Following last week's jubilation about the U.S. Federal Reserve reducing economic forecasts and not immediately raising rates, the reality of economic activity not booming began to set in. In the reverse of last week's activity, almost every equity market was down, ranging from a 2.7% fall in the United States to a tamer 0.7% decline in Europe, with emerging markets splitting the difference.
The big news this week was that there was now more data to sharpen those first-quarter economic forecasts, including a disappointing durable goods report. The recent data in terms of weather and energy-related investments have not been positive, causing a number of major economists to slash their first-quarter U.S. GDP forecasts from a high of 3% to a new range of 0% to 1.5%. Like 2014, we suspect the weather-related issues will cause at least some snapback in spring and summer. However, the slow start may make it difficult for the economy to hit the 3% or higher growth rates for the full year that were prevalent just a month or two ago. For some time we have believed those estimates were too high because of knock-on effects of a slowing energy industry and a slowing manufacturing sector. Terrible February weather further compounded that problem.
Besides the disappointing durable goods orders report, inflation picked up again, as did energy prices. Existing-home sales were also soft, raising even more doubts about the housing industry, although a more nuanced analysis of the data showed year-over-year trends continuing to improve. In contrast, new home sales data was surprisingly strong no matter how one looked at it. To top off that report, even the data for January was revised upward. A lot of the interest was in homes still on the drawing board or already completely finished, explaining why some of the other reports did not pick up on the strength. Most of those more negative reports focus on when the shovels literally hit the ground.
On the international front it appears that the European manufacturing sector is already picking up while China continues its modest slump. Also weighing on stocks this week was more warlike activity in the Middle East that helped boost energy prices but scared other equity fund managers.
Janet Yellen also spoke late Friday and the markets seemed to like her statement that interest rates would only be increased in small increments, but not necessarily on any type of fixed schedule. And she said all changes would be data-driven, not automatic (as they were in the Greenspan era between 2004 and 2006).
Like a lot of economic indicators, inflation is highly volatile and the month-to-month numbers are often hard to put in context. Very volatile food and gasoline prices as well as weather issues can complicate even the analysis of normally more reliable year-over-year data. Despite the jumpiness of the data, it seems relatively clear to us that inflation is likely to hit bottom in the first half of 2015 as energy prices stabilize and non-food prices show continued strength.
The report for February showed that the inflation rate between January and February was 0.2% (2.4% annualized), following three consecutive months of deflation. The year-over-year inflation rate moved back to the zero mark after falling briefly into deflation territory in January. Although I am not a huge fan of excluding food and energy, those prices were up a surprisingly robust 1.7%. Energy, which constitutes 7% of the index, was down 18.8%, and food, which constitutes 14% of the index, was up 3%, all in a single-month year-over-year basis.
Though the Fed prefers to use a different inflation index, that 1.7% Consumer Price Index rate is not all that far off of the Fed target. Inflation in the United States, despite all the popular posts, has not gone away. Those who had hoped that falling energy prices would bleed through to other prices (lower energy costs would theoretically cause vendors to decrease prices because their own energy costs were down) seem to be just a little too optimistic. Those who thought prices would go through the roof as consumers would spend all their gas savings in a willy-nilly fashion, driving up prices, appear to be equally wrong. Inflation less food and energy has been stuck at a 1.6%-2.0% rate for the past 13 months.
If consumers complain that prices don't really seem down outside of gasoline, they wouldn't be far from wrong. Below is the year-over-year category data.
Four categories--none of them small--are up more than 3% year over year, and the prognosis for the year ahead is for continued price increases in these select categories. Continued demand for apartments combined with limited new housing starts is likely to keep the shelter category moving ahead at 3% or more in 2015. As shelter constitutes almost a third of the CPI calculation, it will be very difficult for the CPI to fall below its current 1.7% growth rate. Even if energy prices recapture just a small portion of their losses over the next 12 months, the total inflation rate could easily move to 2% to 2.5%, even in a slow-growth economy. We would like to say that food prices have the potential to drop back, but meat prices are still sky-high and are still moving up. The California drought could also cause fruit, vegetable and nut prices to move up again, after a two-month hiatus in price increases in this category.
Key inflation drivers could move into danger territory over the next couple of years
The four key factors that drive long-term inflation are the output gap, fiscal policy, monetary prices and commodities. Longer term, an easing in fiscal policy and a closing in the output gap are likely to keep prices moving upward. The output gap (the spread between the economy's theoretical capacity and actual output) has been closing quickly. At the bottom of the recession, the gap was as wide as 7% and is currently down to just over 2%. Sometime between late 2016 and early 2018 that output gap could easily close to zero. Every time the economy has moved into a position where it is operating at or above theoretical capacity, inflation has accelerated.
In the short run, commodities will potentially remain under control, with falling demand from China. However, the overall commodities category has been trending down for more than five years, so it seems difficult for commodity price decreases to continue indefinitely. There are limited supplies of some commodities, and the population continues to grow, albeit at a slower rate than in the past. Slightly tightening monetary policies could help keep a lid on price increases, though.
Housing data shows overall improvement (by Roland Czerniawski)
The housing reports this week appeared to be highly contradictory, but after more careful analysis, the data all tended to point in the direction of improvement. First, on Monday, existing-home sales were viewed as disappointing with 4.88 million homes sold (annualized), falling slightly below the consensus. Our focus was, once again, away from the headlines and on the year-over-year trends. The year-over-year, three-month average growth rate for existing-home sales stood at 4% in February, marking a fifth consecutive monthly improvement. True, harsh weather affected last year's winter months, and those numbers might look just a little better than they should. But those improvements shouldn't be overlooked, especially since we put them through the three-month moving-average lens. There are no signs of a boom by any means, but existing-home sales appear to have emerged from last year's slump, and that's encouraging.
The median price was up just slightly, which might be related to the flattening of the inventory growth that has now turned negative year over year. To be fair, January and February inventory levels are typically the lowest of the year, but they now appear even lower than usual. Low inventory levels could be a detractor from future sales, especially if prices continue to rise. Without improving inventory levels it will be difficult to increase sales levels. Like a lot of things, maybe poor weather discouraged sellers from putting their homes on the market.
The second piece of the housing puzzle was the new home sales report, and those numbers looked incredibly good. The sales came in at 539,000 units annualized in February, blowing away the 462,000 consensus view. The January figures were revised upward too, from an originally reported 481,000 to 500,000. Those are really great results, but again, the year-over-year numbers might look just slightly better than they should because of poor weather last year. Nonetheless, it's great to see that the pace of price growth for new homes is moderating, and median prices are even falling on a monthly basis. That is a positive development that we thought was crucial for new homes to gain more traction in the current market.
Interestingly, the proportion of homes sold in the low- to mid-price range is now much greater than it was late last year, when prices for new homes were skyrocketing as the industry appeared to be focused on building mansions instead of homes for middle-income families and first-time homebuyers. Now that proportion is more in favor of lower-priced homes, and along with the median price, it has been improving for the past three months. As we mentioned in last week's column, 
Lennar's LEN earnings transcripts seemed to be confirming this development, as builders appear to be focused on building more competitively priced homes in order to cater to first-time homebuyers. That's very encouraging, and it could explain why new home sales are doing better all of a sudden.
It was also surprising that this new home sales report seemed to conflict with the very disappointing housing starts figures reported last week. After more research, we were able to determine that a large part of February's new home sales improvement was due to sales of homes for which construction had not yet started. (The report also includes totally finished homes that have been sitting around on a builder's lot and were counted as starts in a prior months. This category of new home sales is also on the rise.) These two categories of new home sales allows us, at least partially, to reconcile some of the differences between poor starts and great new home sales, and it should also point to potentially better housing starts going forward. Last week's more forward-looking permits data (second-highest number of permits pulled this recovery) was also very consistent with the surprisingly strong new home sales report.
The final piece of this week's housing data was FHFA's Home Price Index. That report showed that home prices are rising again after bottoming out at about 4.7% last year. The latest year-over-year, three-month average price growth came in at 5.3%, marking a fourth consecutive increase on that basis. While that is still within our 4.5% to 5.5% price growth prediction this year, it might be alarming if prices were to rise much further. As we have seen before, rapid price growth tends to put a dent in affordability and can derail the housing recovery in a matter of just a few months. While the pace of home price growth is not problematic just yet, it is worth monitoring. It will be interesting to see whether next week's S&P/Case-Shiller 20-City Index will confirm this trend. Again, the higher price growth might be related to the unusually low inventory levels of existing homes, which we hope is temporary.
Manufacturing shows a mixed picture
The durable goods order report managed to disappoint investors yet again with orders declining 1.4% between January and February. Even including the volatile transportation sector, orders were down 0.4%, representing their fifth month-to-month decline. The downturn was relatively broad-based with five of seven major categories in decline and just primary metals and electrical equipment showing increases. Orders for durable goods tend to show up as actual production in the following months, making this a relatively important economic indicator. Indeed, the beginning of the decline in month-to-month durable goods orders (excluding transportation) that began in October preceded the decline in industrial production that began in December. I suppose the one piece of good news out the report is that the rate of decline has begun to slow. While the month-to-month decline in orders was 1.2% in October, the rate of decline has dropped to 0.4% for February. However, the year-over-year pattern is still eroding, as shown below.
Not to confuse matters, but we also like to look at non-defense capital goods excluding transportation. They have an even longer lead time and more expensive items included than in the durable goods report. They are also a good indicator of overall business confidence--and the news here is not good. This index started moving down even a month earlier than the overall durable goods index and is now down a scary six months in a row. The year-over-year data has fallen off a cliff too, but at least the trend there has stopped going down.
All of this seems to suggest the deterioration in industrial production and the manufacturing sector isn't quite finished. Certainly, weather and port issues haven't helped and might begin to help the data in the months ahead. However, as we have talked about for many months, a slower-growing auto sector, export-related issues, and a cratering energy sector could limit the improvement. A weaker manufacturing sector was the primary reason that we had a lower 2015 GDP forecast than most other economists at 2% to 2.5% versus 3% or more. In relatively short order our way-off-the-consensus forecast has become the consensus. As bleak as some of the manufacturing data has been, I think that an improving housing economy, especially for new homes, better weather, and a resolution of the port strike will keep the manufacturing sector from falling apart and doing real damage to the economy.
World purchasing manager reports show a modestly brighter picture
Data from Markit suggested that the U.S. manufacturing sector might have bottomed, with a modest increase. A weaker currency has given Europe a nice boost with four increases in a row in the Purchasing Managers Index data. At 52.9 the index for Europe is at its highest level since May. China remained in its funk with the China index dropping to 49.6, indicating that more firms were seeing a contraction than an expansion.
The Markit data has not been particularly useful for determining trends in U.S. activity. While the index has dropped some, it is bouncing around in a trendless and very narrow band. At least it suggests that the U.S. manufacturing sector isn't falling apart, and it remains the strongest of the major manufacturing powerhouses. The slow data on China is consistent with growth forecasts that have been coming in for some time. Those expecting a quick rebound are likely to be disappointed. A relatively strong currency is not helping Chinese exports. The news out of Europe is quite exciting--especially if that momentum can be maintained. A weaker currency has clearly helped and should continue to help, along with the lower interest rates and falling gasoline prices.
GDP shows just modest revisions for fourth quarter
The third and final reading for the fourth quarter came in at 2.2%, unchanged from the second reading. These are the comparisons for the fourth quarter compared with the third quarter and then annualized. Recall that this is a highly volatile series that isn't terribly representative of the real world. Still, this is how most of the GDP data is reported in the press. On this basis the report was modestly disappointing because we thought a revision to some services categories could boost the final result. Unfortunately, changes in inventory data basically offset the consumer services number. At 2.2%, the fourth-quarter result was less than half of the growth rate of both the second and third quarters. Overall, the consumer category showed accelerating growth and was by far the biggest contributor to GDP growth. Business investment growth was also good, but not as robust as the prior two quarters. Net exports, government, and inventories all subtracted from the GDP calculation in the fourth quarter on a quarter-over-quarter basis.
The year-over-year growth rate (as opposed to the volatile and not representative quarter-over-quarter annualized data) in GDP was 2.4%, a level that we believe to be sustainable in 2015 and consistent with the past three or four years.
As an early warning, estimated first-quarter 2015 GDP growth rates have been tumbling over the past several weeks because of both weather-related (reversible) and energy-related (less likely to be quickly reversed) issues. Most of the new forecasts for growth in the first quarter are between 0.0% and 1.5%, down from as high as 3% just a few short weeks ago and the 2.2% growth rate of the fourth quarter. As I always say, forewarned is forearmed. I would suspect that there would be a sharp bounceback in both the second quarter and maybe the third quarter, as there was a year ago. While the weather-related bounce could be smaller in 2015 than 2014, the settlement of the West Coast port labour issues will be an additional positive factor in the second quarter of 2015. However, we are still a month away from the first estimate of first-quarter GDP growth.
Personal expenditures, auto sales, manufacturing, and trade data all scheduled for next week
Of these, the personal expenditures report is probably the most important along with auto sales. Consumers generate about 70% of GDP so consumer health is absolutely critical to the economy and the calculation of GDP. This report is for February and is expected to show 0.3% growth before inflation and just 0.1% after inflation. The goods portion of the report is likely to look terrible, based on the retail sales reports, but services are likely to get a short-lived bounce from energy usage. That compares with a 0.2% decline before deflation and a 0.3% increase after deflation for January. Even with a big bounce in March, consumption is likely to fall well below the 4.4% consumption growth rate reported for the fourth quarter. This in turn could trigger some more downward GDP revisions from those slow learners that will be forced to face the reality of temporarily slowing GDP growth.
The employment report may or may not prove to be exciting. After a string of accurate forecasts for most of 2015, our hand has turned stone cold. We have noted that slowing economic conditions should have led to slowing hiring activity. We have been dead-on the economic slowing situation but employment has continued to accelerate anyway. That is not exactly a logical relationship. About all I can figure is that employment is a strongly lagging data set. Currently it is still primarily reflecting the back-to-back quarters of nearly 5% GDP growth last summer and fall. That would have been the same period when hiring budgets were set for 2015. There is little chance that those hiring budgets could be revised that early in the year, without an earnings disaster or a noticeably slumping economy. The slumping may become more visible in the weeks ahead. Exactly when the hiring brakes go on isn't at all clear. Initial unemployment claims remain at record lows, not just for this recovery, but also for all of more than 60 years of data. Given that the strong employment growth has been due to steady hiring and sharply declining layoffs, it seems like it would be hard for employment growth to take a huge hit without at least some degradation in claims data. Still, at some point, probably when we least expect it, the monthly employment report will disappoint investors. The consensus is for nonfarm payrolls to grow by 255,000 people, down from February's surprisingly strong 295,000 level. Even if this seems theoretically high, most employment data seem consistent with this forecast.
Economists are guessing that auto sales will rebound month to month from 16.2 million seasonally adjusted annualized units to 17 million units in March. We have had a couple of month-to-month declines in a row and better weather should help reverse that trend. Still, the 17 million number seems a bit optimistic to us. Year-over-year improvement is likely to be minimal given the massive weather-related bounce in March of a year ago. A softer oil patch and slumping housing starts might also weigh on the short-term numbers.
The trade deficit was a big hurt to the fourth-quarter GDP report and the first quarter could be just as bad. The West Coast port dispute is now settled. The question is, which will it help more, exports or imports? Given the larger relative size of imports, we are guessing that while helping manufacturing and exports, the settlement will boost imports even more, potentially driving the trade deficit higher. The consensus is for modest deterioration from a deficit of US$41.8 billion in January to an even US$42 billion in February. That seems in the right range, but could be a trifle optimistic.
