One of Yellen's Favorite Metrics 'Jolts' Ahead

There wasn't a lot of U.S. economic data or earnings developments this week. Most of the news focused on nonexistent European growth and speculation on what the European Central Bank might do about the situation.

In the U.S., retail sales month to month also stalled out, but the more dependable year-over-year growth metric remained intact at a lackluster, but not disastrous, 4% annual rate. Job openings, hiring, and quits data (known as the Job Openings and Labor Turnover, or JOLT survey) from the U.S. Department of Labor seemed to indicate that labor markets are continuing to move in workers' favor. Small-business optimism also picked up in the July survey. Industrial production looked very good, too, showing that U.S. manufacturing is doing well, especially when it comes to the auto industry.

Job Openings Report
The formerly unimportant job openings report has taken on a new significance, since U.S. Federal Reserve Board Chair Janet Yellen has included this metric in a list of labor market reports that she is watching closely.

She is watching it for good reason. Before a new person is ever hired, the job must be posted first, suggesting that the number of openings might help predict new hires and employment levels. However, as a practical matter, the number of openings seems to move more in tandem with the employment report rather than leading it. I suppose that is because a great number of jobs are filled very quickly or the jobs are never posted at all.

Still, the openings data can provide a valuable method to doublecheck a wacky-looking employment report. And this relatively new report is now sending a message that we really haven't seen before. Job growth isn't much better than it has been in the past three or four years, while the number of openings per person employed is now at its best level back to 2001 and way above year-ago levels, suggesting that something is changing.

That openings are growing faster than employment and hires suggests that employers aren't able to find all the employees that they need and want. This should eventually mean that employers will need to offer higher wages to attract people from their current job or situation or settle for less-experienced workers and train them. And unless the openings are fictitious, that hiring will eventually need to go up.

Yellen is also looking at the quits rate. People generally feel better about the labor markets if they are willing to voluntarily quit their jobs to perhaps take a better job. The quit rate also improved nicely in June and is well off recession lows. Still, quits are well short of prerecession highs, suggesting that employees are still fearful.

Some readers have suggested that the sudden jump in openings was related to the Affordable Care Act. Employers have fewer insurance obligations with a part-time workforce under the act, so some people are theorizing that firms are splitting one job into two. However, the very limited growth in part-time jobs compared with full-time jobs suggests that this is not the case. Others have posited that all the new job openings are in low-wage job categories. There is some truth in this, but that is not the whole story. In 2013, restaurant and hotel workers were important parts of the growth in openings. The situation in 2014 has been more balanced. In fact, comparing June 2013 data to June 2014 data, retail openings actually fell. Hotel worker openings did continue to grow, but the much higher wage and hours category of business and professional services added more openings than any other category.

Eurozone Economy Hits the Wall
European economic growth overall came to a halt in the second quarter, with the eurozone showing no growth at all. European statisticians report the percentage change between sequential quarters. These numbers are not annualized as they are in the U.S., so multiplying European second-quarter declines by four would approximate the U.S. calculation.

The three largest European economies, Germany, France, and Italy, were all particularly dismal. Germany declined by 0.2%, and Italy had previously announced a decline of 0.2%. Meanwhile, France showed no growth at all. Not every country was in decline, with the Netherlands, Austria, Spain, Portugal, and Poland (in the European Union but not the eurozone) all showing respectable increases. Unfortunately, the big three economies account for about two-thirds of Europe's economic output.

The contrasting results between the core and the peripheral countries are at least partially a reflection of reforms that were implemented in the periphery. The less-desperate core countries have not yet implemented some of the necessary reforms. Unlike the U.S., Europe is just one year out of the big recession and has yet to recover all the output that it lost. In fact, Europe is operating about 2.4% below its peak levels. Also, growth in the second quarter was slower than the first.

Given that the European Union is larger than the U.S. in total output and roughly 21% of all world economic output, the Aug. 15 GDP data was not good news for world trade. However, it's not horrible news for the U.S., which ships less than 3% of its output to Europe. And many of those goods are necessities, like food and oil products that can't be cut drastically. However, trade is a bigger deal to China and other emerging-markets countries.

The numbers for second-quarter growth were modestly below expectations. Still, expectations are for Europe to grow about 1% for all of 2014 and 1.5% in 2015. Arguing for improved growth in the second half are European Central Bank initiatives announced in June that will be implemented in the second half, especially new lending programs. A falling euro could help, too, although the fall has not been as big as one might have expected given the very low interest rates. And part of Germany's issue was a very warm winter that shifted growth from the second quarter and into the first. Weighing on the second half will be Russian sanctions that may hit both German and French companies particularly hard.

Retail Sales Seemingly Disappoint, but Annual Growth Trends Intact
Consumption is a very important part of the GDP report (about 70%) and often sets the tone for overall economic activity. Retail sales make up about a third of consumption.

So the report on retail sales is very important. However, it is also very tricky to interpret. First, the report is not inflation-adjusted, unlike the consumption report and GDP. Second, the early numbers are often sharply revised both in total and by category. This is again why I prefer to look at the numbers on a year-over-year, three-months-averaged basis. Finally, unusually good numbers in one month often lead to very bad numbers the following month. To me these wild swings often suggest data collection issues and not changes in the real world.

With all those caveats, the month-to-month retail sales report was a disappointment. Excluding the auto industry, which is measured from manufacturers data (and not dealer retail sales), retail sales grew just 0.1% month to month after growth of 0.2% the previous month. Expectations were for growth to accelerate given better employment data. In fact, the consensus, excluding autos, was for growth of 0.4%. Therefore, I am a little suspicious of the July numbers. Weather was good, employment was good, and weekly chain-store sales had shown a marked improvement. Therefore, I suspect the July numbers will be revised or August numbers will appear to be unusually strong.

Analysis using my year-over-year three-month-averaged data shows more of the same 4% growth that we have been seeing for some time, as shown above. However, some weather issues have caused some volatility in that figure, too. The volatility is somewhat less if we adjust for inflation, which has had a number of ups and downs recently. Looked at in this manner, retail sales look like they are accelerating at least a little bit recently, which seems to fit other data points a little better.

The category data wasn't really that much help in analyzing this month's report, but a couple of patterns do stand out. First, furniture and electronics both seem to be having a tough time of it. That is probably related to some of the poor housing data this fall and spring. General merchandise and department sales combined (a total of 12% of retail sales) had a terrible month and a year that wasn't much better. General merchandise stores were off 0.5% month to month (though that followed 0.4% June growth). However, there are clearly some issues with this sector, as the year-over-year growth rate is just a pathetic 1.1%, not even beating the rate of inflation. Problems at  Target (TGT) and  Wal-Mart (WMT), which go beyond industry strength, are certainly not helping matters. More surprisingly even nonstore retailers (primarily e-commerce, such as  Amazon (AMZN)) showed a small 0.1% decline (though that followed an unusually strong 0.9% June). Fortunately, year-over-year nonstore retailers showed a healthy 5.9% growth rate, perhaps indicating some type of data collection issue in the July report.

In summary, I am taking the month-to-month retail sales declines with a grain of salt. The year-over-year data suggests more of the same. With employment and job openings data improving and the savings rate up, it is just a matter of time before retail sales begin to show some improvement.

Budget Deficit Still on Track for a Significant Decline for Fiscal 2014
Fiscal 2014, which ends Sept. 30, remains on target to fall to approximately $500 billion from $680 billion in fiscal 2013 and $1.4 billion at its peak in 2009. At the 10-month mark, the deficit was reported at $462 billion, with normal seasonal factors suggesting a slight worsening by the end of the year.

Most of the improvement in the deficit occurred early in the fiscal year because of various tax hikes that were only "new" in the December quarter. The new taxes will have been in effect for all three of the last quarters of 2013 and 2014. Year-to-date collections are up 8%, while spending is only up 1% for the first 10 months as a whole. Large cuts in defense spending and outlays for unemployment were basically offset by higher Social Security and Medicaid payments. Looking more narrowly at July, revenue was up 5% and spending up a still-modest 3%. The Congressional Budget Office hopes to have a new set of projections by the end of August. The sluggishness of government spending is good news for taxpayers, but that restraint is also holding back the economy in the short run.

Small Businesses Slightly More Optimistic; Labor Data Is the Best News of the Report
Small-business sentiment for July as measured by the National Federation of Independent Business improved modestly to 95.7 in July from 95 the previous month, which is just shy of the recovery high of 96.6 recorded in May. Most notable was that job-creation plans were the highest they have been since 2007. The number of firms planning to pay higher wages also increased. Owners also note that jobs continue to be hard to fill, though just a little easier than in June. This data seems consistent with our theme that labor markets are getting tighter.

While the employment sector of the small-business report looks close to being in growth mode again, a lot of the other data points are improved but certainly not in rapid growth mode. Sales, inventory, and capital spending data still are acting like a very slow growth recovery.

Industrial Production Gains Momentum as Auto Industry Heats Up
(Written by Roland Czerniawski of the Morningstar Markets Team)
Industrial production rose 0.4% in July, making it the sixth consecutive monthly increase, exceeding the 0.2% forecast of most economists. The June data has also been revised to 0.4% from 0.2%, matching July's increase. Year-over-year total industrial production was up 5%, the fastest pace since 2010.

When looking at the manufacturing-only sector, which excludes the mining and especially volatile utility sectors, the data looks even better. Utilities, in particular, were a drag on total production in July, contracting 3.4% because of lower-than-average summer temperatures and less demand for air conditioning.

The exclusion of utilities, coupled with off-the-charts auto production, translated to a 1.1% growth in manufacturing IP. The year-over-year three-month average edged higher to 4.3%, a pace we have not seen since August 2012.

Autos, which are a sizable chunk of durable goods manufacturing, had a spectacular July, skyrocketing 10.1% in a single month and 21.9% year over year. The Federal Reserve estimated that 12.85 million (seasonally adjusted annual rate) autos and light trucks were produced in July, the highest number since 2000. Considering very solid sales numbers over the past months, auto production seems to indicate that the current state of the auto industry is very firm. Whether this momentum will continue, however, remains a question.

The growth in other categories was broad-based and steady, with paper products being the only industry that reported falling output. It is important to note that while manufacturing typically reflects the state of the overall economy, its direct effects on GDP and employment are unfortunately limited, as it is now just a small part of the U.S. economy.

Next Week Brings a Triad of Housing Data as Well as Price Changes and World Manufacturing Reports
Probably the most important data next week will be the World PMI Flash Reports compiled by Markit. These reports on manufacturing data in August have become more important given the slow second-quarter growth reports out of many portions of the world. These Markit reports will show if activity has improved meaningfully from the poor second-quarter results or if the downward trend is intensifying. July's reports were in growth mode in most countries, but Europe's index showed a little less growth in July.

The housing recovery has been disappointing so far in 2014, especially for new homes. Next week, builder sentiment and housing starts data should show whether that lull has ended. Builder sentiment improved in July, and it will be interesting to see if that strength can be maintained in August. Housing starts, especially for apartments, were trashed in June, with just 893,000 annualized homes started. Analysts are expecting a big rebound in July to 979,000. Permits data for June, though not wonderful, suggest that starts should indeed accelerate in July. Still, the industry is grappling with supply-chain issues as many suppliers went out of business in the recession and some home supplies are now on allocation. The industry has also been slow to move to more affordable homes, which is where the demand seems to be at the moment. The cheaper existing-home sales category has accelerated recently, though expectations are for a very modest decline from 5.04 million units in June to 5.02 million units in July. The decline expectation is being driven by a lower pending home sale index reported earlier. I disagree with that analysis and think existing-home sales could increase modestly as a weather-condensed selling season causes buyers to attempt to reduce closing cycles so they can be in their homes by the start of school.

For a change, I am expecting good news on consumer prices and believe prices will increase only 0.1% as auto prices erode (incentives), food prices moderate, and gasoline prices fall. This is in contrast to the 0.4% and the 0.3% growth of the previous two months. This should help consumers to spend more in the months ahead.