revisions are a possibility. However, poor permit data the previous month and lower lumber production suggest the revision might be down, not up.

Long-Term Housing Demand Picture Strong, Short-Term Mechanics Are a Killer
Intuitively, nearly everyone has gotten revved up on the housing market, just as the industry appears to have hit a number of bottlenecks including still-tight credit, a shortage of materials and supplies, a lack of skilled laborers, and available land. Don't get me wrong--the long-term fundamentals are still intact (high affordability and rising household formations), but the short term looks a lot riskier than we all thought. My million-unit forecast for the full year is looking a tad optimistic. Perhaps all of us got just a little too psyched up about the long-term prospects and forgot to ask exactly where all those homes would be built, by whom, and with what?

And eyeing the upcoming GDP report, housing starts were actually down almost 9% from the first quarter to the second quarter. That size of a drop won't exactly be helpful.

Permits Fall Less Than Starts, Year-Over-Year Growth Indicates Bottom May Be Near
Permits fell somewhat less precipitously from 985 to 911. Averaging the starts and the permit data, permit growth is now ahead of starts, which means we may have seen the bottom in housing starts.

Manufacturing Still Just Trudging Along
Industrial production figures showed modest improvement in June, growing 0.3% (3.6% annualized) versus a downwardly revised 0% growth rate in May on a month-to-month basis. However, single-month, year-over-year growth was just 2%, below the long-term average of about 2.6%, so certainly no boom here. Absolute level of production is about 99% of the pre-recession year of 2007, on average. In other words, manufacturing is just now approaching its previous peak after four full years of recovery.

By industry, the patterns shifted a bit as consistent losers saw a bounce and some stronger sectors fell from grace. Machinery and textile industries led the pack with monthly growth of 1.5% and 1.4%, respectively. Both sectors have had a rough 2012. Autos, the perennial leader, still did quite well, growing 1.3% after a couple of slower months. Aerospace and transportation, a star in 2012, continued its weak growth pattern in June. Perpetual losers paper and printing continued to fade into oblivion, pressured by a combination of poor international conditions and the move to electronic media. Wood products and furniture, which have benefited from the housing boom, suffered surprising declines in June, falling 0.6% and 0.7%, respectively.

Manufacturing-Only Data (Excluding Utilities and Mining) Still Soft
On a year-over-year, averaged basis the data looked a bit weaker than the monthly data, as shown below:

In fact, the year-over-year data still appear to be in steady decline pattern. An improvement in the last two monthly periods plus the potential bottoming of the ISM Purchasing Managers' Survey could indicate that the worst of the declines are behind us. Boeing (BA) continues to ramp up its production of commercial airliners, too. A shorter auto shutdown should help short-term numbers (July), but then hurt the data in August.

While that's what the data says, I would still be cautious on manufacturing. China and other major export markets still seem to be slow. And for now, housing starts seem to be stalled out, and I am not expecting government defense spending to get much better, either. On the whole, I suspect after head fakes in July and August, industrial production growth will remain stuck in the 2%-3% range, which is bad news for hiring in manufacturing.

Next Week's Calendar Is Mercifully Short, Including Both New and Existing Home Sales Along With Durable Goods
After this week's surprisingly disappointing housing starts report, the existing home sales report will take on increased importance. The market is still expecting a modest gain in June with sales of 5.25 million versus 5.18 million for May. The gap between pending home sales and existing home sales has narrowed sharply over the last three months, which leaves a little room for an upside surprise. Inventories were a little higher, too, and fence sitters may have been scared off of the fence by higher interest rates. A good number here could offset some of the damage done in the construction and housing starts categories. New home sales are expected to remain on their steady growth trajectory, moving from 476,000 units in May to 484,000 in June.

Durable Goods Orders Could Surprise on the Upside
New orders jumped almost 4% in May and markets are expecting a reversion to mean in June with growth of just 1%. Boeing's orders actually accelerated sharply in June, which should mean a better-than-expected report. However, those mysterious seasonal adjustment factors could put a serious dent in my expectations.

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