No Sugar Coating Last Week's US News ...

... but there's still no need to panic, says Morningstar's Bob Johnson.

Robert Johnson, CFA 23.05.2011
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Housing starts remained soft, three separate manufacturing reports--heretofore the strongest sector of the economy--showed meaningful slowing, and existing home sales dipped again (on weather and Japanese supply-chain issues).

Worse, retailers, including Gap (GPS), indicated that higher input prices were beginning to pinch profits more than most analysts had anticipated. Unfortunately, the tale of two recoveries continued; Wal-Mart (WMT) reported same-store declines for its eighth quarter in row as midtier customers moved up and low-end customers moved to even cheaper dollar stores. Meanwhile, Saks (SKS), a luxury goods retailer, affirmed that it was trying to raise its price points. Cold weather in the upper Midwest pinched home goods retailers Lowe's (LOW) and Home Depot (HD) and sporting goods purveyor Dick's (DKS), with weather-sensitive categories off more than 20% from a year ago (think bushes, shrubs, and kayaks).

International News Wasn't So Hot, Either
The European debt crisis remains far from solved as southern European nations push back on austerity measures and northern European nations take to the papers announcing that debts will not be rescheduled or written down. Greek debt was downgraded once again. Greece isn't big enough to do much damage to anybody (well, maybe a few European banks), but the situation highlights that there is no easy way to fix debt problems under the euro. The easy fix of devaluing the currency just isn't there. And debt defaults aren't all that practical because they would wreak havoc on already fragile European banks. Luckily for the United States, its big export binge has been to Asia and the Americas.

Don't Press the Panic Button - Last Week's News Wasn't All Bad
Last week wasn't totally devoid of good news. The International Council of Shopping Centers reported that weekly sales continued to show 3% or more year-over-year same-store sales growth as they have for the last three or four months. Spending growth has remained at consistently high levels despite high gasoline prices and all our geopolitical problems. Even anecdotally, some of my analyst colleagues at Morningstar are reporting near Christmas-like parking conditions at local malls on weekends in Chicago.

Initial unemployment claims plunged for the second week in a row following several weeks of unexplained spikes. I will say that some of the recent spikes came from states with Japanese automobile manufacturing plants. New York state also had a quick run-up of 20,000 claims one week (on a normal base of about 40,000 claims) followed by an equal-sized drop last week. Remember that it is ultimately consumer spending (which is based on employment, consumer income, and confidence levels) that ultimately drives the economy, not housing (1%-2% of GDP) or manufacturing.

Have Gasoline Prices Peaked?
Gasoline prices have backed off from their high of $3.98 three weeks ago to $3.88 according to AAA (as I write this Friday afternoon). Based on the wholesale price of gasoline today and a typical spread of $0.70 for profit and taxes, I believe that the average national price could fall to $3.65 or less over the next month--still high, but not catastrophic.

Interest Rates Fall; Who Needs QE2?
The Fed's moves to help the economy by reducing long-term interest rates has certainly helped assets including stocks and commodities. The boost to stocks has been meaningful, with the market increasing almost 30% since August, when the QE2 rumours kicked into high gear. And the stockholding classes have indeed unleashed some of their gains in the malls.

QE2 comes to an end in June, and we see commodities and stocks beginning to wobble a bit as the market anticipates the end of these programmes. (Higher margin rates on some commodities and some weak economic data haven't helped these markets, either.)

Now, paradoxically, as QE2 ends, long-term interest rates are falling again, as are mortgage rates. The 10-year Treasury has now fallen back from its peak of 3.75% this spring to 3.16% as of Friday. Those same 10-year rates were as low as 2.5% when word of QE2 was leaked out of a Fed meeting in Jackson Hole, Wyo. Something similar happened with QE1, according to economic researchers at Capital Economics.

Upward Revision in First-Quarter GDP Estimate from 1.8% to 2.3% Possible
Large upward revisions in February's retail sales and employment reports could lead to a meaningful increase in the first estimate of GDP growth for the first quarter. As I wrote last week, US retail sales growth in February was boosted to 0.9% from 0.4%, enough to move the GDP needle in a meaningful way. However, some of that increase could turn out to be imports, too, potentially hurting my optimistic forecast. Subsequent data releases indicate that construction spending was underestimated in the original GDP report and inventory growth (which increases GDP growth) was overestimated. However, the construction spending increase was meaningfully larger than the negative inventory revision.

Manufacturing Data: Managers Are Staying Calm, and So Am I
At first glance last week's manufacturing reports were not pretty. Industrial production was flat instead of being up 0.4%, as expected. Then two regional purchasing manager reports, the Philly Fed and Empire State, both declined into the single digits from near recovery highs of the low 20s the previous month. As long as these numbers are above zero, the economy remains in growth mode, though that rate appears to be slowing. I warned last week that the US-based Japanese auto producers might affect the industrial production numbers, but even I was a bit surprised at the magnitude of the decline. Our industrial team summed up the industrial production report as follows:

Industrial production's first material sequential decline of the current cycle was driven by shortages in auto. The overall index was unchanged from March's levels, but manufacturing was down 0.4%, due in large part to a 7% sequential drop in automotive products that was driven by parts shortages resulting from the Japanese earthquake. Excluding motor vehicles and parts, factory activity increased 0.2% sequentially. Mining was up 0.8%, and utility activity was 1.7% greater than March. Overall, we're not surprised by April's lacklustre results, given the myriad comments from auto executives during the last several months. Capacity utilisation was off by 0.1% to 76.9% for total industry, and off by 0.6% for manufacturing to 74.4%. Both remain well below their long-term averages, which sit at 80.5% and 79%, respectively.

The auto industry has always had a disproportionate effect on the purchasing managers' report, in my opinion, and last week's numbers are further proof of that. Rail shipments, diesel fuel purchases, and the employment subcomponents of those same purchasing managers' reports seem to indicate that manufacturing managers aren't panicking and continue to ramp up employment. Interestingly, improved sales outlooks and employee burnout were the number-one and -two reasons for continued hiring. Lack of internal personnel possessing the necessary skill sets was reason number three, according to a special questionnaire attached to the normal Philly Fed report. If managers truly believed manufacturing was about to collapse, they would not be hiring people--trust me on that.

Housing Mired in the Mud with a Ray of Hope
I've got a little mud on my face on this one. Last week I hoped for an increase in existing home sales based a sequential pending home sales increase. I made the rookie error of looking at the sequential growth from the previous month. Our housing analyst Eric Landry gently tweaked me for forgetting to at least glance at the year-over-year data (which is less subject to seasonal errors). He correctly projected this month's softening in existing home sales; I got it wrong. Therefore, I'm turning over this month's housing commentary to him:

Existing home sales' lacklustre results weren't totally unexpected. Total sales of 5.05 million on a seasonally adjusted rate (SAAR) in April were 13% below the year-ago figure and 1% below March's result. Single-family sales of 4.42 million SAAR were also down 13% and 1% on an annual and sequential basis, respectively. Inventories increased to 3.87 million units, or 9.2 months of supply in April.

While we were mildly discouraged by these latest weak results, we can't say we were overly surprised, at least at the sales numbers, given what happened with pending sales in March. We do, however, hold out hope for gradually improving sales performance in the months to come, as prices across the country appear to be firming. Though much of the current positive activity in median listing prices can be attributed to seasonality, the last several weeks' activity is a good start. Last year enjoyed only a small, short-lived bounce. And though 2009 saw a strong seasonal component to pricing during its spring and summer months, much of that was due to government stimulus. The fact that prices are going up this spring without the aid of a tax credit is encouraging and may coax reluctant buyers. More importantly, it may bring lender capital back into the space--a component the market is sorely lacking today.

Housing starts were highly disappointing, but still within the narrow range of the last two years. April starts of 523,000 on an annual basis were down 11% from March and 24% from last year's tax credit-induced period. Single-family unit starts of 394,000 SAAR were 5% below March and 30% lower than last year, while the volatile five-unit and above category sunk 28% from March, but was 6% above year-ago levels.

Durable Goods Orders Due for a Disaster?
The consensus forecast for durable goods is for a decline of 3%, with some expecting even worse results given that Boeing (BA) had what could be politely called a quiet month. Boeing took just two orders in April versus 98 in March. This type of volatility is not at all unusual. But after a week of less than wonderful manufacturing data, the "glass half empty" crowd would have a field day with declining overall orders no matter the cause. Even excluding transport issues, orders are likely to go up a mere 0.5% compared with April's 2.3% based on slowing new order growth reports from the ISM purchasing managers' reports. A quick fall-off in auto-related orders due to Japanese supply-chain issues at US transplant factories could further complicate the interpretation of the normally reliable new orders report. Keep in mind that we've had three extremely solid order months in a row.

New Home Sales Look to Be Flat in April After Big March Jump
New home sales remain anaemic, though March did see a large weather-related jump of 11%. I suspect April new home sales will have a hard time besting March's 300,000 rate of annual increase. I believe the poor location of new home developments (too far from jobs) as well as meaningfully higher prices for brand new homes compared with cheaper existing homes is contributing to the new home market malaise.

Respectable Income and Consumption Growth, but Inflation Will Erode Those Results
Consensus forecasts suggest that both personal income and spending data for April increased by about 0.5% each, before adjusting for inflation. That sounds great on the surface because when the monthly data are annualised, they produce a growth rate of 6%. However, with the Consumer Price Index increasing 0.4% and the government's preferred price index, the PCE price deflator, likely to increase 0.3%-0.4%, that 0.5% growth rate looks a lot less exciting. Recent payroll employment revisions also mean that income and spending growth for February and March will also be revised upward. Of course, that will set us up for harder April comparisons on the income line.

Overall, my guess is that poor new home sales and durable goods orders will get us off to a bad start this week, while potentially better GDP numbers and respectable income numbers at the end of the week could provide a shift in investor attitudes.

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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