Inflation Settles, but Not for Everyone

The big news for world markets this week was the Fed policy meeting on Tuesday and Wednesday. The Fed kept language that suggested a hike in the Fed funds rate was still off in the distance even as the bond purchase program comes to an end. However, the Fed governors' unified front is beginning to crack as two of the governors dissented on the policy statement.

U.S. equity markets loved the news, and were up over 1% as of noon Friday. Bonds had already seen rates move higher the past two weeks in anticipation of some hints on tightening, but didn't really react to the dovish tone, ending the week unchanged. Europe was about flat even with the defeat of the Scottish independence proposal. News out of China continued to disappoint, with real estate data looking soft yet again. That forced emerging markets overall down about half a percent on the week. That news didn't help commodities, either, which were down close to 1%.

Although there was a lot of economic news this week, the data was incredibly hard to analyze because of seasonal and one-off events. Nevertheless, the data failed to show much of an acceleration, even with adjustments. Industrial production was down month to month, monthly housing starts were down, and inflation turned into deflation, at least temporarily (good news for consumer spending, bad news for economic growth). Weekly shopping center data backed off from its torrid summer pace but remained above 3%. Unemployment claims made a surprisingly large dip, but maybe there was a continued Labor Day holiday effect in the numbers. Still, there were no signs of a boom anywhere.

I still feel confident that the U.S. can pull off a 2.0%-2.5% GDP growth rate for 2014. So far in 2014, consumers have piled up savings as weather, along with sky-high utility bills, kept them from shopping. With inflation coming down again and the bad weather and high utility bills in the rearview mirror, I think U.S. consumers will do what they always do, namely shop, in the back half of the year.

Fed Policy More Relevant to Markets and Traders Than the Real Economy
Economists have spilled a lot of ink trying to predict what the Fed might do next. The Fed's next interest rate move is highly relevant to assets that are priced off interest rates, and Fed policy changes have often been market-movers. Last year's hints that the Fed might taper interest rates drove down bonds and stock markets alike.

Still, professionals evaluating long-term assets probably shouldn't care about short-term interest rate moves or exactly which day rates are moved higher. As an example, Morningstar's discounted cash flow model contains a long-term interest rate assumption that has not changed for some time and is unlikely to change no matter when the Fed raises rates.

That said, the U.S. Federal Reserve is not the only game in town. Even as the Fed wound down its bond purchases in 2014, the rates on the 10-Year Treasury bond dropped from close to 3% at the beginning of the year to as low as 2.36% recently. That's a move that no economist foresaw, including me. That's because other central banks were busy loosening credit conditions and dropping rates, largely offsetting the Fed's tightening move. Rates also dropped because of a weaker-than-anticipated world economy, another key determinate of interest rates.

The Fed can't fight basic economic activity levels. For decades the Fed was considered largely a follower of rate trends and economic conditions, especially on upward rate moves. By the time the Fed was convinced of the economy's strength, it was often too late. In sum, the Fed is not an omnipotent god that always gets it right. Investors would be better served spending more time on their own independent economic forecasts, world (not just U.S.) trends, and an analysis of the supply and demand for loans and capital.

With rates so low already, I'm not so sure that even an eventual 1% hike in rates would make much difference. Decisions by individuals seeking a mortgage or to use their credit cards, and businesses making investment decisions, hinge more on economic growth outlooks and confidence than modest changes in the level of interest rates.

Fed Maintains 'Considerable Period of Time' Language
At this week's Fed meeting, it decided to maintain the crucial phrase, "keep the federal funds rate low for a considerable period of time." Fed Chair Janet Yellen had previously said that meant six months or more, in her opinion. The next major Fed meeting (with a press conference) isn't until November, which could imply that the Fed isn't raising the rate until at least May. The press seemed to interpret it as meaning that an early, say March, rate increase was off the table. I'm not as sure. It did leave enough openings in its language that it could raise rates sooner if the U.S. economy were to catch fire. 

Fed Reduces Economic Forecast Again
On the other hand, the Fed's economic forecast didn't suggest that the Fed expected that to happen anytime soon. In fact, the ever-bullish Fed was forced to modestly reduce its GDP forecasts yet again at this meeting. For this year, the GDP forecast was dropped modestly to 2.0%-2.2% growth, with a more substantial cut to 2.6%-3.0% from 3.0%-3.2% for 2015. My forecast for both periods is 2.0%-2.5%.

Fed Opinion on Future Rates Shockingly Wide and a Little Scary
One of the more troubling aspects of the Fed release was a more comprehensive package of Fed governor forecasts for the Fed funds rate by year (see Page 3 of the release). This new dot chart showed all except one governor believed that the Fed Funds rate would remain near zero in 2014. So far, so good. A nice consensus.

But 2015 showed a surprisingly large spread, with a range of 0%-3%, and 0%-4% in 2016. Worse, the data points (individual forecasts) are all spread out, so there isn't a consensus with just two outliers. These are our economic experts with a ton of staff who chat often and compare notes and know the decision-making process. Lots of views are great, and the "wisdom of crowds" folks probably love this. But if our best thinkers and decision-makers can't come close to a consensus view, what is a poor businessperson supposed to do?

Markets hate uncertainty, and the variance of opinions gives even me pause. A zero percent opinion seems to indicate another recession. At a 4% funds rate and typical spreads, mortgage rates might be over 6%. That would seemingly be close to the point where the housing market would grind to a halt, in my opinion. I do caution, this is a new report and is probably still open to  interpretation.

In any case, it's interesting to note that the equity markets loved the Fed announcement and the accompanying data pack, while the U.S. bond market was much less sure.  Rates have been trending up for the past two weeks and inched up a little further after the Fed announcement before settling back to 2.6%, about where they started the week.

Inflation Settles Back, but Not for Everyone
Month-to-month prices dropped a surprising 0.2% between July and August. It's been awhile since we have witnessed an outright decline in the overall index. That is a welcome relief after some relatively large increases this spring that weighed strongly on consumer sentiment. It proves again that commodity-based inflation usually can't last long without support from an overly high capacity utilization rate and loose fiscal policies.

However, I prefer to look at averaged year-over-year data, which is still running considerably above where it was last fall, when consumer spending was looking relatively robust. At least the trend line is now pointing to lower inflation. And in the longer-term scheme of things, inflation remains very low by historical standards and well below levels that would normally set off another recession (4% or so).

The shorter-term picture shows a dramatic drop in prices last fall, a painful bounceback this spring, followed by a small moderation.

Unlike Europe or Japan, I don't think the U.S. is skirting with deflation, either, despite the one-month fluky drop. Most Americans would tell you that inflation is still an issue, and it's hard to argue with them given an over 8% annual increase in beef prices, continued tuition increases, and rising rents. Consumers certainly are not putting off purchases because they think things will be cheaper tomorrow, the true scourge of economic growth. 

My developing labor scarcity theme, which should start to push wages up soon, is also likely to keep the U.S. from falling into a deflationary environment. U.S. inflation appears to be in Goldilocks land, not too hot or too cold. Poor capacity utilization, falling commodity prices, a strong dollar (which reduces the price of imported goods), and sluggish overall growth provide an upside barrier to higher inflation. Labor scarcity, looser credit standards, and easy (but tightening) monetary policy will likely prove to be effective counter-balances to the deflationary winds that are blowing in much of the rest of the world, especially developed nations.

Only a Limited Number of Categories Are Seeing Any Inflation
Perhaps the only case one might make for more sustained deflation is that there were so few categories showing any growth at all.

The four categories (above) showing price increases are the only categories that increased, and those increases were minuscule. Everything else was flat or down with falling energy prices leading the way. Gasoline, fuel oil, and natural gas were all down big. But other stuff was down, too, such as airline tickets, used cars, apparel, and even health care, which again showed declines. The health-care spending Armageddon that so many were expecting was all premised on health-care prices running about 3% more than general inflation. Now, it is just barely keeping pace with overall inflation. If this can be sustained (a big if), the long-term budget deficit situation might not be nearly as bleak as many anticipate.

As I said in my video this week, it was a great month to be vegetarian, as beef prices continued to soar, posting one of their biggest increases in CPI history. Meanwhile, fruit and vegetables were down big time, causing the food number to appear more benign than it actually was. Because of long gestation cycles and a long herd-rebuilding process, we may be stuck with high beef prices for some time, though falling grain prices are planting the early seeds for some eventual improvement. I anticipate that consumers will vote with their mouths, and shift protein sources, which could eventually help bring down prices, too. (I am going to stay out of the argument of whether falling red meat consumption is a good or bad thing for consumers.)

Low inflation should help consumers, though some more than others. (Red-meat-eating apartment-renters who don't drive or fly aren't benefiting so much.) Consumers have been holding back on spending recently and maybe lower inflation (and smaller utility usage) will be the impetus to unleash consumers' savings that have continued to build dramatically for most of the year.

Homebuilder Confidence Continues to Improve
The forward-looking builder confidence index showed a hefty increase in September that exceeded most analysts' expectations. The index rose by 4 points to a reading of 59. It marks the fourth consecutive monthly increase, and the reading is now 14 points above the index low of 45, registered  in May. Any reading above 50 means the majority of builders are optimistic about the conditions in the homebuilding industry.

The report covers three metrics: present single-family sales, single-family sales expected over the next six months, and traffic of prospective buyers. All three metrics showed month-to-month improvements, and while the buyer traffic subcomponent still remains below 50, it showed an increase of 5 points from 42 last month and 39 a month before that. That's very good news and a sign that the homebuilding industry is on the cusp of further improvements.

Morningstar has been skeptical of increasingly positive builder sentiment. The real strength in the composite index has been the very subjective future business component. The current business component has acted quite well but not nearly as well as the future index. Meanwhile, the traffic part of the index has been acting like we were in a recession until the latest two months. 

People may buy many things sight unseen from the Web, but a house is not one of them. Without actual customer visits to model homes, a new sale is highly unlikely. So as traffic numbers lingered in the 30s (versus double that for future sales expectations), there was some reason to doubt the homebuilders' optimism. It's always dangerous to get too wrapped up in one or two positive data points, but the recent dramatic traffic increases seem to indicate that some subtle changes are going on in the new home market. Whether those visits get converted to final sales and starts is still an open question. But finally there is a flicker of interest.

Regionally, the data showed an increase in all areas except the Midwest. The index reading in this area was at an already-high level, and it ticked down 3 points to 61. The South reported the largest increase in September, rising 12 points, all the way to 63. The three-month moving average data, which eliminates some of the monthly volatility, shows that all regions continue to improve steadily after reaching their bottom levels in the second quarter.

Housing Starts and Permits Stuck in Neutral: It's Not Your Parents' Housing Recovery
Although a lot of housing headlines focused on the seemingly meaningful decline in housing starts (one provocative headline from a major news service: "U.S. housing starts tumble 14.4% in August") the reality is not nearly as bleak. Starts, especially on multifamily properties, are exceptionally volatile, and starts grew a whopping 23% overall for the previous month. The true health of the housing industry lies somewhere in the middle of these two extremes. Frankly, that is still a little disappointing with housing not being the economic impetus that everyone anticipated at the beginning of the year. The year-over-year numbers paint a slightly improving picture in both single and multifamily homes.

 

For several complex reasons, the year-over-year data also looks just a little stronger than the reality. Weather artificially depressed spring growth rates, and last year's interest rate hike made for easy pickings comparing this year's summer housing starts with last summer's. Therefore, I don't think the current market is trending in either direction, despite what my revered year-over-year data is saying. Year-to-date, nonseasonally adjusted housing starts are up 9% compared with the same eight months a year ago, mostly due to improving multifamily sales. That is probably a little closer to the truth, but even that might be a little optimistic.

Housing has still been a great help to this economic recovery, but not dramatically so lately. Higher rates, affordability issues, tight credit, and poor weather have all held back this recovery. Remember, though, that residential home spending also includes remodeling and commissions on existing-home sales. In this recovery, these last two items are kicking in more growth than more traditional tract homes. And even in the new home market, there has been more interest in apartments. In fact, averaged multifamily unit starts are now above levels just before the recession began, while single family units languish at far less than half of the previous peak.

Interest is in smaller, more centrally located communities instead of ever-bigger McMansions located farther and farther from central cities. Those shifts in interest cannot be accommodated in many markets very quickly (with the possible exception of Texas). At the beginning of the year, I was very clear that Boeing production, auto sales, and housing would all improve in 2014, just not as fast as some hoped and certainly not as much as in 2013. Of these, housing has been even more disappointing than my somber assessment at the beginning of the year.

Industrial Production Drops, but Nothing to Worry About
The single-month industrial production figures dropped 0.1% between July and August. Furthermore, the July growth rate was revised down from 0.4% to 0.2%. As usual, month-to-month numbers can be quite deceptive. Swings in auto production, up 9.0% in July and then down 7.6% in August, were at the heart of this month's problem. The issues with auto production are more related to statistical artifacts and some bad weather than a real economic slowing. Shifting summer plant closures are wreaking havoc with seasonal factors as they have for several years. The August jinx hit the auto production almost as hard as it hit the employment report last week (the August inflation report seems a little fishy, too). In addition, a freak summer storm and flooding conditions also weighed on the auto production numbers. Using year-over-year averaged data provides a more realistic view of the health of the industrial sector. This is data is for the manufacturing sector and excludes the volatile, weather-driven utility sector and the hot mining sector:

The year-over-year averaged growth has been accelerating and now stands at 4.4%, well above its long-term average of 2.6%. Given the world economy isn't exactly on fire at the moment, it does seem like the year-over-year industrial production-manufacturing data could fall back under 4% sometime in the fourth quarter.

Also worth noting is that utilities and mining both had good months. Utilities were up a full percentage point, and mining, which includes oil and gas extraction, was up 0.5%. Most of the other sector-level data wasn't terribly useful. On a year-over-year basis, durable goods have been doing much better than nondurables. Food, apparel, paper, and plastics are some of the laggards.

Despite the dumpy top-line number, I still believe the manufacturing sector is in good shape. The single-point August data seems to be yet another one of the August outliers that comes out of nowhere. Other manufacturing metrics, the purchasing managers' surveys in particular, have been more bullish. That said, manufacturing seems to be running a little ahead of the real economy at the moment.

Lots of Numbers, not Much Clarity Next Week
Next week's data includes new and existing-home sales, home prices, flash world manufacturing data from Markit, durable goods, and perhaps an eye-popping GDP revision for the second quarter. 

In our new-normal world, existing-home sales are taking on an increasing role in overall economic activity, as new home sales fail to catch fire. The last read on existing-home sales was great, and next week I am anticipating another upward move based on the last pending home sales report, which was up sharply. The dearth of new home sales is fueling more interest in existing homes, especially well-located homes that have been fixed up. The consensus is for sales to move up to 5.22 million annualized units for August, compared with 5.15 million units in July. It's hard to believe that sales got as low as 4.59 million units this past winter. While an existing-home sale may not provide as much juice to the economy as a new single family home, economists probably shouldn't pooh-pooh this category as much as they do. Both new and existing homes require furniture and mortgages and new services that will help move the economy forward.

Markit Manufacturing Data Could Rock the Market
The Markit data is always market-moving. China is everyone's new big worry, especially here at Morningstar. The manufacturing data, which has been slumping, should help determine if China is beginning to pull itself out of its rut. With real estate still smarting, that might be a tall order, unless iPhone production manages to save the day.

European data has also been slumping, but a number of production reports for July don't look nearly so bleak as those of the second quarter, despite dropping but positive Markit numbers for July and August. It will be very interesting to see what happens to Europe in the September flash report, which should have much fresher data. I can't help but believe that a substantially lower euro will have a positive effect in the relatively near term.

Don't Be Faked Out by Durable Goods Report
Heads-up: The durable goods report is likely to look like a depression hit the manufacturing sector. Never fear, it is just a counterbalance to July's too-good-to-be-true report, which was driven by airline orders. July was up 23%, and August is expected to be down 14%. As usual, I will be focusing on the nondefense capital goods orders excluding those pesky aircraft to measure business confidence and business spending on long-lived assets.

Second-Quarter GDP: Was It Really That Close to 5% Growth?
I'm no expert on the machinations of all the GDP revisions, but I know retail sales have been revised up, and the trade deficit looked a little better, which has economists salivating. The second-quarter growth rate was already at a stunning 4.2% (yet another reversion-to-mean story, not the beginning of a new trend), and now economists are expecting that to be revised up to 4.7%. Unfortunately, that doesn't really change the grand scheme of things, since any upward revision will make third-quarter improvements that much more difficult. But it will still be fun if the anticipated upward GDP revision really happens, and bonds might get pummeled, at least for a day. Then again, the government statisticians might just find yet another way to snatch defeat from the jaws of victory with unexpected adjustments.