A sharp downward revision to first-quarter GDP will have many economists reaching for their erasers, but I'm taking a wait-and-see approach, writes Morningstar's Bob Johnson.
It was a wild week for economic data, but markets generally took the news in stride. Housing data looked surprisingly healthy, showing that we are now well past the bottom in the housing market, but still a few months away from housing sales finally stimulating more economic growth.
Speaking of economic growth, the GDP revision was a huge bomb, now showing a massive and unexpected first-quarter decline of 2.9%. Two thirds of the revision was due to negative revision to the effects of the Affordable Care Act, and a third was due to an expected revision in net exports.
Turning to more recent data, initial consumption reports for May suggest that things aren't improving as much as hoped in the second quarter. This means a lot of growth forecasts for the second quarter and the full year will be moving down. However, because of the categories affected, it's not likely to have much of an effect on the employment outlook.
On the bright side of the ledger, consumer income data and savings rates also continued to move up nicely. Given that U.S. consumers can't usually manage to hold on to their cash for long, I suspect consumption rates will be moving up nicely in the months ahead. World manufacturing data, especially in the United States and China, also looked good, suggesting that the manufacturing renaissance is continuing.
First-Quarter GDP Growth Revised Sharply Lower on Reduced Health Care Growth
Everyone knew first-quarter GDP data would be revised downward. However, I don't think anyone expected it to be revised down to a shrinkage of 2.9% from a previously estimated rate of decline of just 1.0% and the original estimate of 0.1% growth. Unfortunately, it was a revision that no one saw coming because it was a Bureau of Economic Analysis estimation change.
BEA had been including a manual estimate of the impact of the Affordable Care Act and previously it was estimated that it would be a large contributor to growth in January, February, March, and April. The estimates of spending were based on the number of people who signed up for health insurance on the exchanges. People with new insurance were widely assumed to begin immediately using large amounts of services. It didn't happen, and BEA ’fessed up with the last revision to the GDP report for the first quarter. Based on the April Trade report, economists correctly anticipated that there would be a decline in the first-quarter GDP estimate (which was actually a little better than feared), which accounted for a third of the GDP revision, with health care accounting for the other two thirds of the revision.
Last week I called the crummy GDP estimate water under the proverbial bridge. I didn't care how bad the first quarter ended up being because I believed what was lost would show up in the second quarter. Based on the nature and size of the GDP revision, plus a crummy consumption report for April and May, I can't be quite so cavalier. Still, I believe the economy might grow at 2% in 2014, but that is now probably the best-case scenario. Because of the consumption data we have seen so far in April and May, it looks like the best-case scenario for the second quarter is now 3% GDP growth, not the 3%-4% range that I had been estimating. Then I would need 4% growth in the third and fourth quarters to get to my full 2% growth rate for the year. That 4% seems a little aggressive, even to me.
But I continue to think the health-care data will be revised yet again, up this time. The employment and hours data don't support the massive decline in health-care consumption. Prescription drug sales are up, too, and you can't get those medications unless you visit a doctor or are in a hospital. There is also a shot that BEA's forecast surge in health-care spending comes through, just later than it thought. There is anecdotal evidence that a lot of Affordable Care Act insurance signups occurred in March and even April, and are unlikely to start helping the numbers for another month or two. (Waiting for insurance cards and scheduling appointments account for the lag.) At the same time, conventional insurance users' health care surged in the fourth quarter as they tried to beat new higher deductibles and copays scheduled for 2014. Then usage dropped in the first quarter as the fourth-quarter surge pulled ahead a lot of health-care spending that otherwise might have happened in the first quarter. Health-care spending is finally moving back up again in May after falling each and every month of the first quarter, which is almost without precedent.
Consumption Data Massively Revised; Month-to-Month Data Looks Depressing
Wednesday's poor GDP report for the first quarter was followed by even more disappointing consumption data, which now showed consumption expenditures slumped 0.2% in April and 0.1% in May. However, the month-to-month data has proven to be exceptionally volatile, as shown below on the left. Any outsize moves in one direction are almost completely reversed within a month or two. Meanwhile, year-over-year data averaged over three months has shown almost rulerlike growth, as shown below.
The May data had a lot of quirks including a large drop in food spending and a massive swing in utility bills. The food spending drop seemed to be partially a reaction to higher prices and partly due to some weird calendar effect, accounting effect, or an out-and-out measurement error. (I doubt that we all actually ate less food in May.) Without those two items, monthly consumption growth would have been a more sensible 0.2%. Monthly averaged data on a year-over-year basis tends to remove a lot of these anomalies.
Income Data Continues to Improve, Potentially Fueling Future Consumption Growth
The income report provided at least a small antidote to the GDP and consumption reports, notching its fourth consecutive month of growth. The income growth for May was 0.2% or 2.4% annualized, which should have fueled more spending growth than it did.
Savings Rate Up
With consumption down and incomes up, the savings rate moved sharply upward and is now nearing 5% again. High savings rates are often followed by nice increases in consumption in the following months. The last time recently the rate got as high as 4.8% was August 2013. That spike in the savings rate was followed by very healthy consumption increases of 0.2%, 0.3%, and 0.5% in September, October, and November, respectively. American savers can stand thrift only so long. This is part of the reason that I am not panicked about the economy despite this week's nasty surprises.
World Manufacturing Economy Picking Up Steam
All three major Markit manufacturing indexes regions rose above 50, indicating more firms were seeing improvement than those seeing declines. That's the first time this year that all three regions have been above 50 at the same time.
The U.S. continued to pull ahead of the pack with the highest absolute reading and the most months of consecutive improvement. The U.S. improvement was broad with production orders and employment all managing increases. The overall reading of 57.5 was the highest reading since 2010. U.S. manufacturing has been looking stronger to me for several months as affirmed by last week's industrial production report for May. But as I have continually lamented, at 9% of U.S. employment, manufacturing by itself is not large enough to move the U.S. economic needle.
China's Markit PMI data, while not producing readings as high as the United States, nevertheless managed to crack the 50 mark for the first time in 2014. The good news about the manufacturing sector in China is that it's large and can move the economic dials all by itself. I suspect that most of the recent improvement was due to domestic Chinese demand, aided by incremental stimulus the government implemented during the past several months in response to slower growth. At 50.8 the Chinese index is at its highest reading in seven months. Also important, the New Orders Index, often a leading indicator of the broader index, was even higher at 51.8. The makeup of those orders was surprising, with some slippage in export orders, apparently indicating that the bulk of the improvement was internal as growth prospects in Europe and the United States began to fade.
The European news was not as good as in China and the United States as the manufacturing Purchasing Managers Index fell to a seven-month low of 51.9, notching a second month of declining rate of improvement. Germany continued to do well, but the rate of improvement diminished while the situation in France was bad and continues to erode. Rates in the rest of Europe (excluding France and Germany) are now matching German performance. Overall, the New Orders Index slipped again, which points to another month of continued decline in the total manufacturing index next month. It will be interesting to see if the European central bank's easing may break the negative manufacturing cycle that seems to be building.
Durable Goods Order Looking Better Cut the Right Way
Overall, durable goods orders shrank by 1.1% in May compared with April and still shrank by 0.1% excluding the transportation sector. However the year-over-year data paints a much brighter picture, when averaged over three months, as does the averaged month-over-month data.
The picture for nondefense capital goods ex-transportation equipment, a fantastic indicator of business confidence, mirrors the good news of the overall orders reports ex-transportation. So like a lot of news from the manufacturing sector, durable goods orders are pointing to a continuing improvement. Autos and metals were the stronger sectors of the overall May report.
Housing Sector May Be Breaking Out of Its Doldrums
Both new homes and existing homes moved nicely higher in May than in April and were considerably above expectations. Single-month year-over-year data was improved for new homes while existing-home sales were down. This is because people were racing to close deals before interest rates accelerated again, and that favored existing-home unit sales a year ago. Data had been in a pattern for a while where either new home sales or existing-home sales did well, but seldom both at the same time. I am hopeful that this is a sign that interest in housing in general is improving. With the labor market growth continuing, weather improving, mortgage rates down again, and home price growth slowing, I think the picture looks good over the next several months. With this week's housing data, it would appear that housing will be a bright spot in the second-quarter GDP report after negative results in the fourth quarter of 2013 and the first quarter of 2014.
Existing-Home Sales Continue Their Improvement
The May existing-home sales report was encouraging. Between April and May, existing-home sales increased by 5%. It now appears existing-home sales bottomed in mid-March, increased modestly in April, and finally popped a little in May. Looking at the short-term graph of existing-home sales, it looks like housing is approaching its short-term trend of 5 million units. The past year's worth of data was initially biased upward because of the pop in mortgage rates a year ago, causing an artificial rush as homebuying fence sitters leaped off. Then weather and a hangover from last year's midyear surge artificially depressed the data. Now we are finally returning to something that looks more normal. Despite the recent volatility, the trend line still has at least modest upward bias over the past two years.
In addition to the good news on the unit sales front, inventories continued to increase, which is good news at this point in cycle. Home shortages were slowing sales in some markets, particularly in the West. In fact, tight inventories in the West made this territory the worst-performing geography in May, with only a 1% gain compared with the 5% national average. Price increases continued to moderate, with median prices up about 5%. That is probably just about the Goldilocks level: high enough to continue to help those with underwater mortgages and low enough not to ruin affordability, especially in light of improving worker incomes.
As I warned earlier this year, it will take at least a few more months for the improvement in home sales to finally influence other parts of the economy, including home improvement items, remodeling contractors, and furniture, to mention just a few. But the seeds of future economic improvement are being sown now.
New home sales for May were also up nicely and above consensus estimates, providing further fuel for economic growth in the months ahead. New home sales hit a recovery high of 504,000 annualized units, the first time we have crossed the 500,000 level this recovery. That represents a 19% increase from April and 17% from last May.
Home Price Growth Continues to Slow
This week's data from Case-Shiller and the Federal Housing Finance Administration showed more extensive price-growth slowing than CoreLogic data released earlier in the month. This week's data strongly suggest that home price growth has finally begun to moderate. CoreLogic's pending home sales price index for May suggests that growth in its price index will finally plunge in the May data set. Some of the more drastic slowing in growth rates has been on the West Coast where annually growth rates that may have soared as much as 30% at one point have now moderated to 20% or less, according to Case-Shiller. The rest of the nation in general has seen a slowing in price increases, but not nearly as dramatic. Remember, we are talking about slowing growth rates and not price declines. For the full year, I am expecting 5%-6% increases in home prices, a much more palatable level for homebuyers.
