Things Are Looking Up, Really

The underlying trends don't point to an economy coming apart at the seams.

Robert Johnson, CFA 08.08.2011
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Markets experienced one of their worst weeks since the recovery began as a result of spreading debt contagion issues in Europe, a messy resolution to the U.S. debt crisis, and what many viewed as weak economic news. Pundits jumped on and misinterpreted the consumer income and expenditures reports and an admittedly weak ISM Purchasing Managers Report. Meanwhile, a jump in auto sales, a steady decline in initial unemployment claims, and even a respectable jobs report went largely ignored. While I can't portray the economy as robust, the U.S. economy is certainly not about to fall back into the abyss.

I would characterize the economy as neither booming nor busting. At times it certainly felt like it was about to boom (after those stellar jobs reports of February, March, and April of 2011). At other times it looked more like a bust. Just last August we had a run of bad employment and manufacturing reports that spooked the Federal Reserve. After a run of bad reports, the Fed began to openly discuss QE2 (the government's program to repurchase long-term government bonds to reduce interest rates). Many of those very short-term booms and busts appear to be nothing more than statistical mirages. Those boom and bust conditions always seemed to revert to a steady state, slow growth economy that just isn't very satisfying. Worse, those at the bottom of the economic ladder appear to still be going backward. The unemployment rate for those with less than a high school education has increased by more than 1% even as the rate for the entire population has fallen.

To be honest, I've been in the booming camp for most of this recovery, which has made me look right about half the time and like a stubborn fool the other half. I will admit to a certain bullish bias about recoveries based on growing up in the 1970s. The U.S. faced then what I viewed as horrendous problems including double-digit inflation, a war lost, riots in the streets, and even a president facing impeachment procedures. Penn Central Railroad went bankrupt and New York City came awfully close. My view has been if we could recover from that, we could recover from just about anything. And periodically, data from this recovery have supported that view. However, a lot of government numbers have either been restated or partially flawed, further confusing the interpretation of where we are now, let alone where we are going. Nevertheless, I surmise that even with the revised data I would have stayed relatively bullish (though I was probably more bearish than anybody else on the second-quarter GDP forecast due to Morningstar's analysis of auto production data).

However, recent results have made me temper that attitude. My belief now is that truly booming conditions typical of most economic recoveries are not going to happen this time, at least not without a big change in the housing market. I still think we're going to get to a better housing market--it will just take longer than I thought. Population growth almost guarantees it has to get better at some point. But the psychology of home buying has changed drastically and it's going to take time to work through. These issues extend well beyond foreclosures and upside-down mortgages, too.

The Tale of Two Neighbors
Attending a recent college graduation party brought home to me how big the change has been in potential home buyer attitudes. The 2011 graduate, who was lucky enough to get a great job, will be living at home despite the fact that he lives 45 minutes away from his new job (on a good day). At a similar party for another neighbor five years ago, the neighbor's son announced that he had bought a small condo in the city. The thought then was that if you didn't get in the housing market early, you'd miss your whole chance to ever afford a house. I know similar cases where the parents even helped provide some of the down payment money. Such buying accelerated the housing market of the mid-2000s and is now weighing heavily on the low end of the market. But even the 2011 graduate will most likely buy a home when he/she begins forming a family. Truly this is demand deferred, not permanently destroyed.

The Jobs Market Can't Make Huge Strides Without Housing
About a fourth of the eight million jobs lost during the recession were direct construction jobs. If one were to add in things like mortgage processors, realtors, lumberjacks, and so on, the job losses due to a poor housing/construction market would exceed 40% of the total. Yet construction employment levels have gone up less than 5% from the recession low. In fact, construction employment was still going down until January of 2011, more than a year and a half after the recovery began. I believe this is the true reason employment gains have been so hard fought.

Consumption, Income, and Manufacturing Data Spook an Already Jittery Market
The week started off on a bad note with the national purchasing managers' report showing growth in the manufacturing economy but at a sharply lower rate. Consumer income and expenditure numbers also looked weak (on the surface and when not adjusting for inflation), convincing the market that a weaker economy was in the works. But a lot of other data including better auto sales, lower unemployment claims, improving real incomes, and growing employment all suggest that we may have seen the bottom of this soft spot in the economy. I still hold to the belief that a confluence of odd events--political unrest in the Middle East (driving oil and gasoline prices higher), Japanese supply chain issues, and bad weather--badly distorted second-quarter data. I believe the second half will be substantially stronger than the first half. My biggest fear is no longer inflation, but that we scare ourselves back into another recession.

Income and Spending Data Look Weak Until You Adjust for Inflation
Despite the fact that most of the data were already in last week's negative GDP report, the market seemed shocked that disposable income grew a measly 0.1% and consumer spending fell by 0.1%. However, the data showed an improvement in trend when adjusting for inflation. The inflation- and non-inflation-adjusted data showed opposite trends. Inflation-adjusted consumer incomes were up 0.3% in June (3.6% annualized), their best performance since January. The non-inflation-adjusted data showed the worst growth of the year. The media choose to focus on the non-inflation-adjusted data, which is the wrong way to look at it. For July, continued tame inflation, a jump in employment, and the largest monthly increase in hourly real wages of 2011 mean real consumer incomes are likely to experience growth just as fast as June's 0.3% jump.

Disposable Income Growth

Consumption Lackluster, Held Back by Autos and Gasoline Purchases
The story on the consumption data was much the same if not as dramatic or quite as positive as the income data. The recent income gains will take a month or two to work their way into the spending data. Note that the trend in the non-inflation-adjusted consumption data look horrendous, while the inflation-adjusted data show we have broken a modest downward trend. May and June consumption data were also sharply depressed (both inflation- and non-inflation-adjusted data) by falling auto sales more than anything else (related to Japanese supply chain issues, depressed inventories, and resulting high prices). Given a general positive chain store sales report for July and improving auto sales, I suspect July consumption figures will be even better on both an inflation-adjusted and a non-inflation-adjusted basis, as shown in my estimate below.


Auto Sales Rebound from Supply Chain Issues
Auto sales had been a real bright point in the economy in the early part of the year before falling apart in May and June because of a shortage of Japanese cars. U.S. dealers took advantage of the opportunity by raising prices and cutting incentives on all cars. That in turn cut demand even further. As the Japanese factories based in the U.S. return to normal, I suspect more discounts and higher unit volumes are just around the corner. Even with just a small rebound in supply and no price relief, July sales looked a lot better than June. July car sales are not consistent with an economy that is falling apart.

US Auto Sales

Employment Data Muddled by Seasonal Adjustment Factors
It now seems clear to me that the seasonal adjustment factors have seriously blurred the monthly jobs report. The numbers this spring were aided by seasonal adjustment factors, while the May and June data were overly deflated. A decent jobs report for July, a month reasonably untouched by seasonal adjustment factors, reinforces my view. Also looking at the data on a year-over-year basis (where the same messed-up seasonal adjustment factors are applied to equally to both years) and using a three-month moving average to smooth the bumps, the employment data become a lot clearer and a lot steadier. The trend looks better, as well.

Private Sector Employment Growth

The 1.6% figure represents job growth of 150,000 jobs per month, which I believe represents an appropriate benchmark for employment growth. The low 80,000 growth rate that we saw in June and the high of 261,000 we saw in February were equally unrealistic. I admit to being faked out by the strong data early in the year; I'll try not to let it happen again. While an improving auto industry, a stronger gas production industry, and better health-care data might get us close to a 200,000 rate, we are going to be hard-pressed to get much better than that without housing beginning to kick in. For more details on the July jobs report, see this week's employment video.

Initial Unemployment Claims Trending Down Again
Initial unemployment claims trended down through most of 2011 before beginning to rise sharply in April. I can't say whether it's just happenstance, but the upward spike did coincide with the U.S. production problems of the Japanese auto producers. As those production problems were fixed in June and July, claims started to fall again. While seasonal adjustments are appropriate, unadjusted data for the most recent week were at the lowest level of the recovery: 339,348.

 Initial Unemployment Claims

Nonresidential Construction Data on the Mend
Even though I usually don't bother to report on construction data, I wanted to show the true breadth of at least slightly positive data that we got this week. News on nonresidential construction is improving if not quite what one would call booming. Nevertheless, it does show slow and steady forward progress. Both the sequential and the year-over-year data look better. Again, this is not indicative of an economy that is falling apart at the seams.

 Nonresidential Construction

Manufacturing Data Looking Weaker
The only bad news this week in my mind was a sloppy manufacturing sector. Below, Adam Fleck, a member of industrials team, sums up the data; It's not all that pretty, either in the U.S. or abroad. However, I caution that manufacturing data aren't particularly good at predicting recessions. The PMI index slipped below 50 four times during the 1990s and proceeded to produce just one recession. Also, though the PMI has been on a relatively strong downward trend lately (after some pretty hefty increases during the last 12 months), employment data point to a manufacturing economy that has steadily added new jobs, albeit at a glacial pace. It seems to me that employment growth in manufacturing would not have continued if company managers were fearful the wheels were coming off the wagon.

Manufacturing Employment

ISM manufacturing survey confirms near-term growth is slowing, but input price declines are a positive. This week, the Institute for Supply Management's Purchasing Managers Index (PMI) measured 50.9 for July; while still indicative of growth, the metric is the lowest since July 2009. Although the index of input prices--at 59--showed the slowest growth in about a year, the overall reading reflected the worrisome tone we've heard from most industrial companies' management during recent quarterly earnings reports. Most troubling, new orders fell below 50--the key demarcation between expansion and contraction--for the first time since June 2009. Inventories also fell dramatically.

Eurozone Markit manufacturing PMI was also markedly slower. According to the authors of the report, the eurozone region's final July 50.4 PMI reading (in line with earlier flash estimates) was the lowest since October 2009 and fell from 52 in June. Only Italy showed sequential strength, climbing back above 50. Both Spain's and Greece's readings remained below 50, and Germany, France, and the Netherlands showed slowing expansion. Per Markit, declining new orders drove the reduced PMI, another negative sign for European manufacturers.

China's HSBC PMI is indicative of reduced industrial production growth, albeit at a high level. China's final July PMI slipped to 49.3 from 50.1 in June, its lowest tally since March 2009. That said, HSBC noted that this level will still support 12%-13% industrial production growth, allowing the Chinese government some room for additional tightening in an effort to further curb input price inflation. Raw material prices, according to the authors, remained muted during the month, a positive sign for industrial manufacturers in the region. In addition, although new export orders reportedly fell for the third month in a row, the rate of decline slowed in July.

Comments on the U.S. Debt Downgrade
Just as we were at our publishing deadline, Standard & Poor's reduced the credit rating on U.S. government debt. Although there might be a knee-jerk negative reaction to the news early next week, nothing new fundamentally was revealed by S&P in its downgrade announcement. The alternatives to U.S. debt for investors looking for large, liquid markets are extremely limited. Even with the Sword of Damocles hanging over the market all week (namely the potential for an S&P downgrade), U.S. debt markets were strong all week, at least until Friday. Although rates could back up a little on the downgrade, I am not expecting a large increase in U.S. interest rates.

GDP Table to Appear in Next Week's Column
I promised a new GDP contribution table this week, but I ran out of room. Next week will be a slow news week with just some warmed-over retail numbers that should actually look pretty positive. The trade balance is also due, and I suspect that news won't be as good there, as the Japanese begin to ramp up production and exports again. That lack of data should allow plenty of room for a fuller discussion of GDP. A quick hint: the highlight is the important role of exports and the amazing disappearing inventory adjustment that walloped the revised GDP numbers. Stay tuned and stay calm.

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

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