Can the U.S. Economy Go It Alone?

Markets, especially U.S. equities, were generally up this week through Thursday (I was traveling on Friday), with the S&P 500 setting a record high. Bonds also continued to hold their own, and the U.S. 10-year Treasury remained at about 2.4%, near the lows of the year.

Economic news out of the U.S. was excellent. The housing data that many people worried about last month showed a marked improvement in July, and some of the poor June data was revised away. And for an unusual change, both the new- and existing-home markets appeared to gain strength at the same time. I don't think housing is going to explode on the upside from here, but with lower mortgage rates and improving employment, continuing small steps forward seem possible.

Consumer prices also took a break in July, rising just 0.1% after several months of healthy increases. The Markit survey of U.S. purchasing managers also continued to show good improvement. Unemployment claims remained under control, and weekly shopping center data sustained its recent gains.

The news out of non-U.S. markets was not as good, with the purchasing manager surveys out of Europe and China each showing declines. Unfortunately, manufacturing is relatively more important in those regions than in the U.S. The markets seemed to take the drumbeat bad news in stride. In fact, we seem to be in one of those market moods when bad news is good news because it could mean more central bank easing in Europe and in China.

Paradoxically, weak overseas economics have probably helped the U.S. at least as much as it has hurt. Weaker overseas activity has kept a lid on commodity prices, which is finally beginning to help consumers again. Central bank actions or potential actions have also driven down world and U.S. interest rates, which may be responsible for the small revival in this week's housing data. And though the U.S. is a massive exporter, the percentage of goods exported, at 13%, is one of the very smallest levels of any developed country, and many of those goods are going to Canada and Mexico. Furthermore, a lot of the goods shipped out of the U.S. are either necessities or under very long-term contracts ( Boeing (BA) jetliners). However, poor export growth has indeed held back the U.S. economy for a couple of quarters.

Markit PMI Points to Sustained Momentum in U.S. Manufacturing, While Europe and China Weaken
Written by Roland Czerniawski

The Markit Purchasing Managers' Index report showed a sharp increase in the U.S. manufacturing sector, as the PMI reading bounced all the way up to 58.0 in August from a three-month low of 55.8 in July. The August number is the highest observed since April 2010. A combination of strength in new orders, exports, output, and employment contributed to the sharp increase, demonstrating that the manufacturing momentum continues to build into the third quarter.

The report also showed that the growth in manufacturing activity in the rest of the world, namely Europe and China, has remained muted. China's reading edged lower to 50.3, hovering just slightly above the 50.0 expansion line. The report underscored that deflationary pressures have returned, showing up in both output and input prices, which means that the economic recovery is and will most likely remain relatively slow in China.

The news from Europe wasn't much better, as the manufacturing PMI reading decreased from 51.8 in July to 50.8 in August. Output growth in Germany slowed but remained firm, rising for the 16th straight month. The PMI in France, on the other hand, softened further, suggesting that the pace of contraction has accelerated slightly.

While the strong manufacturing numbers in the U.S. can indirectly signal a pickup in overall economic activity and increased optimism domestically, the not-so-good data from Europe and China carry a little more weight, since those countries rely on their manufacturing sectors significantly more than the U.S.

The most recent softening in manufacturing could mean that the subdued economic recovery in those nations could extend into the third quarter or even beyond. This indicates that more accommodative monetary policy and stimulus in Europe and China could be around the corner. While the fragile recovery abroad will continue to threaten U.S. exports, it should also keep interest rates and commodity prices low, giving the U.S. consumer more space to breathe.

Price Growth Slows; Potential for Slower Growth Ahead
U.S. consumer prices grew a very modest 0.1% in July after growing 0.4% and 0.3% in May and June, providing consumers with considerable relief. The year-over-year averaged price data, my preferred metric, still looks at least a little elevated but is no longer showing accelerating increases.

As the nasty increases in May and June fall out of the averages, it seems quite likely that the year-over-year inflation rate will drop to under 2% again this fall. (A dip all the way back to the 1.1% level of last November doesn't appear in the cards for now.) Holding prices down in the months ahead will likely be continuing declines in both gasoline and natural gas (because of more supply and softer demand) and moderating food prices (as the drought situation eases). This will probably be offset by health-care increases and rent increases that will keep at least some upward pressure on the data.

Some of these future trends already began to form in the July period, especially in the energy-related complexes, as shown below:

The one exception is food prices, which again spiked in July after modest increases in June. Lower prices for corn and soybeans should eventually work their way through the whole food chain, at least helping to moderate some of the recent increases.

Striking in the monthly July data was the relatively large number of items that decreased in price. The price of airline tickets, recreational goods, used cars, furniture, and tobacco all declined in July, easing some of the sting of the larger 0.4% increase in food prices. Also, rents continued to run a little higher than a year ago and are trending toward a 0.3% monthly growth rate, or 3.6% annualized. It's not great news for consumers, but it should drive more people to consider purchasing either a new or existing home.

Medical-related inflation was relatively contained in July, though still a bit higher than a year ago, when the move to generic drugs held back health-care inflation. Since fewer drugs are coming off patent this year and more people are insured because of the Affordable Care Act, I am surprised that health-care price increases have been relatively moderate so far this year. I suspect that health-care inflation could accelerate a bit later on this year.

Housing Looking Better With the Latest Data
The housing news this week was much improved over what everyone thought just a month ago. Builder sentiment, housing starts, and existing-home sales all showed nice increases, and every piece of housing data came in above expectations. Just as importantly, housing starts for the previous month were revised sharply higher.

Over the past year, we have had periods where new-home sales (or starts) did better and periods where existing-home sectors did better, but seldom did both do well or poorly at the same time. This month, both sides of the housing market looked better, perhaps reflecting lower mortgage rates, moderating price increases, and somewhat easier lending conditions. From here, I expect to see continued moderate growth in housing--no boom and no bust. Hopefully, we are also past the periods where housing will detract from GDP growth, as it was in the fourth quarter of 2013 and the first quarter of 2014.

The most forward-looking of this week's housing metrics, builder confidence, showed a surprise increase in August, moving up to 55 from 53 in July. Any reading over 50 indicates that more builders are seeing improving conditions than softening conditions. This is the third consecutive improvement in the index.

All three components of the index--existing sales, sales expected in six months, and current traffic--all improved. Traffic still remains under 50, but builders claim that the potential buyers coming through homes today are more serious about a purchase, offsetting the relatively lethargic (but improving) traffic trends. All four geographic regions also showed improvement, perhaps indicating the universal impact of lower interest rates.

Housing Starts and Permits Look Better, Too
Housing starts and permits each bounced back to over 1 million after a poor showing the previous month. Starts jumped a strong 15.7% sequentially to 1.09 million units, with single-family homes increasing 8.3%. Though the new single-family category is not lighting the world on fire, it has been showing a relatively steady increase versus the more volatile multifamily sector. The year-over-year averaged data show that most of the slump in housing because of interest rate/price shocks may be behind us.

Multifamily Housing Leading the Way
The housing recovery continues to be dominated by interest in multifamily housing. Multifamily housing starts are now back to 2007 levels and are running at 97% of the prerecession highs. Meanwhile, single-family homes are at a pathetic 34% of the last high. Increased demand for rentals and close-in housing is driving these metrics.

Existing-Home Sales Increase Instead of Decrease as Widely Expected
Existing-home sales increased 2.4% sequentially to 5.15 million units for the single month of July, the highest level in 10 months. Based on softer pending home sales, analysts had expected that existing-home sales would be down. I had surmised in my column last week that existing-home sales could surprise on the upside as cold weather compressed the spring/summer selling season, leading to a faster closing cycle. The steady improvement in existing-home sales should eventually help furniture and remodeling sales, which suffered from weaker activity early this winter. These items tend to react with a three- to six-month lag compared with existing-home sales.

As good as the short-term sequential numbers look, sales levels are still about 3% below year-ago levels, which were buoyed by a rush to close deals to beat large mortgage rate increases. Most of that rush was over in August, after which the year-over-year data will become increasingly meaningful again by the end of the year.

Inventories were also up, which should help unit sales of existing homes in the months ahead. In many markets, especially on the West Coast, low inventories were constraining sales. Inventories are now up about 5.5% year over year in a period when sales are down a smidgen. Inventories, though up, are still in a very acceptable range and a far cry from the huge levels experienced in the middle of the recession.

And Business-Related Construction Is Looking Up
Like the housing industry, the commercial industry was on a roll until it hit a wall late last summer, perhaps also related to higher prices and interest rates. However, it now appears that things have begun to improve.

One measure of the improvement is the Architecture Billings Index. That index jumped to 55.8 in July, the highest of this recovery and the best since 2007. The recent high culminates three months of steady improvements. I believe the improvement partly reflects upgraded business confidence. It may also indicate upcoming progress in the apartment building sector that is benefiting from higher rents and a lack of supply in some markets. Single-family and small-unit buildings are not included in this metric, but large apartment building complexes are.

Next Week, More Housing Data, Durable Goods Orders, Revised GDP, and Personal Income
The housing data continues to flow next week, with new-home sales and pending sales of existing homes. New-home sales are expected to increase from 406,000 units to 435,000. Unlike the starts report, this report includes only single-family homes. It also includes sales of homes already built and those still just on the drawing board. A healthy increase in homes not even started yet would be an early indicator of a housing market that is breaking out of its slump. Unfortunately, the advance is not likely to be too sharp, as builders have not fully reacted to the fact that buyers want smaller and cheaper homes in closer suburbs and not McMansions in distant suburbs.

Existing-home sales have had a decent run, as noted above. Can the trend continue even as the spring/summer selling season comes to an end? Next week's pending home sales report should give us some valuable clues. Pending home sales skyrocketed in May and held most of those gains in June. I suspect the July data will be little changed to maybe just a smidgen better than the June reading of 102.7, as mortgage rates continued to slump and inventories continued to increase.

Durable goods are expected to show a big (double-digit) jump in July, driven by strong airliner orders. Even excluding those orders, I still expect some improvement in other durable goods and the all-important nondefense capital goods excluding aircraft segment. The only potential fly in the ointment is that export orders could be weak on a slowing Europe and a China that still hasn't gotten back in gear. However, a strong new orders segment of the Markit purchasing managers survey suggests that strong domestic orders swamped any potential weakness in the international segment.

Before inflation, personal income and consumption are expected to be up 0.3% and 0.1%, respectively. If the consensus turns out to be correct, it would mark yet another month when consumers put more money in the bank and earnings outpaced spending. The relatively poor consumption number is based on an already-known retail sales figure combined with very weak utility demand because of unusually moderate summer temperatures. The wild card in the spending report will be other services and health care, which have shown more volatility in recent months than they have shown in many years.

The market is very hopeful that the revision in this go-around of the GDP report for the second quarter won't show the neck-snapping revision that occurred in the first quarter. Based on the data that analysts have seen so far, they now expect a minor revision from 4.0% growth to 3.8%. That's a fly speck compared with the 1%-2% revisions in each new version that we saw in the first quarter. (From the very best to the very worst official report, the swing was close to 3%, from 0.1% to a negative 2.9%, before swinging back to negative 2.1%). Those large swings probably were a result of weather conditions that affected the measurement process. Mercifully, there were far fewer of those issues in the second quarter.