US Perspectives: Data Points Not as Bad as Market Suggests

Despite last week's data, I suspect that the economy won't move into another recession (without some help from our politician friends). Auto production continues to rebound, gas prices are falling again, and Boeing just might make the second half look a little better as new jetliners finally roll off the production line. My biggest fears are that we will talk ourselves into another recession and falling stock markets will affect consumer spending at the high end, heretofore an area of strength. (However, the evidence that falling stock markets crater consumer spending is pretty thin; effects on spending were minimal after the Nasdaq collapse in 2000/2001 and the one-day 25% crash in 1987. But the profile of consumer spending has shifted to the high-end spender during the ensuing years, potentially amplifying the effects of a falling stock market.)

Regional Purchasing Managers' Report and Industrial Production Paint Different Pictures

To add more confusion to the manufacturing picture, industrial production showed its third monthly increase in July after weakness earlier this spring. The table below shows the trend well:

Industrial Production Looks Good, but Weather and Autos Helped

Based on real production, it appears the time to be worried about manufacturing was this past spring. Since then both the monthly data and year-over-year data have shown improvement. While the ups and downs can at least partially be explained by Japanese supply chain issues, the numbers are still trending the right way when excluding autos. I suspect August will not be quite as strong (autos provide less of a rebound) but I still expect a positive number.

PMI Is a Hyperactive Indicator

I have also posted the much-heralded Purchasing Managers' Index (PMI) numbers that looked relatively strong before the spring slowdown and then collapsed in front of the recent acceleration. While the PMI is useful at market bottoms, it is less so during a normal recovery and when the economy is particularly volatile. The PMI indicator tends to have some false positives; during the 1990s this indicator flashed four signals that produced exactly one recession. It does a better job predicting industrial production than the overall economy, but in the short run even that relationship isn't perfect--as the chart above indicates.

Regional PMI Data Looked Terrible, Not Necessarily the End of the World

A pair of very negative regional PMI reports (Philly Fed and Empire State) particularly unnerved the markets last week. The Philly Fed report fell to negative 30, a number normally associated with recessions. (This means the percentage of firms reporting declining results exceeded those that saw improving conditions by 30% and excluded those reporting flat conditions. Almost all the readings of this index are in a range of negative 40% to positive 40%). The reading from the Empire State was less damaging at negative 7.7%. These regional reports are even more volatile than the national report and have also forecast many more recessions than have actually occurred.

So What's Really Going on in Manufacturing?

A short-term rebound in the auto industry and more favorable weather conditions are probably behind some of the relatively strong industrial production numbers of late. The regional PMI data is probably hurt by the way it's gathered. A lot of the regional reports are an up-or-down question on overall conditions and at least quasi-subjective (versus the national survey, which is an objective average of several different measures). The two regional surveys were taken in early August when the deficit-related crisis was at its worst, potentially influencing the more subjective overall rating (individual categories were negative, but the biggest negative number was the overall reading).

The Economy Is Neither as Strong as Industrial Production Suggests or as Weak as PMI Reports Purport

The reality is that export sales, while still strong, aren't growing nearly as fast as they were a year ago. One major manufacturer indicated that export sales are now growing at a 25% rate now versus 50% at this time a year ago. That's hardly anything to sneeze at, but it's still a lot slower than it was. In addition, the inventory replenishment cycle coming out of the recession has also run its course (except in autos), which also may be responsible for some of this apparent slowing in the manufacturing sector. Finally, with prices now beginning to fall, the big push to get orders in before further price increases are implemented is probably well behind us, too.

Appraisals and Tight Lending Standards Throttle Existing Home Sales

Existing home sales unexpectedly fell in July by 3.5% to 4.67 million units on an annual run rate basis. I had been thinking sales would actual grow this month based on pending home sales data, which have been positive over the past couple of months.

The National Association of Realtors attributes the discrepancy to the failure of clients to obtain mortgages after signing purchase agreements or the failure of properties to appraise at the agreed-upon prices. Either event can result in the cancellation of a contract, which occurred about 16% of the time over the last couple of months, well above the long-term average. Appraisals continue to come in below the prices agreed to by the interested parties. Overly cautious appraisals and the inclusion of foreclosed homes that sell at distressed prices certainly appear to be hurting the closing process. To editorialize for a moment, I wish the Federal Reserve would spend at least as much time solving the appraisal issue and overly tight lending standards as it does keeping interest rates so incredibly low.

I suppose the ray of good news in the report is that existing home sales were not a problem across the entire U.S. but instead largely confined to the West Coast. The relative growth rates by region are shown in the table below:

Often, an improvement in one of the regions bodes well for the other regions in the months ahead. That would be very good news. In the past I have pooh-poohed existing home sales data because they are not a direct input into the GDP calculation, merely recorded as an asset transfer. However, growth in brand new home sales is not going to happen until more of the existing home inventory is cleared. New home sales are included in the GDP calculation and are the key to new construction jobs. Exceptionally limited growth in construction jobs following severe job losses during the recession is what is holding back this recovery.

Indeed, housing starts fell to an anemic 604,000 units again in July following a downwardly revised 614,000 the prior month. As long as that number remains mired in the 500,000-700,000 range, I wouldn't read too much into any slowing or acceleration. It is just noise in a volatile series. As I indicated above, it is going to be hard to get out of that range until existing home sales look up--or existing home inventories mysteriously collapse.

Initial Unemployment Claims Spook the Market--They Shouldn't

Initial unemployment claims are a highly volatile metric affected by large layoffs, processing delays, holidays, and seasonal adjustment factors. Weekly claims for the most recently reported week jumped a relatively modest 8,000 to 408,000 from the previous week. Pundits were quick to point that the figure was back above the magic 400,000 level, as if that jump was going to cause an immediate collapse in the economy. Trust me, there is nothing magic about 400,000, other than it's easy to remember.

The preferred method of analyzing the initial claims data is by looking at a four-week moving average. On this basis, initial claims fell to 402,500 from 406,000.The metric has been on a three-month downward trajectory from an interim high of 440,000 on May 14. Much like the industrial production figures, the most negative data were from this spring, with some improvement over the summer. Unfortunately, an increase in the Challenger Gray Job Cuts report and this morning's announcement of large (and quick) layoffs at Bank of America will probably keep this metric from showing much improvement in the short term.

Inflation Back Up Again in July After June's Decline

The scariest number of the week was the robust 0.5% (6.0% annualized) CPI growth rate, which served to push consumer inflation-adjusted earnings into negative territory. That means less free cash to spend in stores. The Labor Department estimated that about half that increase was due to a quick backup in gasoline prices during July that quickly reversed itself again in August. Groceries and clothing (driven by higher cotton prices) were other key culprits in the negative report. Falling crop prices lately and a 25% drop in the price of cotton should help down the road, but unfortunately not for a few more months. Falling natural gas prices and transportation services prices as well as flat new car prices (after a run of five months of substantial increases) kept the report from being worse than it was. Unfortunately the large inflation increase will blow another hole in the third-quarter GDP reports, which are reported with a subtraction for inflation.

Consumers Punish the Price Boosters

The good news is that consumers are voting with their feet when prices get too high. Auto sales collapsed in May and June when prices were sky-high and then modestly rebounded in July when prices flattened out. Consumers ate out more when home grocery prices accelerated. And gasoline usage by consumers has been on a multiquarter decline as prices rose. Companies that raise prices too fast will be unpleasantly surprised. I suspect as consumption remains lackluster, more consumer price cuts may be in the works. Potentially this is good news for the consumer, for retailers not so much.

This Week's List of Indicators Is Mercifully Short

Like last week's news, we are likely to see the good, the bad, and the ugly this week. Durable goods are expected to rise 2.3% mostly due to some good orders at Boeing that won't be completely stripped away by seasonal adjustments. Excluding the airline orders I wouldn't expect many gains. Still, a strong headline durable goods number combined with better shipments from Boeing should finally make the manufacturing sector look a little better. Other potential good news is the home price data out of the FHFA, which should show a small increase but probably not as large as the previous month's 0.4% gain. Still, I'll take anything I can get. The bad includes new home sales, which remain mired in the low 300,000s. The ugly will include a likely downgrade from the initial 1.3% second-quarter GDP growth reading reported last month to something less than 1.0% when reported on Friday. Lower net exports, adjusted downward in the interim, are the primary culprit for the likely reduction. Again, everyone and their brother know about the possible reduction, but never forget the shock value of a negative data point in a panicky market.

This is an edited version. The article originated from Robert Johnson’s column at Morningstar.com.