Time to Pull Out the Rose-Colored Glasses?
When examined more carefully, the economy seems to be picking up a little bit of steam.
It was a very mixed week for markets, with the U.S. and European equity markets up over 1% and the U.S. making new highs. Bonds also did well as the 10-year U.S. Treasury bond saw its yield drop to 2.48% as the headline economic news remained weak. Emerging markets and commodities both had bad weeks, declining by more than 1% each.
At first blush, the key economic headlines this week were bleak. GDP growth for the first quarter was revised down to a negative 1.0%, while real consumption for April dropped 0.3%. However, the year-over-year averaged data continued to show improvement in consumption and income. And higher wage and income growth seem to suggest more spending in the months ahead. Business confidence, as measured by capital goods spending, showed some very nice improvement, too.
Examined more carefully, the economy seems to be picking up steam. It might just be time to pull out my rose-colored glasses--but not my rocket ship. On the other hand, bond traders must be reading the headlines and ignoring the details as bond rates continued to edge lower. (Bond traders seem to be exceptionally pessimistic about the economic outlook at the moment.)
The U.S. Economy Contracted in the First Quarter After All
As many economists anticipated, first-quarter GDP growth was reduced from a 0.1% positive number to a decline of 1.0%. Although many categories shifted, it was inventories that really moved the needle. Therefore, economists and markets took the negative report in stride.
Inventories are notoriously volatile. To top it off, inventories are especially difficult to measure and seasonally adjust. Wide swings in the data more likely represent measurement errors and timing issues and not necessarily things happening in the real economy.
Given the rock-solid growth rates in employment and consumption, I doubt that inventories changed as much as the report suggested. The size of these swings is massive when compared with overall GDP growth, which generally averages 2%. The first quarter would have shown some modest growth if it weren't for the inventory subtraction shown below.
Still, the first-quarter report was nothing to write home about. Weather played some role in the soft data, though it is clearly not the whole story. Housing began to slow last summer before the nasty weather hit.
Outside of consumer categories and intellectual property, most other categories were down for the quarter. Buildings of all types were weak, and business spending remained unusually subdued. Government was still a subtraction, too, but far smaller than in some recent quarters. Net exports were a larger subtraction than in most recent quarters. However, the all-important consumption category showed its third quarter of improvement in a row. This time around it was the services categories that did particularly well, driven by high utility demand and increased demand for medical services driven by the Affordable Care Act.
Home Price Growth Remains Relatively High
I have been hoping to see some deceleration in home price increases in 2014, but the declines are almost imperceptible. Home price growth generally peaked last October and November with the broader FHFA index down quite significantly and the CoreLogic (CLGX) data showing almost no change.
The reason I want to see some moderation in home price increases is because home affordability has slipped, mostly because of higher prices, but also because of higher mortgage rates. Less affordability means fewer transactions and less housing-related economic activity. So the economy needs to work a balance between some price appreciation that keeps both investors and consumers in the market without so much price appreciation that no one can afford a home.
Looking at six-month data over six-month data, the year-over-year home price growth still appears poised to shrink. Doubling the most recently reported six-month data (2.9%) suggests that home prices are currently increasing at an annual rate of 5.8%, which strikes me as the perfect Goldilocks level, not too hot and not too cold.
Unfortunately the six-month price trend line has accelerated slightly since the December reading. And now with rates a little lower again and a compressed spring/summer selling season, it feels like prices could be accelerating once more. For now, I am sticking with my full-year forecast of 5%-6% price appreciation, but I am a little queasy that could prove to be too low.
Pending Home Sales Improve, but not by as Much as I Hoped
The pending home sale index for April moved up 0.4% to 97.8 from 97.4 the previous month. Recall that the pending home index peaked way back in June of last year at 110.8 and fell in an uninterrupted straight line to 94.2 in February. Then March showed a huge 3% increase.
The April increase was more muted and was due mostly to weather-related improvements in the Midwest and small increases in the Northeast offset by softening in the South and West (after stellar March numbers for these two regions). Because of unusually warm weather last year and cool weather this year, along with a race to beat mortgage rate increases in 2013, the year-over-year numbers don't look so great.
The unusually long length of the warm and cold spells is raising a ruckus in my normally reliable, year-over-year, three-month averaged data. However, the rate of year-over-year declines has stopped accelerating. And when analyzing year-over-year trends, one needs to take heed of even small changes in either direction.
Furthermore, the narrowing gap between the more forward-looking pending home sales report and the existing home sales report (which tends to be affected by pending homes sales with a month or two lag) suggests the existing home sales may be up next month.
Income Continues to Grow Even as Consumption Slumps
Consumption growth, adjusted for inflation, dropped 0.3% in April, which was below expectations and is quite disconcerting taken in isolation. However, one has to consider that there were huge jumps (probably due to weather) in the prior two months that weren't really sustainable. Also, incomes continued their nice upward slope, which should provide fuel for consumer spending in the months ahead.
Keep in mind that both incomes and consumption need to average a monthly growth rate of about 0.2% on a monthly basis, to maintain 2.5% annual consumption growth, which is what is embedded in my economic forecast. The improving consumption trend looks even clearer in the annual, year-over-year averaged data. Consumption data that had been stuck at 2% forever is now showing an accelerating trend that is very hard to deny, especially in the face of a lot of weather-related obstacles. Though I do caution that consumption got a bit of a boost from high utility and health-care spending related to the Affordable Care Act. The diminution of those factors probably means that it will be hard to maintain that 2.7% consumption growth rate, but with improving wage growth, I don't anticipate that we will revert to the 2% level anytime soon.
Real-income data, which is normally a very reliable indicator of consumption, has been muddled for most of the past year because of actions taken by businesses and individuals in late 2012 to avoid higher taxes due in 2013. And there was the higher payroll tax, too, which took close to 1% off of real income growth during many months of 2013. Income and wage data for February and especially March and April 2014 are now breaking free from those anomalies. Income growth is now probably in the low 2% range, which would support consumption growth of close to 2.5%, a bit lower than the 2.7% consumption growth rate shown above for April but still generally above where it has been for the past two or three years.
I also want to introduce a new chart this week that uses BLS employment and wage data to construct total consumer wage growth. Unlike the wage growth data from the BEA, this data set doesn't generally include bonuses and special payments, which tend to accrue to higher-wage earners who typically spend a much smaller fraction of their income. It also is a nice way to get around the prepaid bonus issues of late 2012. The new graph shows a much tighter relationship between wages and spending. It also shows wage data that is much less volatile. For the curious, the gap between wages and income in 2011 is probably related to temporarily higher inflation in 2011, which consumers correctly anticipated would dissipate.
Durable Goods, a Confusing Jumble Yet Again
Although readers know that I am not much of a fan of this report because of the volatile aerospace sector and defense, this month the data was even harder than usual to tease apart.
Big military orders (probably a delayed reaction to all the fiscal policy agreements last fall) surged, causing overall orders to gain 0.8% instead of a decline as widely anticipated. Excluding transportation orders of all stripes, though, orders were down about 1.2%. However, there were huge revisions to previously released data, and this month's data represents a reversion to mean and not a new decline. Core orders were up 4.7% in March for the single month and not annualized. That is clearly not a sustainable level.
I do like to look at the nondefense capital goods, ex-aircraft to get a handle on business confidence. The news there seemed much better and clearer.
These are goods that companies would not buy if they didn't have confidence in the longer term. Both the year-over-year and month-to-month data are showing clear signs of improvement. Poor business spending levels held back the economy in the first quarter, but are unlikely to do so again in the second quarter, based on this report.
Motor Vehicle Sales Data and Payroll Data Are Key Reports to Watch Next Week
There will be the usual flood of economic data for the first week of the calendar month, including construction, trade, and PMI data in addition to the far more important employment and auto sales reports. The auto and employment reports are the ones I will be focusing on next week.
Auto Sales Likely to Remain Above the Key 16 Million-Unit Run Rate
Autos have been one of the real keys to the economic recovery. However, sales suffered a meaningful decline in the winter months before rebounding sharply in March and April. The question is, can the momentum be sustained in May? Auto production has remained relatively high and inventories have been running a little high as automakers anticipate continued strength. The current consensus is for auto sales to increase modestly to 16.1 million units in May, up from 16.0 million in April, but below the recovery high of 16.4 million units. The consensus forecast would amount to about an 8% increase compared with a year ago.
Employment Growth Likely to Slow
Employment growth has averaged 190,000 new jobs each month over the past 12 months, which also happens to be my forecast for 2014. However, that number has been on a real yo-yo over the past five months, ranging from just 84,000 jobs in December to 288,000 last month. Reversion to mean suggests a much lower number for May. A lot of the other metrics, including Challenger Gray layoffs, many of the PMI reports, and initial claims haven't been nearly as volatile but are generally showing modest improvements. Therefore, it's unlikely we will see tiny growth or even a contraction. Still, the consensus has been falling like a rock all week, with the latest estimate expecting job growth of just 200,000, which would match the longer-term trend.
The hourly wage number is as important as the employment number. Despite some decent employment gains month to month, wages haven't budged for two months, which is unusual except during a recession. Without at least some gains for May, consumers will be disappointed. I will also be closely watching the health-care employment figures to see if some of the Affordable Care Act spending is turning into employment, as promised.