Enjoy Low Oil Prices While They Last

Last week I griped that the economic news was amazingly good and no one really cared. With better news out of the Fed, oil prices stabilizing, and even more economic good news, the U.S. equity market bounced sharply off of its bottom. The magnitude of the attitude adjustment was truly stunning. The United States did the best of various country metrics, with the S&P 500 up 3.3% even after having been down sharply early in the week. Europe and emerging markets did half as well, with most up in the mid-1% range. Commodities were down just a touch, and the U.S. 10-year bond rate was a bit higher at 2.18%.

The best of the economic news was a surprisingly strong report on U.S. industrial production. Purchasing manager data also suggested that European production may have stabilized. However, China continued to look weaker. U.S. prices also ticked down, although parts of the report were troubling, including rising rents, rising medical costs, and sky-high beef prices. The housing industry remained stuck in neutral, showing no real signs of a breakout in either direction.

With both retail sales and industrial production--two of the most concurrent economic indicators--showing unusual but sustained strength, it's quite tempting to raise my 2015 growth forecast from 2.0%-2.5% to something closer to 3%. However, with housing and business construction remaining soft and the trade situation likely to worsen with a strong dollar, I am staying put for now. Low gasoline prices could make my conservative stand look silly for a couple of more quarters, but I don't think low energy prices are sustainable for very long. Plus, I think the December employment report will potentially have a negative surprise or two.

Markets Thrilled That the Fed Didn't Seem More Hawkish at Its Recent Meeting
I am not so sure that the Fed really changed much but a couple of words around its stance on interest rates. I am not going into the linguistic exercise of parsing words, but both the old and new wording suggest that the Fed is not in any rush to raise rates. That is why the market rallied sharply after the release. Frankly, if the economy grows faster than expected (the Fed thinks it will grow at a 2.6%-3.0% rate in 2015), it will raise rates sooner. If the economy stalls out, rates will stay low indefinitely. Longer-term, I believe that rates need to be at least above the inflation rate, but demographics and low inflation argue that rates may not need to go that high to be what might be considered normal.

Industrial Production Surprises to the Upside
Strong utility demand and recent employment data presaged a good report on industrial production, and even still results were far better than expected. Total industrial production grew by a very strong 1.3% versus the most recent expectations of just 0.9% growth. Even better, results for the previous months were also revised upward. Stripping out utilities (which are about 10% of the index) industrial production grew by 0.9% in November.

After some up-and-down auto-related issues this summer, the sector has now strung together a stretch of very good monthly performance. The year-over-year data has stabilized at a high level of growth for the manufacturing-only data. Manufacturing has been growing at a 4.5% year-over-year rate recently, significantly above its long-term average of just 2.6%. The strong manufacturing results kicked in before the recent pop in consumption data. I had been worrying that production gains seemed to have a life of their own, regularly besting purchases of goods. It now seems that manufacturers' optimism was not misplaced and that I was too much of a worrywart.

Furthermore, year-over-year comparisons will get easier in the months ahead due to weather issues a year ago. The ISM Purchasing Managers' Report shown in the last column above seems to indicate that manufacturing strength is continuing. I do worry that both export-related and oil-related manufacturing groups could show some weakness in the months ahead, but so far the data has proven to be surprisingly immune to this weakness.

Sector Data Shows Relatively Broad-Based Improvement
As I suspected, the auto sector led the pack in manufacturing, growing 5.1% sequentially and 7.7% year over year. Month to month, autos did twice as well as any other category. Even on a year-over-year basis, autos bested the overall averages, 7.7% versus 5.1% for all of manufacturing.

That said, the other categories weren't too shabby, either. On a month-to-month basis only the "other" category and mining registered declines. Such a short list of decliners is highly unusual. The year-over-year data looks even more balanced as that smooths out some of the monthly volatility. Lately chemicals (a whopping 11% of the index) have been on fire, along with plastics and rubber. We had been waiting for some improvement in these categories because of lower relative energy prices, and the results are finally beginning to show it. Plastics are the single-best performing category on a year-over-year basis, jumping 8.9%. Even the massive chemicals sector showed year-over-year growth faster than the overall index at 5.4%. On the other hand, fabricated metals and aerospace have been relative laggards, probably because of lower defense spending and a stabilization of  Boeing's (BA) production rates.

PMI Data Suggests That the World Economy Isn't Falling off a Cliff
The way oil prices are falling, equity markets are gyrating, and various currencies are dropping, one would think the world is moving into another economic recession. However, this month's purchasing managers' surveys from Markit show that this just isn't the case. The early reads on December suggest that overall conditions aren't very different in December from what they were in November or where we were even six months ago. These reports can often react to new conditions very quickly, and so far no one seems to be panicking.

The indexes for the United States and China did slow some, but in the middle of all this turmoil, the data for Europe actually increased. Improvement came in the important new orders and employment related categories. Geographically, the strength in Europe came from some of the smaller players whose PMIs had their best readings in five months. France and Germany didn't do nearly as well.

The China data did move below 50, indicating more firms were seeing declines in activity than increases. A slowing real estate and construction marketplace has been hurting the Chinese index for some time. The current reading is the lowest since May, but isn't really statistically changed much at all. It would take a far bigger swing to worry me. That said, we believe the rest of the world is finally coming to the conclusion that the days of even 7.5% Chinese GDP growth are behind us, and there is potential for growth dropping to as low as 5% over the next five years because of shifting government policies and unfavorable demographics.

The data continues to show that the U.S. manufacturing sector is the best of the lot, though the flash reading for December was a bit lower than the previous month and has been trending down for some time. This Markit Index, compared with the ISM version, has entirely missed the recent strengthening and broadening of the U.S. manufacturing sector discussed in the industrial production analysis above. I am less sure about whether the root cause of the diverging surveys is methodology issues (the reports use very different weights for the subcomponents) or the number and type of survey participants. Recent industrial production reports have been driven by chemicals and plastics, which might be under-represented in one of the surveys.

CPI Takes a Dip on Lower Energy Prices, but the Best of the News May Be Behind Us
The Consumer Price Index fell a sharper-than-expected 0.3% (3.6% annualized) in November, largely but not entirely because of falling gasoline prices. The year-over-year inflation rate is still over 1% but should continue to trend down to under 1% even if energy prices fall no further. Even the moving average year-over-year growth rate is down to 1.5%. I do caution that the positive effects and the sustainability of the lower prices remain an open question.

One of the things that analysts seem to be overlooking is that the year-over-year inflation rate was actually lower at this time a year ago. The months following those low rates were terrible in terms of consumption, though some of that was probably weather-related. Consumers aren't stupid--they have seen both high and low energy prices come and go many times in the past two or three years and won't reorient their whole lifestyle because of a blip.

And it doesn't seem to me that low prices will last long. Supply and demand were in relatively good balance before the recent slump. However, because a lot of oil is in storage, prices can deviate from supply and demand issues in the short run. We saw that oil prices rebounded very quickly in 1998 when there was a large but temporary decrease in oil prices. However, this time around, a much stronger dollar may mean that oil isn't going back to its old high, at least in dollar terms.

The effects on CPI of rebounding oil prices could be dramatic. If gasoline prices (which are 5% of the CPI) move up 20%, which is only to $3 a gallon, inflation could be pushing 3% year over year by next December. That is, core inflation of about 1.7% plus another 1% for gasoline prices (20% times 0.05) for a total of 2.7%. So enjoy the low prices while they last.

Apparel Prices and New and Used Auto Prices Fall, Too
While falling oil is behind a lot of the November fall in prices, apparel prices, used autos, and new cars also fell. So there is at least some hope that general price increases will remain low. More worrisome is that health care-related prices, which had been tame for several years around the recession, are now picking up a little steam. With fewer drugs coming off patent and many firms boosting the prices for generics, health-care price increases may continue. That isn't good news for either the CPI calculation or the federal budget deficit.

In other bad news, shelter costs were up 0.3% (3.6% annualized), and food away from home was up a stunning 0.4%. Low housing start growth for both single and multifamily homes (apartments) is likely to mean that rents may go up even more in the months ahead. Some of the recent sales gains we have seen at restaurants were apparently price-related, which is also not the best of news. Fortunately, consumers have some alternatives, as food at home prices continued to moderate, just growing 0.1%. Not all the at-home data was good, though, as meats were up 0.6% month to month and 9.1% year over year. Beef prices alone are up a remarkable 18% year over year. Falling dairy and fruit and vegetable prices saved the day. I keep on hoping that meat prices will fall based on lower feed prices, but it's not happening yet.

Don't Expect a New Construction Boom Anytime Soon (by Roland Czerniawski)
The U.S. Census Bureau released the new residential construction report earlier this week, and it showed that November's building permits and housing starts stood at a seasonally adjusted rate of 1,035 thousand and 1,028 thousand, respectively. Coupled with upward revisions made to the previous month, this report reflects neither a boom nor a bust, and it only reinforces how disappointingly slow this recovery has been so far. As we are headed into the sixth year of this housing recovery, permits and starts haven't even recovered half of the previous peak yet. Going into 2014, we were more pessimistic than most housing forecasters, and even that conservative forecast proved to be too aggressive.

As disappointing as it has been, the sluggish housing growth has not been a total surprise for us. Many issues continue to hold the housing market from taking off. The first is affordability. Persistently high price growth in late 2013 and early 2014 proved to be really detrimental to this housing recovery. In addition, it seems that builders now have a greater preference for building more expensive homes to maximize profits and the potential of limited land resources.

The second issue keeping the housing recovery at bay is the fact that student loan balances have been skyrocketing. This topic has been widely discussed by many economists and forecasters with somewhat divided opinions. We think that student loans might not singlehandedly explain why this housing recovery has been so weak, but they certainly appear to be a contributing factor that is particularly harmful to younger first-time homebuyers.

Third, lending standards still remain relatively stringent despite modest improvements over recent quarters. To put this in perspective, the average FICO credit score for a GSE-approved mortgage was around 715 prior to the recession; it stands at 744 as of third-quarter 2014. While, this is an improvement from postrecession levels of 760 and above, it still shows that more credit improvements are still needed.

The anemic pace of the housing recovery has been particularly visible in the single-family construction category, which accounts for the majority of construction activity. As a result, the single-family category is very reflective of the health of the overall housing market. Looking at permits data, it appears that the growth in single-family authorizations peaked in late 2013 and has been declining since then, at least until recently.

The mix of adverse factors mentioned above can probably explain the dramatic slowdown in permits and starts. The first half of 2014 has been especially sluggish, with average single-family permits year-over-year growth of negative 1.3%. The second half, while still muted, has so far showed signs of growth. While we don’t see clear signs of a housing boom anytime soon, this housing recovery is starting to look increasingly more like a painfully slow, but hopefully steady, marathon rather than a sprint.

Personal Income and Consumption Data in Next Week's Highlights
Next week we won't be writing a regular column. Instead, I will do a video reviewing the key weekly releases, including existing-home sales, durable goods orders, personal income, and new home sales.

This time of year the housing reports don't mean too much, but at least we should do better than in 2013. We will probably have to wait until spring to see much change in the housing market. For the record, existing-home sales are expected to be 5.18 million annualized units, down from 5.26 million units in October. That feels a little too conservative to me, though pending home sales did register a small decline recently. New-home sales, which continue to be hit by high prices and little available land, are expected to be flat at 458,000 units.

Based on new inventory data, Wall Street is expecting another large revision to GDP growth in the third quarter, from 3.9% to 4.5%. That smells just a little too optimistic to me. Personal income and spending growth were up just 0.2% last month, and expectations are now for 0.5% for November in both categories. Based on employment data, those very good figures might prove to be low. Adjusted for deflation (that sounds weird, doesn't it?) growth could be pushing 0.7%. Durable goods orders should look good too, but airline orders really make the interpretation of this report tricky.