Manufacturing Sector Stronger Than It Looks

The U.S. was definitely not the focus of world markets this week. Instead, the markets were focused on news from the central banks in Europe and China, which both moved to loosen monetary policy. China reduced some key interest rates and introduced some targeted programs to benefit certain sectors. That caused a huge move in the emerging equity market, which was the winner for the week with a 2.4% gain, more than all of that happening the day of China's easing announcement.

Europe continued on the trail of what economists are calling VE, or verbal easing. This amounts to loudly and publicly announcing that they will do whatever it takes (in this week's case to avoid deflation) while ultimately implementing only modest, if any, changes. On Thursday, Mario Draghi, head of the European Central Bank, formally said that it would be doing whatever it takes to stop deflation, similar to the statements he made more than a year ago for the euro. Markets still loved it, pushing European stocks up by more than 1.8%. U.S. gains were almost as good as that early in the day before prices settled back later when reality hit--that reality being the European and Chinese economies are failing to meet expectations. Worse, the continued softening is happening even though policies have now been getting looser for some time.

U.S. bonds were basically unchanged while commodities showed some signs of life on Friday, gaining 0.5% for the week and more on Friday. The move was probably due to the fact that investors believed that China's looser policy would stimulate more demand for commodity imports. Fat chance.

U.S. economic data was relatively neutral with underlying data providing even better news than the somewhat complicated headline numbers. While the headline industrial production number declined month to month, the year-over-year data still looked great. Even the month-to-month numbers looked great when excluding utilities and mines. Existing-home sales continued their sharp improvement that has now extended their month-to-month improvement to seven months. Unfortunately, new home sales-related data remained largely unchanged. Perhaps the best news of the week was that U.S. inflation was unchanged month to month and was only 1.65% on the longer year-over-year period. On a world basis, the Markit manufacturing data suggest that manufacturing growth was likely to move in reverse in the very near future in non-U.S. markets. It's probably no coincidence that European and Chinese central bankers both tried to orchestrate more easing on the day following this rather dismal report.

Manufacturers Still on a Roll
This week's manufacturing data looked surprisingly disappointing. Both the Markit Manufacturing PMI for the U.S. and the industrial production report seemingly showed outright declines. However, that data did not square with an unusually strong PMI reading from ISM earlier this month and a just-released report from the Philadelphia Fed that showed the best performance in decades. Despite the apparent contradictions in all these reports, I continue to believe the U.S. manufacturing industry is witnessing slow and steady improvement. It's small relative to the overall economy, but manufacturing has been and continues to be one of the real bright spots in the U.S. economy. The situation outside the U.S. is not nearly as bright.

Industrial Production Co-Opted by Weak Utilities and Mining Data
The overall industrial production report showed a decline of 0.1% versus expectations of 0.2% for October. This follows a relatively strong September when industrial production grew a whopping 0.8%. The culprit behind these volatile numbers is a combination of utilities and mining companies. I tend to put less emphasis on utilities (which are driven almost entirely by weather conditions) and the mining and extraction that is seeing some slowing as energy prices fall. It's incredibly difficult to forecast these two components, and neither is a very big driver of employment. Mining declined by 0.9% (16% of industrial production) and utilities (10% of production) by 0.7%. The remaining manufacturing-only sector grew by 0.2% and comprises three quarters of the index. The manufacturing-only sector performed better than forecasters expected--they incorrectly estimated that there would be no growth whatsoever. So, the core manufacturing sector was quite healthy overall, thank you very much.

The year-over-year averaged data for manufacturing also supports my thesis that the manufacturing sector is doing better than average right now, though not really accelerating or decelerating in any clear pattern. This data is shown in the middle column below with the year-over-year growth rate in manufacturing production. The current growth rate of 3.9% is well above the 2.6% average of the past 42 years and the 3.4% average of the previous 12 months, although off its high of 4.4%.

The ISM's version of the purchasing manager survey, shown in the last column above, correctly predicted that manufacturing would begin improving last spring. The most recent reading of the ISM data, at 59, is the best reading of the past year and well above the 50 level that generally separates periods of growth from decline. This would seem to suggest that industrial production will at least hold its own if not accelerate in the months ahead.

What impressed me most in the string of very healthy manufacturing improvements over the past several months is that the advances came despite some relatively dramatic declines in the auto industry. The auto production numbers for the past three months are downright gruesome, with auto production declining 5.6%, 1.8%, and 1.7% over the months August through October. That had followed an inexplicably strong 7.6% gain in July.

All this volatility in a relatively steady auto industry strongly suggests statistical factors that have run amok and not big changes in the underlying health of the auto industry. Weather, shifting car introduction cycles, and changing summer closures have probably permanently damaged some of these data sets--that is, at least, the seasonally adjusted month-to-month numbers.

The good news is that I believe that the auto production declines are likely to reverse in the near future. There has been a number of massive product changeovers this year, many of which involved overproducing vehicles to build inventory before shutting down lines for months at a time. When the new production comes on line, the production data is likely to spike again. The all-aluminum Ford F-150 is the latest vehicle to go through that process. This phenomenon caused production to soar above auto sales by an unprecedented amount this summer. I had never seen that gap so wide. Now with three months of production declines, sales and production are back in line and production should grow in line with auto sales, if not by a little bit more over the next several months. These ups and downs are also visible in other related categories, including many of the metals.

Offsetting the declines in autos have been the plastics, rubber, and chemicals industries that comprise almost 15% of the total industrial production index (and even more of the manufacturing-only version). These sectors have averaged 0.6% monthly growth over the past three months, which annualizes to over 7% growth.

I have been waiting a long time for lower energy prices to give the sector a boost, and the good news appears to have arrived at last. Other industries did well also, with just seven of 22 manufacturing categories registering declines between September and October. Metals- and auto-related categories accounted for most of the decline. With autos and housing both looking poised for a rebound, I suspect that industrial production will look very good in the months ahead. That's even before the massive improvement we expect from the utility sector in November (because of record cold). A combined gain of over 1% for November industrial production figures is not out of the question.

Markit Data Raises Issues About the World Manufacturing Sector
Markit provides purchasing manager data from countries around the world. Those data points are often more important than the U.S. data because manufacturing makes up a larger portion of many key non-U.S. economies, most notably China and Germany. The news here was not as good as the U.S. data found in the industrial production report and last month's ISM report.

In analyzing the U.S. market, I tend to ignore the Markit data, which has a very short track record in the U.S. and a smaller survey base. Markit uses substantially different weights but the very same categories when it constructs its index, and with far different weights for the same five categories. That said, while this month's Markit rating was down from the prior month, it still showed a reading in the mid-50s, which is still a relatively bullish level.

Internationally, China and Europe hovered at just about the 50 level, which is not indicative of a horrible decline or a quick rebound. Still, the readings for both of those regions suggest that neither recent stimulus measures nor a stronger U.S. economy really moved the economic needle. The European data set is the more troubling of the two non-U.S. regions, declining in an almost straight line from January's reading of 54 to a new 2014 low of 50.4. The good news for Europe is that continuing stimulus and a surprise pop in auto sales, as well as higher German business confidence, suggest that a bottom may be near.

China's data has not fallen so far or so long as Europe's, but the Markit/HSBC folks are clearly worried about further declines in China. The press release that accompanied the data suggested even worse news lies ahead. Export orders fell below the critical 50 level, which doesn't bode well for the months ahead. They note that disinflationary trends are continuing and the employment indexes continue to fall. Add in a property market where prices continue to fall and we have a prescription for continuing softness.

No wonder the Chinese authorities are undertaking measures to ease monetary policies, reduce interest rates, and provide slightly more stimulus.

Low Energy Prices Keep Inflation Flat in October (Written by Roland Czerniawski)
The Consumer Price Index was flat in October, after a modest 0.1% (1.2% annualized) gain in September. Year over year, inflation was 1.65%, all the way down from 2.14% in May after seven consecutive monthly year-over-year drops. The 1.65% annual CPI figure is also substantially below the 3% historical median, and it's still running lower than the central bank's 2% inflation target. October's flat prices were heavily influenced by a 1.9% (22.8% annualized) drop in energy prices. Lower gasoline prices continued to be a source of price relief as gas prices dropped 3%, to an average price of $3.17 per gallon in October. We should expect an even more drastic gas price slump in November, as the pace of weekly gas price decreases reported by AAA has accelerated to double digits on a year-over-year basis. The average price paid at the pump in November could be as low as $2.90, and that would amount to about an 8% month-to-month drop on a nonseasonally adjusted basis.

Food, on the other hand, was a modest gainer in October (0.1%) after increasing 0.2% and 0.3% in August and September, respectively. It is great to see that, after some dramatic increases over the past few months, meat prices (excluding beef) are now falling. The bad news for the consumer is that the lower meat prices were fully offset by a large increase in prices of fruits and vegetables, namely potatoes, tomatoes, and citrus fruits. Interestingly enough, according to the Farm Bureau, the average cost of Thanksgiving dinner is projected to increase to $49.41, up only 37 cents from the year prior. For those who drive to their Thanksgiving gatherings, this very modest increase, coupled with collapsed gasoline prices, should actually make the upcoming holidays much cheaper. This dynamic might not hold true for those consumers who decide to fly to their holiday destinations. Despite much lower jet fuel costs compared with last year, airline fares have already started and will continue to increase. In fact, airline fares were one of the top gainers in October's inflation report (up 2.4%), although they do not account for a large portion of the index.

Typically, lower gasoline prices eventually creep into core inflation (a measure that excludes energy and food from the calculation), and this usually occurs with a few months of lag. So far, we have not seen this happen, and the airline situation is an example of how timing and various industry pricing strategies can easily complicate this phenomenon.

Considering that energy prices are quite likely to extend their losing streak in November, and even if the overall CPI increases 0.1% and 0.2% in November and December, respectively, the annual inflation figure would still dip further to 1.6% and 1.5% in November and December. This is an important development, and considering that the Fed's focus is beginning to gradually shift away from employment and to inflation, it might be a key factor in determining when interest rates will be raised. The Fed's monetary policy is influenced by the core CPI, which excludes volatile energy and food prices, and that number currently stands at 1.8% (slightly above the overall CPI figure). However, as I mentioned before, low energy prices will eventually find a way to leave their mark on core CPI itself. This, along with the current slowdown of worldwide economies, should indicate that even the core inflation will probably run below the Fed's target for at least another three months, and during that time any decision on contractionary interest-rate policy might not be an easy one to make.

Housing Data Positive on Balance
Although headline housing starts were a bit disappointing, we took some solace from the fact that permits and builder sentiment both improved. Those latter two factors are more forward indicators, so I suspect that we will see some improvements in housing starts and new home sales in the near future. However, a shot of really cold weather in November and normal seasonality are likely to limit the improvement in the short run.

Better employment data, continued low mortgage rates and potentially smaller new homes are likely to make 2015 a better year for new homes than the rather disappointing year in 2014. But some of the poor new home sales have caused a short-term surge in existing-home sales. Those existing homes are benefiting from a $50,000-$100,000 cost differential compared with new homes. While sales of new homes are generally more advantageous for overall economic growth, the existing-home market is 5 times the size of the new home market. While the economy benefits from the whole cost of a brand-new home, an existing home provides only mortgage fees, broker commissions, and lawyer fees up front. Eventually, new furniture, remodeling, and moving fees all will see increases because of an existing-home sale. It's not a horrible consolation prize for poor new home sales. Still, this week's builder sentiment suggests better days ahead for new home sales.

Builder Sentiment Bounces Back (Written by Roland Czerniawski)
After a substantial pullback in October, builder sentiment increased from 54 to 58 in November, the third-highest reading in over nine years. This number was as low as eight in the middle of the crisis. Generally, a reading over 50 means that a majority of builders see housing market conditions as favorable. What was especially positive about this month's report was the fact that all three categories--current sales conditions, expectations for future sales, and traffic of prospective buyers--all increased, by 5, 2, and 4 points, respectively. It is great to see that again. The index growth is not mainly driven by some future hopes, but by tangible improvements in the current housing sales and the traffic that is a precondition of a future sale. With that being said, further improvements to the traffic component are still very much needed as it has been hit especially hard during the recession, and it remains below the 50-point threshold.

Starts and Permits Seem to Indicate Little Progress
The starts and permits data defies any type of easy analysis. Bad-weather trends lasting more than our three-month average periods wreck our usually quick fix for analyzing irregular data. An extended rise in interest rates in 2013 and the on-again-off-again government shutdown don't do the data analysis any favors, either.

The best way to look at the data is probably year-to-date permits activity. By using permits, we eliminate some of the volatility caused by the inability to start a home even though the permit had already been pulled. Looking at year-to-date numbers probably works some of the interest jumpiness and the government shutdowns out of the system. (Year-to-date data would include the downs of the government closure but most of the subsequent rebound.) Year-to-date average interest rates would be slightly higher in 2014, but both periods would include significant episodes of both mortgage rate increases and decreases, just in a different order. On that basis, housing permits in total are up a measly 5.9%. Worse, the important single-family home market saw year-to-date permits increase just 1.4%, while large multihome projects increased a more significant 14.9%.

On a month-to-month basis both permits and starts have shown almost no growth, but no contraction, either. Recent moves have been little more than statistical noise. Tough credit and limited and expensive choices have really kept a lid on new home sales. Distant locations and a limited inventory of starter-type new homes certainly haven't helped matters. The Wall Street Journal recently ran a blog post that indicated that builders are finally beginning to get the point as average square footage of new homes has begun to drop. So far the drop has been relatively small, from 2,500 square feet to 2,400 over the past year. That is still way above the recovery low of about 2,240 square feet reached in 2011.

Existing-Home Sales Take Some of the Sting Out of Disappointing Starts Data
The existing-home data suffers from the same year-over-year comparison issues as the starts and permits data, just the peaks and troughs are in different months. The summer 2013 sales rush to buy existing homes to beat the interest rate increase really messed up the data set. With existing-home sales of 5.26 million units, we are finally inching back to the too-good-to-be-true 5.38 million units reached in July 2013. In fact, the October existing-home figure is among the top three months of the recovery. Unlike the starts and permits trend, the six-month trend in existing homes is transparently obvious and shows little sign of abatement. Also notable is that activity seems to be heating up in lower-price homes, which could explain the increased difficulties faced by homebuilders.

The nonaveraged data looks even better, but then again, that would be cheating.

The report also noted that first-time buyers accounted for 29% of sales. First-time buyers have represented less than 30% of purchases for 18 of the past 19 reports. The report also mentioned that the first-time buyer percentage is now at a three-decade low. The softness was attributed to poor job prospects for recent graduates combined with ever-increasing student loan balances.

GDP Revision, Durable Goods, Personal Income, and Pending Home Sales on Tap
Despite the holiday-shortened week, there will still be a lot of new data to look at. Pending home sales will probably be one of the more important indicators of the week. It's the last look we will get for the housing market before poor weather begins to complicate our analysis. With mortgage rates lower, employment up, and home prices moderating, I am somewhat hopeful that pending home sales will be up yet again.

At one point I was worried that new revised government data (primarily construction- and export-related) could cause the GDP estimate for the third quarter to drop from 3.5% to under 3.0%. As often happens, the more recently released inventory data is likely to offset a decent portion of my feared decline. Overall, I am guessing that the new revision will show third-quarter GDP growth of 3.3%.

Both consumer and incomes should look really good in October, based on the employment report and the retail sales report. Both incomes and spending should increase an impressive 0.4%. Even more impressive, if it happens, is that there was no inflation in October. This will make the inflation-adjusted report at 0.4% one of the best results of the year and 4.8% on an annualized basis.

With some conflicting data on manufacturing, analysts will also be watching the durable goods reports. Because of issues in airline orders and autos, investors are expecting more bad news, with orders expected to be down close to 1% for the second month in a row. The report will require a much more nuanced analysis when it is released, including sector analysis and excluding some volatile and pesky segments, including auto and airliners.