Consumers Pull Back on the Reins

The economic data this week continued to be mixed with weak durable goods orders, personal spending, and pending home sales data offset by higher home prices and reduced initial unemployment claims. However, none of the news seemed to deter the Federal Reserve in its intent to reduce bond purchases in the short run.

There is an increasing number of Fed governors who seem to believe that there has been enough bond buying, and that the program wasn't terribly effective, anyway. And unless the economy is falling apart, they want to begin to taper bond purchases now. Still, there are some governors who continue to believe that the economy is in a fragile state. Without clear evidence of an accelerating economy, these governors are more reluctant to make any changes. This smaller group may try to resist the calls for reducing bond purchases.

It seems to me that a small tapering might represent an acceptable compromise. That is, unless the economic indicators next week fall apart. (The August employment report has been full of nasty, negative surprises over the last few years.)

During the entire pre-holiday week, news out of Syria weighed on the market. Those fears were clearly present in the oil market, where the benchmark oil price touched $110 per barrel before dropping to just under $108 on Friday. Though Syria produces no oil to speak of, there are fears that other Middle Eastern oil producers would be drawn into the conflict. Higher oil prices are not what the world economy needs just now.

The news out of emerging markets continued to be bad, with rising inflation and depreciating currencies beginning to affect local economies. The Indian and Turkish currencies are at record lows, and the Brazilian and Indonesian currencies are off sharply. Depreciating currencies can raise the local price of oil sharply, sparking more inflation.

I believe the long-term outlook for the U.S. economy is excellent due to the potential of the housing, oil, aerospace ( Boeing (BA)), and auto industries. The renaissance in manufacturing is also continuing and the banking system remains strong. Inflation also appears under tight control. That said, there is no denying that fiscal austerity and higher interest rates are taking at least a short-term toll. The table in the next section of this report suggests that consumption, which represents 70% of the U.S. economy, has been on a slow drift down over the last year despite all the breathless talk of escape velocities and booming housing markets.

Personal Income and Consumption Start the Quarter on a Soft Note
On a month-over-month basis, real disposable income increased a minuscule 0.1% while spending did not increase at all in July. Although I am not a huge fan of looking at just monthly numbers, monthly consumption growth for each of the last four months averaged less than 0.1%, which annualizes to a rate of about 1%.

The year-over-year consumption data looks better, but the trend is still down. However, the consumption data looks better than the inflation and tax-adjusted personal income numbers, which are still taking a hit from the payroll and income tax increases. Expenditures have exceeded income growth for some time, and that gap will eventually need to close over time through a combination of better earnings and lower spending.

This data will get the third quarter off to a bad start. Given limited growth in July actual data and lackluster shopping center data so far in August, I believe consumption data will be hard-pressed to grow much faster than 1.5% in the third quarter overall, compared with an increase of 2.3% in the first quarter and 1.8% in the second quarter. Given that consumption is the largest component of GDP, the data would seem to indicate a slowing in the overall GDP growth rate in the third quarter.

Second-Quarter GDP Revised Sharply Upward on Huge Change in Net Exports
The second-quarter GDP estimate was revised sharply to show 2.5% growth compared with the previous estimate of just 1.7%. In terms of the GDP revision, almost every category was little changed while the much-anticipated revision in net exports accounted for almost the entire 0.8% revision in the estimate.

The revised growth rate is also sharply higher than the 0.1% rate in the fourth quarter and the 1.1% rate in the first quarter. Through all of these periods, consumption, which accounts for 70% of GDP, stayed in a very narrow range while things like inventory, net exports, and business structures remained on a wild roller coaster. Many of these other factors seemed more accounting related rather than reflecting any underlying changes in what we think of as the real economy. For example, spending on business structures swung from a negative 0.8% in the first quarter to a plus 0.4% GDP contribution in the second quarter, accounting for almost the entire improvement in overall GDP growth between the first quarter and the second quarter. Yet, construction employment and spending on construction supplies was little different during the two periods.

Then there is the huge swing in the government contribution from negative 1.3% to negative 0.2% between fourth-quarter 2012 and second-quarter 2013. Sure, the employment data for the government sector showed some improvement, but not that much. Again, this category is affected by when government checks are sent out, and not necessarily when the underlying work was completed. And when the sequester was having its greatest impact in the second quarter, GDP reported government spending was having one of its better quarters in some time.

With all the volatility due to a lot outside, irrelevant factors, I am beginning to lose some faith in the GDP reports, especially over the short term. A quick look at consumption data and business spending data might provide better insights than the overall headline GDP number. On that front, consumption growth fell from a relatively robust 2.3% in the first quarter to 1.8% in the second quarter, hardly anything to get too excited about for either the economic bulls or bears. Just more slow, relatively steady, and unsatisfying growth.

Higher Interest Rates Weigh on Pending Home Sales Data
Pending home sales fell 1.3% between June and July, while the year-over-year tally was up 6.7%, its lowest showing in 2013. (Three-month averaged data dropped too, just not as drastically.) The data was weaker in the Northeast and West, where prices are higher, and still OK in the South and the Midwest. That's a telltale sign that higher rates may be behind the overall slowdown.

Unfortunately, pending sales are tracking lower than existing-home sales data, which means that the more closely watched existing-home data are likely to show slower growth rates in the months ahead. The data also seem to indicate that the big jump in July existing homes was a result of a rush to close mortgages faster, and not gains in the housing market. The ongoing pipeline was drained down instead.

Case-Shiller Housing Price Data Stops Accelerating
While the Case-Shiller Index continued to show 12% year-over-year growth, the rate of growth has started to moderate. I believe that rate will continue to slow in the months ahead as mortgage rates have risen dramatically since June. For the 20-City Index, 13 of 20 markets showed a moderating rate of growth. The hyper-growth rates continued on the West Coast, though New York recorded its best reading since 2002. Overall the data is quite good, and prices are about 19% above their March 2012 lows.

The Case-Shiller indexes cover a more limited market than some of the other price reports and emphasize some of the more volatile markets. The lower-growth FHFA data, which is less volatile, probably does a better job of capturing the experiences of average readers, at least those not living near the West Coast.

Housing Affordability Beginning to Slip
Home prices have risen sharply over the last 15 months as demand increased modestly, because the inventory of homes for sale were limited and new home starts remained remarkably slow. However, rising interest rates and declining affordability may keep a lid on prices, at least for a few months. Affordability has slipped from an index of 210 to 166, and that was before rates really started to increase this spring.

I believe rising home prices have helped consumers feel better and encouraged additional spending on housing-related items in addition to other goods. I am thinking some slowing in price appreciation won't spoil that party and may keep home prices in an affordable range. The recent rise in prices was one the strongest in recent memory and a pause isn't anything to get too worked up about

Overall, the Housing Market Is Slowing Its Growth Rate
I have talked about a lot of housing data in isolation, and some of the monthly data is good and some is bad. However, when one steps back and looks more broadly, a little slowing in growth rates, or at least a plateauing, is visible in the composite data I show below:

Data related to new home construction/purchase has shown the most dramatic slowing. Higher rates, tight lending conditions, lack of available land, spot labor shortages, and supply chain issues have all begun to take a short-term toll. Long-term trends in population and household formations and population growth remain intact and are very bullish. However, that doesn't mean that all short-term weaknesses can be avoided.

Inventories are still tight, but less tight than they were several months ago. Slightly better supply combined with higher rates have begun to slow the rate of price increases, which nevertheless are still very high by historical standards.

Existing-home sales have done better recently. Better inventories have helped a little, but some of the existing-home data is being inflated by sellers' demand to close all sales quickly because of accelerating interest rates. Pending home data suggests that the spurt in existing-home sales growth will be short-lived.

Durable Goods Orders Prove Exceptionally Difficult to Analyze, but It's Clear There Is No Manufacturing Boom
As expected, durable goods orders fell a sharp 7% in July as Boeing orders artificially boosted the metric to 4% growth in June before falling back. Boeing's ups and downs have made this metric difficult to analyze. And Boeing orders don't make much difference to the economy in the short run or even the intermediate term as orders stretch out over a decade. Boeing is currently limited by its own manufacturing capabilities and not by end-user demand.

Nevertheless, orders excluding the transportation sector were still down month to month by 0.6%, catching the market by surprise. Most categories were down, with only autos and fabricated metal showing any growth. On the other hand, the year-over-year data looks less worrisome, suggesting that noisy seasonal factors contributed to the decline.

To gauge business confidence, many investors like to look at just the capital goods orders portion of the order book and exclude the volatile defense and aircraft sectors. These are goods that last three years or more, so they aren't bought on a whim. Month to month, this data was down 3.3% on a single-month basis, but because of a strong spring, the year-over-year improvement continues. The truth probably lies between the dismal July monthly numbers and the overly optimistic year-over-year data.

The actual manufacturing data as reported in the industrial production report and the new order book analyzed here are not nearly as optimistic as the purchasing managers' reports. At a minimum, it doesn't appear that manufacturing is running away on the upside. That's not really too surprising given how miserly the consumer has been lately.

Slower Durable Goods Shipments May Weigh on Third-Quarter GDP Growth
Though the forward-looking orders report is what everyone cares about, the data also includes shipments of capital goods, which are a tiny input into the GDP report. Shipments declined slightly from June to July, which generally had economists scrambling to reduce their third-quarter GDP estimates. I am not worried yet, given this is the first month of a quarter, but there doesn't seem to be a boom going on, either.

Employment, Manufacturing, Trade, and Auto Data All on Tap
August's employment report will get far more attention than usual as it will be the last report before the Fed's September meeting. To guide its decision on monetary policy, the Fed is watching two key economic indicators: inflation and employment (actually, the unemployment rate). There seems to be a building consensus that a strong employment report would most likely cause the Fed to tighten at its September meeting, potentially reducing its large bond-buying programs.

The July report was a lemon with job growth of 162,000, well below the 12-month average of approximately 190,000. Forecasters are expecting more of the same for August, with a teeny rebound to 165,000 new jobs based on a monthly improvement in initial unemployment claims. Nevertheless, August has been a month that has held a lot of negative surprises, with one recent August report originally showing no job growth at all. The slowing consumption data for July noted above will not bode well for hiring, either. Finally, restaurant hiring has dramatically outpaced sales for some time, which suggests some slowing is imminent in restaurant hiring. Although it's hard to fight the surprisingly good initial unemployment claims data, I still think a disappointing employment number is in the cards with job growth of just 140,000 a real possibility.

ISM Purchasing Managers' Index Could Slow
The Institute for Supply Management purchasing manager data for July was shockingly strong at 56, and the consensus is for some softening to 55 in August. Recall that the flash from Markit showed some improvement from July to August, but the Markit data didn't do the huge July bounce, either. Frankly, both the ISM and Markit data have been out of sync with poor recent industrial production and durable goods reports. The Purchasing Manager Index data is looking more like a sentiment indicator than a data-driven exercise about the strength of the manufacturing sector. Nevertheless, ever-accelerating automobile production is likely to keep ISM data afloat for another couple of months.

Auto Sales a Key Driver
I will be looking very closely at the auto data as a true measure of consumer sentiment and the strength of the economy. Auto sales in July (15.7 million annualized units, according to the Bureau of Economic Analysis) held their own after a big bounce in June, from 15.4 million to 15.8 million. In fact, the big bounce and subsequent plateauing in auto sales are largely the cause of both a poor retail sales report and the consumption report for July discussed above.

The forecasts I have seen so far are all over the map, ranging from 15.5 million to more than 16.0 million units with an average of 15.8 million. An early Labor Day holiday will complicate the data interpretation even more. The August report will include the full Labor Day weekend. Still, this report, not the employment report, is the most important report of the week. A new recovery record of 16 million units or more would assuage many of the worries embodied in the recent consumption report.

June's Trade Report Too Good to Be True
The trade report has been all over the place lately with an average of around $40 billion, but a May report of a sharp increase to $44 billion and a subsequent collapse in June to an unsustainable $34 billion. The consensus is forecasting a revision to mean, which suggests a trade deficit of about $38 billion. Overall, I would expect trade to be a small subtraction from the GDP calculation in the third quarter instead of its neutral effect in the second quarter.