It was a bad week for markets no matter how you cut it. All major equity markets were down as were most commodities. China and emerging markets bore the brunt of it, but developing markets weren't spared, either. The major emerging indexes were down, close to 8% for the week. That's not over the past year, but in the past seven days. Europe and the U.S. markets were down in the 6% range. Commodities that were already decimated in prior weeks were down about 3%.
U.S. government bonds, a safe haven for scared investors around the world, were up nicely as the 10-year U.S. Treasury bond yield, which moves inversely with prices, fell from 2.2% to 2.05% after reaching over 2.4% earlier this year.
Though complacent investors, stretched valuations and vacationing portfolio managers might be factors, ongoing China issues were the proximate cause of this week's decimation, in our opinion. The worst of the shellacking happened on Friday when the purchasing managers' report for China confirmed investors worst fears, namely, the Chinese economy was worse off than officials were willing to admit. Headlines trumpeted that China's PMI ratio dropped to a 77-month low and was getting dangerously close to a recession-like level at 47. I am not so sure it was really news. The index has been acting badly for months, but it certainly put the fear of God into investors on Friday. Later in this report, we detail why China may or may not be important to various countries and sectors.
Our main worry is that some trader or corporation somewhere, with a little too much debt and wrong about China's direction, will be put in some severe financial duress. Because of China's more closed economy, we don't, however, believe that a weakening China will result in the same financial contagion as the U.S. subprime mortgage crisis. Still, the possibility cannot be ruled out, and with memories of 2008 and 2009 still fresh, potential fear can overwhelm the reality of the economic situation, causing investors to hit the panic button around the world.
The economic news was surprisingly good for the U.S. and even Europe (a nice increase in their purchasing manager reports) this week, perhaps suggesting that China is not the be-all and the end-all of the world economy. U.S. housing data was especially strong this week with recovery high housing starts and existing-home sales. Those strong numbers should have knock-on effects on the U.S. economy as those homes are financed, furnished and remodelled.
Inflation in the United States was also surprisingly tame, taking a little heat off the Federal Reserve. Its most recent set of minutes, which seemed to show a greater willingness to raise rates, are not terribly relevant as the situation in China worsened. It's tough to justify a rate increase in the face of financial turmoil. However, it is highly unlikely that the Fed understood how strong the U.S. economy was in the second quarter. Next week, based on already-released data, we suspect the U.S. Bureau of Economic Analysis will raise the GDP growth rate for the second quarter from 2.2% to a range of 3.0%-3.5% with the emphasis on the higher end of that range. For the full year we are still expecting U.S. growth of 2.0% to 2.5%.
Markit world PMI data shows mixed results
Markit purchasing manager reports are almost always market-moving, and the August report kicked off one of the worst stock market routs in years. Overall, Markit flash purchasing manager data showed a very soft and weakening China, a decent and improving Europe, and an acceptable but softening U.S. manufacturing sector.
The U.S. reading is still the strongest of the bunch, though it moved down to from 53.8 in July to 52.9 in the August flash report. The report noted a strong dollar and slower exports as well as the continuing slump in the oil patch as the reasons for the softening. (We generally prefer the ISM purchasing managers' report for the U.S. sector, but the Markit data provides an earlier look and helps judge relative country performance.)
European manufacturing holding its gains
Markit was effusive in its praise of the European economy in its flash report, though the report didn't seem like anything special to us. While the composite of services and manufacturing was up nicely and the employment composite looked particularly strong, the manufacturing-only component remained stuck at 52.4 in August, the exact same reading as in July (and the August manufacturing flash report for Europe is still less than the U.S. reading).
Markit pointed out that manufacturing hiring made its steepest increase since 2011. In some ways employment growth and forcing unemployment rates down is almost more important than overall economic growth, which may be why Markit was so tickled about the European report. Though we generally focus on manufacturing, the composite, which includes services and manufacturing, increased to 54.1, which is very close to a recovery high and represents 26 months of growth.
It's interesting to note that the eurozone excluding France and Germany is doing exceptionally well, now registering a clear recovery high with mid-50s readings well in excess of either Germany or France. Clearly a softer euro and cheap energy prices have been a bigger factor in the European periphery than in France or Germany. French performance in August was again disappointing, but I am not sure if we should read much into this vacation-dominated month. Germany appeared to be gaining a little momentum, but I fear that won't last long. Low oil prices will limit export sales of energy-related equipment to the U.S. and Russia. In addition, China is an important export partner for Germany (2.6% of GDP versus 0.9% for the U.S.), so the slowing effect from China will be much bigger there than in the U.S.
Overall, Markit indicated that the July and August data combined suggest that European GDP growth may accelerate marginally from 0.3% (1.2% annualized) to 0.4% (1.6% annualized), which is certainly moving in the right direction. Its analysis is based on correlations between previous PMI readings and reported GDP. With the extensive quantitative easing combined with lower energy prices, the improvements in Europe do not come as a real surprise.
China slump is for real
Several weeks ago, when China announced it was devaluing its currency modestly after a multiyear run, many investors correctly reasoned that China's economy must be slowing. Indeed, statistics over the past several weeks have confirmed this thesis, including this week's Caxias Purchasing Manager Index. So there can really be no more denying that something is amiss with China's economy.
This month's composite index fell from 47.8 to 47.1. That would represent the lowest reading in almost 6.5 years. Any reading below 50 demonstrates that more firms are reporting slowing than are showing growth. Both new order and export growth readings were also below 50, suggesting that there may be even more contraction ahead.
Through a combination of the law of large numbers, slowing population growth, slowing investment spending, and softer exports, China's growth has been moderating for some time as we have noted in many previous columns.
While the Chinese government has so far remained steadfast in its forecasts of 7% GDP growth for 2015, that has always appeared to be a stretch to us. Something in the 6% range for 2015 and dropping to the 3%-5% range over the next five to 10 years seem to be a more likely scenario to us.
What does slower growth in China mean for the U.S.?
The direct answer is, relatively small. Exports of all goods and services that the U.S. ships to China amounted to 0.9% of U.S. GDP for all of calendar 2014, with two thirds of that being goods and one third being services. And a lot of those exports relate to necessities such as food and fuel, and a large portion relates to airliners under long-term purchase agreements. While there could be some shrinkage in what the U.S. sells to China, it is hardly big enough to move the economic needle.
Perhaps more affected will be multinational corporations that sell a lot to China, but ship those products from outside of the United States. Those firms did particularly well just after the recession ended, even as U.S. GDP growth remained anemic. We may now be seeing the reverse of that, where multinational earnings are hurt by weak overseas demand as the U.S. economy continues to chug along. U.S. commodity producers, especially the energy industry, are also suffering. And anyone producing equipment to process/mine commodities is in a world of hurt at the moment. However, these are probably not big enough sectors to truly damage the underlying U.S. growth rate. And commodity-oriented corporations suffering from lower growth and lower prices are likely to offset gains from increased consumer spending power.
China's slower growth will continue to help reduce commodity prices. Energy, lumber, copper and even paper prices have generally been soft this year and may become even weaker. That could help bring down the price of all new construction, which would be welcome news for homebuilders and new homebuyers. It may even help tip the balance toward more new homebuilding rather than the purchase of an existing home. A stronger housing market combined with a 10% decline in commodity prices overall would help the U.S. consumer more than slowing U.S. exports to China would hurt.
Consumer price growth slows surprisingly, except for rents
On a month-to-month basis both headline inflation and inflation excluding food and energy were just 0.1% (1.2% annualized) versus expectations of 0.2%. Year-over-year inflation was up just 0.2% as energy price declines earlier this year continued to weigh on the annual results.
Core inflation, which excludes food and energy, was up 1.8% over the past 12 months. The core rate has been at 1.8% for four of the past of the past five months. Though the Fed uses a slightly different metric, that 1.8% rate is tantalizingly close to its long-term 2% goal.
By category, the inflation rates seem to be converging some, with a balance of price losers and gainers. Energy items dominate the losers list, but both new and used cars as well as airline tickets were down, too. Restaurant food prices, for an unusual change, were flat and even health care was up just 0.1% month to month.
On the increase side, the worst news was that rent prices are continuing to accelerate, gaining 0.4% in a single month and now at a 3.6% rate year over year. Unfortunately, those renters, who are more typically urban dwellers, may not even own a car and are not reaping the benefits of falling gasoline prices. On a year-over-year basis, only motor vehicle insurance is growing faster (5.4%) than rents. Even health-care and pharmaceutical drug prices are growing at a slower rate than rents.
With sky-high rents and low raw material prices, one might expect homebuilders to be pulling out the Champagne as renters figure out that owning a home is a lot cheaper than renting. Builder sentiment data (which is now at a recovery high of 61) and some of the housing data seem to support that thesis, as we note below. However, we are more than a little concerned that high rents may make it difficult to save for a down payment.
New residential construction in good health as starts hit new recovery high (by Roland Czerniawski)
This week's report on new residential construction showed that the housing market revival continues. While the news about the weakness of many economies around the world, particularly China, have been dominating the headlines, the pace of the U.S. housing market seemed to pick up considerably. Permits were good, and starts were even better, beating most expectations. This week's report was without a doubt one of the best new construction reports of this recovery.
Permits were down 16.3% from an incredibly high number last month, which was a widely expected decline. Year-over-year, permits were 7.5% higher in July and averaged for three months, year-on-year growth was 20%. We have not seen permits that strong since late 2013. To be fair, both May and June permits numbers were highly elevated due to the expiring tax break for multifamily New York City developers. Single-family permits were up a more modest 6.1% year over year in July.
The starts portion of the report looked much more impressive than the permits. Total starts were 1.2 million in July, just slightly up from an already-high level a month ago. June and July starts both recorded the highest readings of this recovery. What was particularly impressive about the starts was the single-family category, which increased 12.8% month to month, and 19% year over year--the highest single-family reading since 2007.
One of the reasons single-family builders are rushing to build more homes is a large drop in lumber and copper prices, which are down nearly 20% compared with just three months ago. That creates a huge incentive for any builder to take advantage of much lower prices for those crucial homebuilding commodities. The lower prices might not only help to improve the builders' bottom line, but also could allow them to pass on more discounts, and consequently improve the affordability of new homes. Regionally, the best single-family category was the Northeast, with a stunning 67% increase. Other regions were strong, too, posting double-digit month-to-month growth rates, with the South being the only exception with a 3.8% increase. These are all solid results.
The tables below show a very clear trend of rapid improvements in the construction industry. The latest growth rates for both starts and permits are probably not sustainable and will most likely come down to low double-digit figures. Nonetheless, those would still be good growth rates, especially considering that the full-year starts growth has not grown double-digits since 2013.
Existing-home sales join the housing party (by Roland Czerniawski)
The strength of this week's housing news was not just limited to new home construction. Existing-home sales also reported the best number of the recovery at 5.6 million units in July. Despite relatively low inventory levels, which are about 100,000 units fewer (annualized) compared with last year, the average sales price was down month to month, and the year-over-year pace of growth has moderated substantially to 3.9%, or 4.6% when averaged for three months.
The price growth rate moderation has not stopped the total transaction value (average price times units sold) from rising yet again, this time to a new recovery high. The total transaction value was up 64.2% annualized from the first to the second quarter, and those relatively large increases continued in July. This means that sales commissions, which are part of the GDP calculation, could be poised for another quarter of growth. Existing-home sales also benefit mortgage brokers, and they eventually drive sales of furniture and remodeling materials. 
Home Depot HD reported better-than-expected earnings this week and issued a positive outlook after seeing an accelerated housing market recovery in the second quarter.
These are all the signs that the housing recovery has, in fact, accelerated. It is not clear whether we're seeing the beginning of a new boom or just a moderate pickup, but the housing market now appears to be in a much more healthy state than it did just six months ago.
Next week: 2Q GDP could get a huge boost. Plus, new and pending homes sales, durable goods, and personal spending
The statisticians have been very busy over the past month since the first read on the second-quarter GDP growth rate. The original report showed just 2.2% growth. However, if one adds up the known revisions over the past month, GDP will potentially be revised as high as 3.5%.
About half of the improvement will be from higher-than-expected inventories, which isn't the most helpful thing in the world. However, the other half of the gain will be due to highly positive factors, including revised retail sales, higher construction spending, and more government expenditures. Economists are onto this potentially large revision, with a consensus estimate for 3.4% growth in the second quarter. However, I am not sure that most investors are aware that growth will potentially look that high. Or if they are, they seem to be convinced the stronger second quarter will mean a weaker third quarter. Given an accelerating housing market, that is not necessarily a foregone conclusion.
This week showed the current state of the housing industry as very strong and accelerating. Next week brings the two more forward-looking housing metrics, namely, pending home sales and new home sales. The pending data is usually a great indicator of future existing-home sales, though last month it predicted existing-home sales might be down modestly, even as existing-home sales managed a nice increase. Rapid moves to close before school started may have shortened closing times, so maybe pending sales will manage a nice increase for July when they are announced next week.
The new home sales report can be quite predictive because it is the only report that includes homes sold prior to commencement of construction in addition to already started and even completed homes. Current estimates are for new home sales to be very near the three-month moving average of 507,000 homes. We believe sales could be slightly higher, perhaps as much as 525,000 units for the month of July.
Durable goods orders could be OK
Forecasts for durable goods orders seem to be all over the map, with some estimating gains of over 1% while others believe orders could decline as much as 1%. Volatile airline orders may account for some of this variability. The bulls are counting on a strong auto market to pull things up, while the bears are worried about Boeing BA orders and renewed declines in the oil patch. Various purchasing manager reports seem to suggest no real boom or bust in the manufacturing cycle just yet. The consensus forecast is for a 1% decline, which seems too pessimistic to us.
Income and consumption data should look good
Current expectations are for income growth of 0.5% and spending growth of 0.4%, both better than last month. The consumption report will be helped along by a decent retail sales report and a strong month for autos in July. However, cool weather may have limited spending on air conditioning, which puts a little bit of artificial pressure on the consumption number. A good employment report that included an increase in hours worked as well as some wage gains should help push up the income number faster than consumption. We will also be closely monitoring the PCE inflation metric, the Fed's favourite inflation gauge. Expectations are for it to mirror the 0.1% CPI inflation rate, though that seldom happens. This will be the last inflation report before the Fed's September meeting.
