Feeling Out of Sync With the Sentiment

U.S. stock markets made little progress this week, with the S&P 500 basically unchanged, as mixed earnings data and weak existing-home sales were counterbalanced by better news on new-home sales and healthier data from Europe. Manufacturing looked a little better, too.

Not all the earnings news was uniformly bad, either, with key companies including  Boeing (BA) and Ford (F) doing better than expected. Improved airliner shipments and auto sales are key to an improving second half after what was a much tougher-than-expected first half of 2013 for the U.S. economy. 

There was nothing in this week's data to suggest GDP growth will be any faster than my 0.5% forecast for the second quarter, which represents quite a fall from 1.8% in the first quarter. (Benchmark revisions and new accounting methods for intangible are due with this report and could mask some of the weakness.) Although there may be a series of odd factors that distorted the second quarter, I remain worried that consumption has not picked up. Both weekly and monthly retail sales data have been unusually weak. Employment growth and faster economic expansion will be extremely difficult without consumption growth. Interestingly, the weakening retail environment comes even in the face of improving consumer sentiment announced this week. (That's one reason I just don't trust the sentiment data.) On the other hand, there is some good news: improving manufacturing results and a better Europe. Still, these two bright spots will not save the U.S. economy from poor consumer spending, just as reduced results from these sectors did not throw the U.S. into another recession.  

I am feeling a little out of sync with my sense of caution. Consumer sentiment is at a new recovery high, summer cocktail parties are buzzing about improved home prices and for-sale homes selling in just a matter of days, and manufacturing data seems to have turned the corner. Plus, stock prices rise nearly every day despite higher interest rates, falling retail data, and stubbornly high oil and gas prices. I am not outright bearish on the economy, just queasy--and worried about market overconfidence.

Home Prices Continue to March Upward, Though Pace Stabilizing
This week's FHFA home price survey showed year-over-year growth of 7.3% on a single-month basis for the period ended in May, not much different from April's results. This is in contrast to  CoreLogic data that is continuing to accelerate at a pace well over 12%. Keep in mind that the FHFA data is always much less volatile because it captures primarily Freddie Mac- and Fannie Mae-eligible mortgages across a broad range of cities, large and small. Case-Shiller is the narrowest of the price indexes, including just 20 cities, and will report its take on home prices next week. I will show the full comparisons in next week's column. It also bears mentioning that the FHFA data is used in the official net worth report issued by the Federal Reserve, which is why the sometimes less-noticed FHFA data is very important.  

The three-month moving average of year-over-year prices is still increasing nicely, although the big improvements seen earlier in the year have diminished, according to the FHFA.

According to the FHFA, home prices are now 11% below their peak (versus 20%-plus for some of the other price metrics). Homes purchased between January 2005 and fall 2008 are the only homes now selling below current prices. That window has narrowed by a couple of years in just the last year. That should lead to more consumer confidence, more remodeling, and more refinancings (if interest rates don't move any higher).

Prices Still Have Some Room to Move, Though Peak Growth Rate Approaching Fast
The CoreLogic data, which can peer one month further into the future than the FHFA and Case-Shiller data, would seem to suggest at least another month of solid gains in June. However, after the June data, higher interest rates, tougher comparisons, and some negative seasonality this fall will slow the rate of price increases, in my opinion. However, I really don't think that the U.S. housing market is back in bubble land just yet. Prices are still below the past peak and incomes are now considerably higher and interest rates are lower, even after recent moves. Inventories also remain incredibly tight, putting a floor under home prices for now.

Not Everyone Is Partaking Equally in Housing Gains
The year-over-year home price data shows a wide range of returns, depending on the region of the country. Although the national average was up 7.3%, the range was from 2.7% (East South Central) to 15.8% (Pacific). Every single one of the nine regions reported price increases. The hardest-hit markets in the recession are doing the best now. That also explains why some parts of the country are doing better than others, with auto sales particularly strong in states with the largest real estate price increases.

Tight Lending Conditions and Inventory Shortages Keep Lid on Existing Home Sales
Existing home sales this week were a disappointment, as sales levels fell from May to June after a big increase between April and May. Some of the upward momentum in existing home sales has stalled. Existing home sales have remained in a relatively narrow range since January. Lending standards remain tight and paperwork beyond absurd (including requirements to bring this week's payroll check to the closing as final proof of employment). Inventories also remain tight, with not all that many people interested in selling, even with today's higher prices. Higher interest rates could throw another wrench into the works in the months ahead.

Averaging the data shows a stronger picture of slow but more continuous growth than the more volatile month-to-month numbers only.

Looking at transaction values and not just unit volumes shows an even better picture.  That's because the price of the same house continues to move up, and fewer low-priced homes are being sold. The days of banks dumping hundreds of low-priced homes at discount prices are over. As a very crude estimate, three quarters of the price gains are appreciation-related and one quarter on mix issues.

Inventories improved slightly in June, but not by much in a month when inventory increases are the norm. Given that tight inventories have been holding the market back, any increase is welcome. Compared with a year ago, inventories are still down 11%, but that's a lot better than the 25% decrease that we saw earlier this year. Also, inventories have crept up to 5.2 months from a ridiculously low 4.3 months in a seasonally slow January. These tight inventory levels explain why prices have remained so robust and existing home sales unit growth has been relatively lethargic.

Housing Investment 2.8% of Real GDP, and It's Not All New Homes
Residential fixed investment, which includes brokerage commissions, remodeling, and new-home sales, contributed about 2.8% to first-quarter GDP. That's up from just over 2.4%, but well below its average of just under 5% and a high of close to 6%. All percentages will be marked up about another percentage point as many ancillary housing market fees (title search, mortgage fees) will be moved to the investment account from banking fees in the GDP report to be released and revised next week. In my opinion, residential fixed investment will make just about the same 0.3% contribution to the second-quarter GDP report. However, the makeup of that contribution will be considerably different from the first quarter. Home brokerage commissions and remodeling contributions are likely to increase while new homes make a substantially smaller contribution than in the first quarter.

Although new homes are the biggest mover of residential fixed investment, it is not the only factor in this investment account. Remodeling provides a much less volatile contribution to residential fixed investment. Although existing home sales do not count in the GDP calculation directly, commissions on those home sales do count toward the GDP calculation. 

Overall Housing Data Mostly Improving
The housing markets overall continued to improve, based on the data released in July.  Inventories of homes for sale remained tight, which in turn has caused a big spike in pricing. Those inventory shortages are easing ever so slightly, which could begin to soften some of the price increases in the months ahead. In fact, the pace of increase has already begun to soften, according to the FHFA, as noted above.

The transaction-related data was decidedly mixed, with existing homes and housing starts showing rather dramatic slowing in trends. Offsetting those two categories was continued stability in the new-home sales report, as more new-home buyers resorted to buying homes that hadn't even been started yet. The year-over-year new-home growth remains high at 30%, and the report for the month of June showed considerable acceleration, though the prices of those homes were modestly lower. New-home sales are now at their highest level since 2008. 

Although I don't expect higher interest rates to have large effect on the housing market if rates stabilize at current levels, some of the lower-end homebuilders did mention rate-related issues cropping up in the homebuilder conference calls. Homebuilding stocks took a significant hit this week.

Manufacturing News Gets Better in Europe and U.S.; China Not So Much
This week there was a lot of excitement around the Markit Purchasing Manager Indexes for manufacturing, which showed significant improvement in both the U.S. and Europe, while China's indexes continued to falter. The data released this week was the advance or flash version of the July data that includes only 85% of the surveys.

The European index moved above 50, indicating that more firms were seeing growth than contraction for the very first time since January 2012. The European trend has been up four months in a row. The more forward-looking portion of the index, the new orders component, was also above 50, the first time that has happened since 2011.

A lot of the comments on the improved European indexes sounded downright ebullient. Quoting from Markit's chief economist, Chris Williamson:

"The best PMI reading for one-and-a-half years provides encouraging evidence to suggest that the euro area could--at long last--pull out of its recession in the third quarter.

"The revival is being led by a broad-based upturn in manufacturing, where growth surged to a two-year high. Increased goods production was reported in Germany, France and across the rest of the region as a whole."

While I am very glad to see the improvement, I think it is too early to declare mission accomplished in Europe. Slowing in China and the U.S. could begin to affect European exports. Furthermore, I think the bank issues and sovereign debt issues have yet to be fully resolved. As good as the numbers were, with improvement in almost every country, Germany was the only country in the region with a reading above 50. Meanwhile, it seems that Italy, the region's third-largest economy, isn't showing much progress. This Spiegel article notes ongoing issues in Italy and the recent S&P downgrade of Italian debt.

China's Manufacturing Sector Continues to Fall, but It Isn't All Bad News for the Long Term
The Chinese data was an entirely different story, and it looks more like the European data of a year or two ago. The new orders portion of the index showed a faster rate of decline than in the prior month, which is not good news for the headline, all-in composite for the next couple of months. The poor manufacturing data comes on the heels of China's release of GDP growth rates for the second quarter, which showed yet another decline. The PMI data would suggest there is more slowing coming in the GDP growth rates in the quarter ahead. Further government-ordered capacity cutbacks won't help, either.

In the short run, a slowing Chinese economy is not good news for countries and companies counting on Chinese growth. However, a shift from an export- and commodity-driven economy to one more focused on consumption, and the shuttering of truly wasteful and inefficient production facilities is very good news for the world economy over the longer term.

U.S. Durable Goods Report: Good News and Bad News
In total, durable goods orders jumped 4.1%, well ahead of the consensus of just 1.1% growth. Much of the "surprise" was related to strong Boeing orders that revived after the Dreamliner issues were put to rest. I say "surprise" loosely, as the Boeing orders were publicly posted more than a week ago. Excluding the transportation sector, orders were flat with rates declining for three months running.  

Worst of Manufacturing Slowdown May Be Behind Us, but Not Before Hurting GDP
Drilling down into the non-defense capital goods sector, which is used as a direct input in the GDP calculation, order growth was 0.7% (8.4% annualized) in June, which followed two months of hefty gains. That, along with improving PMI data, suggests that maybe the worst of the manufacturing slowdown is behind us. The bad news is that the non-defense capital goods (ex-aircraft) category shipments showed no growth at all in June, which likely means the business investment in equipment and software category will be a small subtraction from GDP growth instead of the 0.3% contributor that it was in the first quarter. 

Flood of Data Coming Next Week: GDP, Employment, Autos, Construction, Personal Income
Probably the biggest and most controversial report next week will be the GDP report for the second quarter. The consensus over the last week has come in a little, with consensus of a 1% inflation-adjusted growth rate versus 1.8% last quarter and a long-term average of just over 3%.

It's really hard to find a single category of GDP that will make a larger contribution in the second quarter compared with the first quarter. Consumptions contributions will likely be considerably smaller than in the first quarter (1.1% versus a 1.8% contribution), accounting for most of the decrease in the GDP estimate for the second quarter. Housing will likely contribute about what it did in the first quarter, about 0.3%. Business investment is likely to be slightly negative and worse than the first quarter. Net exports will also likely be a detractor. Inventories, which contributed 0.6% in the first quarter, are likely to make no contribution, at best.

Government spending remains the largest question mark. Government subtracted 0.9% in the first quarter, and many are hoping for at least some improvement in that large decrease in the second quarter. Volatile defense shipments make forecasting this variable a very tough exercise. The monthly government data and the increasing vise grips of sequestration would suggest relatively little, if any, improvement. However, defense orders did spike in June. 

My Forecast Is for Second-Quarter GDP Growth of 0.5% or Less
My single-point GDP growth estimate remains at 0.5%, but if most categories broke the wrong way, GDP growth could be negative. That's not necessarily the most likely case, but a possibility. The question remains how the market reacts to the data, which is highly likely to disappoint. Although investors seem to be becoming more aware of the negative possibility, they don't really seem to care. I think most people hope the number is a one-off fluke. An improving Europe, rising consumer confidence, better manufacturing data, and booming home prices over the last month could lead some to pooh-pooh the backward-looking second-quarter report. I am not so sure of that and believe the second half might not be all that much better than the first. Slowing consumption growth, absolutely the most important part of the GDP report, is real and is not a one-time deal. Weekly shopping center data has continued to deteriorate in July.  

Auto sales are probably one of the more important reports next week. Retail sales have been sloppy lately, even in the face of high confidence numbers. Some of that weakness can be offset by better auto and housing news. June auto sales were exceptionally strong at 15.9 million units. Expectations are for that rate to be matched in July. If that rate or better can be sustained, it would certainly start the third quarter off on the right foot and could go a long way in offsetting the negative effects of a poor GDP report. 

Employment Growth Likely to Slow, at Least a Little
Given the slowing retail sales environment, poor restaurant sales in June, and the potentially weak GDP report, it's hard to get excited about the employment report for July, due on Friday. At least the seasonal factors are more positive. Consensus is for job growth of 175,000 in July versus 188,000 June. I am still expecting a reversal of restaurant growth to cause a dislocation in one month of the job report, though it's not clear which month that could be. Given that August is usually the month of negative surprises, we still might be safe in July, but I wouldn't bet on it.

ISM Manufacturing Could Look Better
Given recent order data and the flash Markit data, expectations are high. The consensus forecast is for the ISM data to increase to 52.0 for July and 50.9 in June. Boeing's continuing ramp-up and the shorter summer shutdowns in the auto industry could help the report. Again: A good manufacturing report, especially the more important forward-looking components, could take away some of the sting of a poor GDP report.