U.S. Manufacturing Powers Ahead, but Housing Gets Hazy

I don't quite know how to characterize the markets this week other than to say they gyrated. There was no place to hide except maybe U.S. government bonds, which were little changed. U.S., European, and emerging equity markets were all down about 2%, while broad commodity indexes were down a little less than 1%.

More important, the gyrations this week were a new phenomenon with the Dow swinging 100 points or more per day with no ability to develop a clear trend in either direction. Also unique is that the news flow was very muted and certainly not the cause of the wild moves. This type of thing can happen--especially given jitters over relatively high valuations, the longevity of this bull market, and the market's generally weaker performance in many August and September periods. The temptation to take at least a few profits appears to have become irresistible to some.

U.S. economic news was generally good. The manufacturing sector in the United States looks particularly strong, with continued strength in purchasing manager surveys and strong durable goods orders (when adjusting for those pesky transportation orders). Housing data was really mixed with existing-home sales falling back just a touch but new home sales hitting a new recovery high.

The GDP report was modestly revised upward from 4.2% to 4.6%, which sounds great until one considers that the first quarter was down 2.1%. The midpoint of my GDP forecast for 2014 of 2.3% suggests the U.S. economy needs to average annualized growth of about 3.4% in the back half of the year. For a change, it may be strong business spending (as indicated by the durable goods report) that provides that extra dose of growth in the second half. The most threatening factor for the back half of the year is a feeble European economy and a weak euro. While direct imports to Europe account for just 3% of GDP, the precipitous fall of the euro could make European goods sold in other markets more competitive with those from the United States. A soft euro is most likely to hit corporate profits harder than the U.S. economy. On the bright side, a stronger dollar around the world will keep a lid on U.S. inflation.

Outside the U.S., Manufacturing Data Not Much to Write Home About
This week Markit released its flash purchasing managers' reports for countries and regions throughout the world. The numbers really didn't show much change, which is disappointing because investors were hoping for some European improvement and a sharp acceleration in China. We got neither.

The China index was up a little, to a reading of 50.5 from 50.2 the prior month. Neither the absolute level nor the change inspires hope of a big rebound. That's especially true as the real estate-related sector continues to slump, which is a key driver of Chinese manufacturing activity. Chinese orders and exports both looked a little better, so the overall report was certainly no disaster. However, employment and inflation-related metrics continued to decline, which aren't signs of a robust economy.

After some nice bumps in the manufacturing numbers for Europe this winter, the European index dropped for the fifth consecutive month and is also now barely above the growth level at 50.5. The news from there only gets worse. The predictive new orders part of the index dropped below 50 for the first time since June 2013. Employment was flat, backlog readings dropped precipitously, and prices continued to fall. Unfortunately, the manufacturing sector is relatively important to European growth, so this week's news is truly painful.

It's not entirely clear what will pull Europe out of its malaise. With employment still looking terrible and wages showing little growth, more consumer spending won't likely come to the rescue. And with debt levels already high, it's not probable that there can be a lot of government stimulus. Even monetary policy might not help much, as lower rates and new attempts to stimulate bank lending come up against increased capital requirements meant to make banks safer. At the moment, the most likely help may come in the form of a much lower euro, which might stimulate at least some export demand. Although with China and emerging markets slipping, the U.S. not lighting the world on fire, and the Russian-Ukraine situation, even a cheap euro may not stimulate exports enough to save the day.

Meanwhile, surprisingly, the United States maintained its sky-high reading of 57.9, although the index didn't get any better between August and September.

Durable Goods Report Says All Systems Go for Manufacturing
Despite a dismal-looking 18% decline in August orders for durable goods, this report marked five straight months of growth in durable goods orders, with year-over-year growth rates, excluding the volatile transportation sector, continuing to accelerate. Recall that we exclude transportation in our analysis because of the ups and downs in  Boeing (BA) orders, and because we have a better source for auto-related data. Boeing orders are irrelevant to current manufacturing activity because of huge, decade-long order backlogs. Boeing's production schedule, and not new orders, is what drives the transportation component of industrial production and even GDP. Excluding the transportation sector, orders were up a decent 0.7%. And averaged year-over-year orders continued to accelerate and are now in excess of 6%, well ahead of recent industrial production growth.

There was a lot to like in this report, including the longevity of the current improvement. This is a lot more than a weather-related bounce. Durable goods can take months to manufacture, which should provide a nice underlying base for the economy in the months ahead. And the strength was broad-based, with five of the seven major categories showing nice growth and only transportation and fabricated metals showing declines. If only this were a bigger part of the U.S. economy.

Although it's very hard to deny the strength of the U.S. manufacturing sector, no matter how you measure it, something doesn't feel totally right about the report. U.S. consumers aren't really knocking down the door to buy stuff; housing, often a key driver, has gone flat, and the rest of the world's manufacturing sector is stuck in neutral. Boeing, autos, and some very modest re-shoring probably explain some of the difference, but the yawning gap, as shown earlier by the Markit PMI data, still seems a bit odd.

On a more positive note, I also like to look at the nondefense ex-aircraft capital goods orders as an indicator of business confidence. (It generally works a lot better than surveying CEOs.) Purchases of these goods usually mean expansion plans are afoot. Furthermore, the long-term nature of these products and their very high cost suggest that improvements that companies are seeing are not short-term in nature.

Existing-Home Sales Sputtering
Existing-home sales have been relatively volatile and difficult to interpret lately, and the August data was no exception. Overall, existing-home sales fell from an annualized rate of 5.15 million units in July to 5.05 million in August, confounding most analysts, including me, that had anticipated a small increase to 5.2 million units. The single-month, year-over-year trend wasn't wonderful, either, as sales last August were the second-best month of 2013, just a bit below the best number of 2013 (July) and for the whole recovery, for that matter. Year over year, existing-home sales declined about 5% in units.

So on the surface, the existing-home recovery has stalled out. But I would be a bit cautious about making such a bold statement on just one month's worth of data. Two key factors complicate the analysis. In 2013, buyers were scrambling to buy any house that they could before interest rates moved even higher. This created way-above-trend-line growth in July, August, and September 2013, a period just long enough to confound my three-month averaging process. Poor weather in early 2014 hasn't helped the averages, either.

The second factor thwarting the analysis of existing-home sales is a mix shift to more expensive homes. More correctly, the large number of really cheap homes that banks owned because of the foreclosure/short sales process are now gone. Sharply falling delinquency rates have meant that the easy source of inexpensive homes is gone, sharply reducing unit volumes. Since early 2011, unit sales of homes are up a rather anemic 15%. Including mix shift issues (fewer cheap fixer-uppers for investors) prices are up almost 30% over the same period. Same-home to same-home prices (assuming constant mix) were up only 20%.

When all is said and done, the existing-home market isn't booming, which is what a number of folks, including me, thought at the beginning of the year. Even the National Association of Realtors wasn't expecting any growth in existing-home sales in 2014, and it ultimately may prove to be correct. The truth of the market's health lies somewhere between the month-to-month, averaged data, which has grown from 4.6 million units in March to 5.1 million units currently, with some winter sales shifting to the summer because of the weather (shown in the first table below), and the year-over-year growth percent data in the second table that looks flat to down but is being killed by last year's interest rate-induced rush in the year-ago comparison period.

The other good news is that broker commissions on existing homes will still show a meaningful contribution to the GDP growth rate in the third quarter, though not as much as it did in the second quarter.

Maybe Builder Sentiment and New Home Sales Will Trump Last Week's Starts Report
Last week builder sentiment data was up strongly in each and every segment of the report, including the heretofore weak traffic statistics. Then, the government's report on housing starts showed some weakness a couple days later, with starts and permits off from the previous month's level (though the month before that was unusually strong). The year-over-year data was relatively trendless but at least showed some growth. Then this week, the new home sales report showed stunning single-month growth and even year-over-year growth. For the first time in the recovery, single-family new home sales crossed the 500,000 mark. Even the averaged new home data looked strong.

So why are starts an outlier? The new home report includes sales of homes that are sold based on tours of model homes where construction has not yet begun (a housing start). Purchases of new homes not yet started were one of the stronger segments of the new home report, which tends to validate builders' optimism. However, 50% growth reported in the western segment of the report seems to be just a little too good to be true, suggesting that we might well see a big downward revision to the August data or a surprisingly low number for September. In any case, the new home market seems to be making some progress that should turn up in the starts data in the relatively near future. Still, I think builders are probably still a little too focused on large tract homes in faraway locations when buyers are looking for cheaper, closer-in homes.

Prices Continue to Slow
FHFA data confirmed the  CoreLogic report earlier this month showing that home prices continued to slow during July. Between June and July prices rose just 0.1% on a single-month basis and 4.4% year over year. The three-month averages showed much the same slowing pattern. The three-month average year-over-year price growth rate peaked at 8.2% in September 2013 and has dropped in pretty much a straight line. The FHFA metric is less volatile than some narrow indexes, such as Case-Shiller, which was up close to 13% on an averaged year-over-year basis at its high-water mark. Interestingly, the FHFA index is now just 6% below its 2007 peak after being down more than 20%.

Looking at the data from the nine regions, home price changes are beginning to converge after a period when the largest improvements were concentrated on the West Coast. Year-over-year gains ranged from 7.2% in the Pacific region to 1.2% in the Mid-Atlantic region, which pulled up the rear. On a month-to-month basis, four of the nine regions were either flat or down.

Slowing price home price growth, as long as it doesn't get out of hand, is not a bad thing. Recent price gains have brought a lot of underwater mortgages (especially when combined with equity growth from several years of payments) back into the black. However, the rapid gains of 2013 had a chilling effect on affordability, which is responsible for slowing housing data, along with anemic income growth and higher interest rates. So slower price gains are a welcome phenomenon, in my opinion. Interestingly, through all the market's ups and downs, prices, not adjusted for inflation, have grown at a compound annual growth rate of just 3.3% since 1991 and 3.0% since 2000.

Data Flood Next Week: Consumer Income and Spending, Auto Sales, and Employment Top the List
Although there are a lot of reports next week, not many of them will add much to the debate about the strength of the economy. Consumer income and spending is always interesting and the key to the economy. The good news is I am expecting a great report; the bad news is that the data is from August, which is kind of in the rearview mirror right now. The neat thing about this report is that deflation data for August suggests that whatever the headline growth figures are, we get to add another 0.1% or 0.2% for the effects of lower prices (instead of the normal subtractions for inflation).

Income growth before deflation is likely to remain just about flat in August at 0.3% as poor job growth is offset by higher wages. Spending, on the other hand, should show a rather dramatic increase from negative 0.1% in July to 0.4% in August as both auto sales and retail sales surged. With a decent report on spending, consumption should be back on track to be a major contributor to third-quarter GDP growth after a shaky start in July.

Auto sales have been a bit of roller coaster, with great months often followed by disappointing ones. Fortunately, the great months have continued to move higher each time, and the dips have still kept sales above 16 million units for most of the year. Expectations are for auto sales to drop back to 16.8 million in September from a stunning 17.5 million in August.

While the manufacturers talk breathlessly about aging fleets and new models driving demand, I can't help but think that longer loan terms and looser credit terms are helping things along. Manufacturers often conveniently forget to mention that households are getting larger, miles driven per year continues to be soft, the housing market is faltering (which dramatically affects sales of pickup trucks) and cars are lasting longer. I suspect that either terms or incentives for the consumer will have to increase or sales could stall out at the 17 million-unit level over the next year or two. That's not a bad place to be, although it will make for a smaller contribution to GDP. And interest in more expensive models and falling input prices may help industry profitability even in the face of demand that may not get a lot better.

The employment report is always tricky to predict, but after last month's dramatic slowing, everyone is optimistic about a rebound for September. Almost all the other labor market reports have continued to hold their own if not improve a bit over the past several months. That suggests either a strong September report or some sharp revision to the lackluster August report. The August data showed job growth of just 142,000 versus a 12-month average of over 200,000 workers added each month. The consensus is for 218,000 new jobs, and my bet is for closer to 240,000. As a continued reminder, hourly wage growth will be equally if not more important than the number of folks added in this jobs report. Also, remember that employment is a lagging indicator that isn't a lot of help in forecasting the economy. And never, never rely on one month of originally reported data. The revised data could easily paint a different picture in just another month or two.

Other data next week includes the trade deficit (likely flat with lower oil prices offsetting potentially huge iPhone imports) and construction spending (likely up but not as much as last month).