Europe Rattles Markets, Bonds Soar, and U.S. Equities Benefit From Both

Overall, world markets were pointing in different directions this week. Interest rates fell and bonds soared as even more signs of economic weakness turned up in Europe along with the likelihood of some type of quantitative easing by the European Central Bank (or at least keeping rates very low for an extended period of time). Commodities were also up for the week, perhaps because of the prospect of continued low rates.

Those same weak economic statistics out of Europe hurt equities both in Europe and emerging markets. U.S. markets were a little soft but performed much better than other world equity markets. On Friday, the U.S. market soared. Maybe investors realized that the best growth prospects remain in the United States, that corporate earnings accelerated in the second quarter, and that U.S interest rates could remain lower than expected because of central bank easing outside of the United States. I am loath to repeat what has become accepted as common wisdom--namely, that alternatives to U.S. equities are few and far between. However, I warn that logic like that doesn't hold much water if fundamentals deteriorate.

There weren't many important economic indicators out of the United States this week, but there were a ton of little ones. Weekly shopping center growth was over 4% yet again this week, indicating that the U.S. consumer is indeed back at the mall. Initial unemployment claims were back under 300,000, although seasonal factors may be helping that metric along, at least a little. Lending data was really mixed, with some sources indicating little improvement from the first quarter (Fannie Mae FICO scores) and other reports (the Fed Lending Survey) showing some easing. It's fair to say that at least things aren't getting worse, but some of the rapid loosening of the past couple of quarters seems to be over. 

The July ISM nonmanufacturing survey of purchasing managers--the poor stepsister of the more widely followed manufacturing survey--was downright ebullient. Furthermore, data from  CoreLogic suggested that home price growth continued to slow, which is a very positive development for a renewed push in the housing market, which had been hurt by higher prices.

More Troubles in Europe
After mounting a modest recovery since last June, European economic conditions seemed to be slipping again. The bad news has been mounting since last Thursday when the eurozone announced a June inflation rate of 0.4% year over year versus 0.5% the previous month and the ECB target of 2%. Then this week Italy moved back into a recession, posting its second straight quarterly decline in the June quarter. Then Germany topped off the situation with growth in industrial production falling below expectations and now below year-ago levels. And all of this bad news happened before the worst of the Russian sanctions began to kick in. More country-level GDP reports will be available next week.

U.S. Corporate Revenue and Earnings Both Doing Better Than Expected
Paradoxically, corporate revenue and earnings both improved sharply in the second quarter, just as the U.S. stock market rolled over (the Dow is down over 3% since topping out in July). With 73% of all S&P 500 firms reporting, it now looks as if year-over-year earnings growth will come in at 8.4% for the second quarter, well above the 4.9% estimate when the quarter ended on June 30, according to an Aug. 7 report from FactSet. If that 8.4% growth holds up, it will be the second-best performance since the fourth quarter of 2011. The strength is broad-based with all 10 sectors reporting year-over-year improvement.

Perhaps more exciting for the second-quarter earnings growth is that revenue growth now looks to be 4.3%. Yes, that is still slower than the rate of profit growth, but it is much better than other recent quarters when there was little to no revenue growth. Cost-cutting and share repurchases have enabled EPS to grow faster than profits, a trend that probably can't continue forever.

FactSet also notes that analysts are expecting to see growth in earnings remain high in the second half with the third quarter projected to show 7.1% growth and 9.1% in the fourth quarter. Revenue growth is projected at 4% for the back half of the year. The forward-looking 12-month earnings per share estimate for the S&P 500 is 128.15, which puts the current forward P/E at 15 times.

ISM Nonmanufacturing Purchasing Manager Survey Surprisingly Strong
In all honesty, I don't pay a lot of attention to this report because it has a shorter track record (2008) than the manufacturing series (1930s). It also combines things that I would call goods producing (homebuilding, gasoline) with more conventional services. This mixing of apples and oranges means it is not great at forecasting manufacturing or services. However, this report was so unbelievably bullish that it caught even my very jaundiced eye. The survey for July showed a reading of 58.7 versus 56.0 the previous month, the highest number in more than 6.5 years of the index's existence. Like the manufacturing survey, this survey quickly asks managers if things are the same, better, or worse than in the previous month. The percent of those reporting better is combined with half of those saying that things were the same. Though the number could range from zero to 100, most of the time is spent in a range of 35-60.

The more forward-looking new orders subcomponent of the index increased a whopping 3.7 to 64.9 in July, which could mean even more improvement in the months ahead. Even the normally dilatory employment component increased 1.6 to a reading of 56. The improvements were broad-based, with 16 of the 18 of the industry segments now in growth mode. The "other" category was flat and utilities where down as cool weather kept overall demand down. Even the commentary of individual respondents, which is not usually as bullish as the headline numbers, was unusually bullish. This report, combined with the strong manufacturing report from ISM last week, suggests that the economy is really picking up steam. However, I caution that this all may be a continued part of the winter bounceback and not the start of a pattern of significantly higher long-term growth rates.

Home Price Increases Continue to Moderate (Written by Roland Czerniawski of the Morningstar Markets team)
The CoreLogic Home Price Index was released on Tuesday, and it pointed to a continued slowing trend in home price increases. The report contained June's home price index, along with the preliminary estimate for July, which is based on pending sales indexes. That's what makes this report extremely useful, since it not only comes very early in the month, but also it contains an additional month of estimated data, which is something that neither FHFA nor S&P/Case-Shiller indexes can provide.

The year-over-year, three-month average price growth slowed down to 8.5% in June and even further to 7.6% in July, slowly approaching the 5%–6% target we have estimated for the end of the year. That's a significant decrease from the high of almost 12% recorded in October and November 2013.

While the pace of the increases is clearly cooling off, home prices are still rising because of relatively tight supply and strong demand, especially on the West Coast, where prices are still growing at a double-digit rate. Despite the fact that overall prices are still about 13% below the 2006 peak, 13 states are now at all-time highs. On a more granular level, 98 out of the 100 most populous metropolitan areas showed year-over-year increases in June, with Southern California regions leading the pack. Slowing home prices are good news, as they should further boost affordability that has plummeted over the past months, and they will be an absolutely vital contributor to what has been--so far--a muted housing recovery. 

Weekly Chain Store Sales Continue Their Run of Good Numbers
The good news is that improvement in the International Council of Shopping Center's weekly chain store sales has proven to be more than the temporary flash in the pan I was so fearful of. The five-week moving average year-over-year growth rate has improved each and every week since mid-June and has now moved from 2.7% to 4.0% over the past seven weeks. The single point for the latest week showed a reading of 4.6%, its best reading since the holiday season of 2011. ICSC data for the full month of July was also unusually strong (the monthly data includes fewer stores, and categories different from the weekly report) even against a very strong July 2013 report. This is a great way for the industry to hit the all-important back-to-school season that peaks in August.

The Mall May Not Be Dead Yet
We have been talked about the slow demise of brick-and-mortar retail for some time. A tough winter for brick-and-mortar stores made a meandering move down into what looked like a death spiral for stores. That seems to have corrected itself some and it now appears that stores may not be on their deathbed after all. I do think that e-commerce will grow faster than stores and that it could change the long-term dynamics of the number, size, and role of retail stores. I am linking two articles to this week's column that address opposite sides of the issue. The Wall Street Journal notes a continued drop in traffic even if sales are up some while a Forbes article points to surveys that show shoppers truly enjoy the shopping experience and would prefer the brick-and-mortar channel. I will let readers decide which has the more compelling case.

So Why Is the Consumer Getting Stronger?
No matter where they shop, I think there are a lot of reasons consumers are feeling better lately and buying more. Certainly falling utility bills (no more huge heating bills to pay off and moderate summer temperatures have kept a lid on air conditioner use) have helped put more dollars in consumer prices. The falloff in gasoline prices, even in the face of a tough geopolitical environment, is amazing.

Gasoline prices are now below where they were last August. According AAA, prices are down for 37 of the past 38 days and average prices have fallen 18 cents per gallon over that very same period. In fact, prices this August are lower than in August 2011, 2012, and 2013.

Top that off with a lower unemployment rate and a continually improving job market, there are many good reasons for consumers to be feeling better.

Trade Deficit Improves at Last
An expanding trade deficit over the past two quarters has genuinely been an albatross around the neck of the GDP calculation. An increasing trade deficit took 1.7% off of the first-quarter GDP calculation and a still painful 0.7% in the originally reported second-quarter GDP report. Though the current trade situation might not be wonderful, last year's poor U.S. farm crops, and now lower crop prices, in addition to higher internal oil demand in the U.S. due to poor weather, are the primary culprits behind the past two quarters of dismal trade news. However, a stronger dollar, a sharply improving U.S. economy (which means more imports), and a softer-than-expected Europe means there are a few longer-term issues that could limit improvement in the trade situation over the next year.

That said, the June data provided some welcome relief with the trade deficit down meaningfully, surprising BEA forecasters and Street economists. The trade deficit in June fell from $44.7 billion to $40.5 billion. With the low number for June, there is some hope that the trade deficit may be a smaller detractor from GDP in the third quarter.

Canada Still the Largest Trading Partner for the U.S.
One of the most frequent questions I get from readers is the impact of slowing exports to a given country. My usual answer is: not much. Overall exports are just 13.5% of U.S. GDP, one of the smallest numbers for a large, developed economy. Given that a lot of U.S. trade is to Canada and Mexico, the impact of a slowing (or growing) Europe or China is quite small. China exports through the first half accounted for just 1% of GDP and Europe was 2.8%. This week, I had several questions about exports to Russia, which in reality is too small to make much difference to the U.S. economy as a whole.

Retail Sales, Industrial Production, and Job Openings all on Docket for Next Week
Retail sales have been doing better recently and I expect to see some improvement in July. Ex-autos, retail sales are expected to be up 0.3% in July, though autos may drag the overall number down to just 0.2%. Unit auto sales were down in July, although some of that was because of fleet sale issues that don't affect the retail sales report. Given the strength in shopping center data, both weekly and monthly, and some improved individual corporate earnings reports, I am hoping the 0.2% consensus forecast may prove too low. Ex-autos and gasoline, I am still expecting year-over-year growth of 4%, not much changed from recent reports.

Industrial Production Could Be up or Down, Depending on Whom You Believe
The industrial production report is quite controversial, with most analysts expecting a gain of 0.3% following a 0.2% gain in the previous month. Utility output is likely to hold back short-term results as cool weather weighs on utility usage. On the other hand, there are a few analysts who noted that while manufacturing employment was up in July, hours worked per employee were down, potentially holding back industrial production and possibly even pointing to a small decline. Lately, employment report data hasn't been as helpful as it has been with predicting production data. Given accelerating retail demand and strong purchasing managers' reports, I certainly wouldn't panic if the bears turn out to be right and the short-term IP number was down for July.

Job Opening Report Bears Watching
The jobs opening report has recently indicated a sharp rise in openings, in both high- and low-quality jobs (based on weekly hours and wages only, no value judgments here). Hiring numbers have not looked nearly as good. Some of that gap may close with the report for June as the employment reports have looked stronger this summer. Alternatively, a skills mismatch between what employers want and what employees have may still keep the gap wide. The jobs opening report has been one, but not the only, linchpin to my theory that we are about to enter a period of labor scarcity. Interestingly, the Wall Street Journal talked about the shortage of computer programmers this week and the potential to alleviate the problem with more-focused training that might not require a full bachelor's degree