(By Robert Johnson, CFA) Though there was some movement midweek, the S&P 500 remained unchanged for the week despite a flood of economic news, most of it positive, at least when properly analyzed.
Even more surprising was the yawn given to the Fed's new quantitative easing program (even more bond buying and continued low rates) as well as the Fed's new concrete programs drawing new lines in the sand about when to end these programs based on inflation and employment metrics.
Even continued lack of progress on the fiscal cliff didn't really move the market much (except maybe a little down on Thursday). I guess after a 15% upward move in the S&P 500 this year, and all the potential uncertainty and valuation metrics that suggest that equities are fairly valued, it is not surprising that equity market looks like the proverbial deer in the headlights, afraid to move in either direction.
The doom-and-gloomers thought they were gaining the upper hand after a series of Sandy-swamped economic reports (October consumption, industrial production, and retail sales) combined with already sloppy fall data. The fall statistics were hit hard by rising gasoline prices and seasonal machinations in the volatile auto sector. The normally well-respected ECRI consultancy affirmed that they believed we already we were in a recession (for at least the second time this year). Dr. Gloom himself, Nouriel Roubini tried to toss cold water on recent positive economic news. We didn't even have to wait a week to find these two bears were premature yet again.
This week world purchasing manager indexes moved uniformly upward in all regions of the world: U.S. industrial production jumped 1.1%, retail sales managed to move up 0.3% despite a huge headwind of 0.3% deflation in the month of November, and weekly initial unemployment claims hit a new recovery low. That's on top of last week's surprise jump in auto sales to 15.5 million units and a decent employment report.
If It Weren't for the Fiscal Cliff...
If it weren't for the fiscal cliff, I think markets would be relatively happy and performing better than they are now. A better housing market, a well-contained inflation rate, an accommodating Fed, and a soft landing in China would normally have markets cheering even if valuations are looking a little stretched. But what about our boys and girls in Washington and the fiscal cliff?
There really isn't a lot more intelligence that I can add to the discussion. Eventually the government has to raise taxes and cut expenses. Period. Do we do it slowly and spare the economy or do it quickly and conduct a giant science experiment on how much austerity the world's largest economy can endure without cracking? It could be that U.S. citizens might surprise themselves with their resiliency. And the true effects of the new taxes and spending cuts may take longer to take effect than the word "cliff" seems to imply. But it's still an experiment that no one in their right mind would consciously undertake.
The Consumer Is Alive and Well After All
The retail sales report for November was quite a positive surprise and validates my belief that as of last month, consumers were still not backing off making purchases, despite the fiscal cliff. Headline retail sales were up 0.3%, pretty much as expected. The real surprise was that stripping out autos, sales showed no growth, instead of declining 0.3% as most economists had anticipated. Leaving out gasoline, which was down mainly because prices were down, monthly total retail sales would have been up 0.4%. Not bad for a month when 25% of the population was out of commission for most of the first week of November because of Hurricane Sandy.
A lot of individual categories did very, very well with only gasoline stations, grocery stores, and department stores showing a decline.
Non-store retailers such as Amazon.com (AMZN) did well with some Black Friday/Cyber Monday benefits showing up in the numbers. Early in the month, the storm may have caused more shoppers to consider online purchases. (The converse of this is the poor department store numbers, which are being hit hard by online sales.)
Electronic stores are doing better with a flurry of new products (iPad, iPhone, Windows 8, and now the Wii U, all helping electronics retailers). Building materials also did well, though post-Sandy rebuilding, probably artificially, boosted this category. However, I suspect we have at least another month or even two of higher building materials sales.
Auto sales were also perhaps helped along by Sandy-related damage and replacement cycles (though October numbers were badly hurt by the storm). Better furniture sales, which have been improving for some time, probably got a lift from rising housing starts, and potentially storm replacement needs. Though not shown in the table above, restaurant sales were up a strong 0.8% in November. I always like to see a strong restaurant number because I believe it's a decent indicator of consumer moods.
The year-over-year data excluding autos and gasoline (on a three-month moving average basis) were not quite as robust. Sales remained in their usual rut of about 4% year-over-year growth, as shown in the table below.
Without the effects of Hurricane Sandy, I believe that October and November would have shown at least 4% growth. Slower year-over-year growth rates in retail sales since June is primarily a result of falling inflation and not a big shift in demand. Last year, inflation was running at about 3.6%, while this year inflation is growing just under 2.0%. Unfortunately, the retail sales report is not adjusted for inflation, one of its primary flaws.
Initial Unemployment Claims Indicate Steady Employment, Though Some Numbers Too Good to Be True
Initial unemployment claims fell sharply to 343,000 for the week ended Dec. 7, the best level of the current recovery. I think the number is good and indicative of a decent but not great employment picture.
I wouldn't get too carried away with one week's worth of data, though. California processed a huge number of claims the prior week to make up for days not worked during Thanksgiving week. Processing of California claims dropped back to normal rates for the week ended the Dec. 7 (this week's report). That is why it is always best to look at the four-week moving average, which has now moved back to 385,000 and is highly likely to fall back into the 360,000-ish range in the next week or two.
I am going out on a long limb here, but I think I can definitively say that the spike we saw in initial unemployment claims was due solely to Hurricane Sandy. Furthermore, firing patterns have yet to see any worsening due to worries about the fiscal cliff, despite the media hoopla.
The CPI, the Single Most Important Economic Variable, Moves Down in November
Month to month, consumer prices dropped by a hefty 0.3% in November following a smallish 0.1% increase in October. Gasoline prices led the index lower with a massive 7.4% decrease in just one month (that is not annualized). However, there was a lot of good news in other categories, too.
Used-car prices were down as were drug prices and apparel. Some of the big gainers included electricity and natural gas, which are finally catching up for some large declines earlier in the year.
Registering a 0.3% increase for the second month in a row, food at home prices were elevated but not as bad as I feared given the severe drought. Looking ahead to food prices in the months ahead, the Producer Price Index for finished goods registered an outsized gain in November, which probably means at least another month or two of increasing consumer prices for food.
The good news is that raw food prices and intermediate goods were both nearly flat in November, which could mean the recent runup in food prices could come to a close by early next year.
The year-over-year data continues to be affected by a sharp increase in energy-related products late this summer and the current bounce in food prices. Still, at 2% year-over-year growth, the CPI is far from the 4% level that typically triggers a recession. With energy prices continuing to fall since the November report and with food prices near an interim peak, I believe that year-over-year inflation will fall to well below 2% early in 2013.
Fed Opens the Spigots Again
David Sekera, Morningstar's director of corporate bond strategy, summed up this week's Fed's announcements as follows:
"The Fed announced that it would purchase outright $45 billion of long-term Treasuries after Operation Twist ends. In addition, the Fed eliminated the calendar date guidance on how long it anticipated keeping interest rates at zero. Instead, it replaced the calendar date with an unemployment target of 6.5% as long as one- to two-year inflation projections are below 2.5%. Based on the FOMC's current projections, unemployment would decline to that level sometime in the first half of 2015. If the Fed were to purchase $45 billion of Treasuries and $40 billion of MBS through then, it will increase its holdings by approximately $2.5 trillion, nearly doubling the size of the Fed's current balance sheet.
"The intent of the Fed is to support the housing market by reducing rates on mortgages. By keeping mortgage rates low and supporting the housing market, the Fed believes its monetary policy will transmit into the broader economy as home affordability improves and homeowners refinance into lower-rate mortgages, freeing up disposable income. The Fed's premise is that as house prices stabilize and rise, banks will become more willing to extend credit and consumer sentiment will improve as household net worth increases. Considering zero interest rate policy (ZIRP) was launched in December 2008, that target would entail six and one half years of ZIRP. With inflation ranging from 1.5% to 2%, real interest rates are negative through the 10-year Treasury, resulting in considerable financial repression for savers."
Import/Export Data: Lots of Hysteria, Not Much Analysis
The trade deficit increased slightly from a downwardly revised $40.3 billion in September to $42.5 billion in October. Despite what the pundits are saying, that is good news, in my opinion. The deficit is still at the very low end of its 2012 range of $40.3-$52.3 billion. In fact, adjusted for inflation, the deficit in goods declined from September to October and was at its best level of the year.
The goods deficit is even lower than it was a year ago, an event that almost never occurs during a period of economic expansion. While a lot of economists are whining about the slightly higher non-adjusted deficit in October and how it is likely to be a detractor from GDP in the fourth quarter, they are dead wrong so far. The BEA uses only inflation-adjusted numbers to figure GDP. The October deficit was lower than any other single month of the third quarter. That means, with just one month on the books, that the fourth quarter has the potential to be a net contributor to GDP.
Trade Deficit Changes Reflect Routine Shifts and Storms, Not a Dying World Economy
A lot of the economic analyses I saw focused on down non-inflation-adjusted exports as a sure sign that a slowing world economy was finally beginning to take its toll on the United States. And certainly down imports to the U.S. showed that even internal U.S. growth prospects were beginning to crumble. Indeed, exports of goods were down in October, with goods exports down $6.5 billion, or almost 5%.
But almost two thirds of that decline had nothing to do with the state of the world economy. Soybeans and other grain shipments were down $1.4 billion, not because of demand but because of drought-restricted supply. Petroleum exports were down $1 billion primarily because of lower prices. Gold shipments were down $0.9 billion along with $0.3 billion in other gemstones, hardly bulwarks of the U.S. economy. Airliner shipments also dropped $1 billion, not reflecting anything about world demand, instead showing changing Boeing (BA) production schedules and mixes of domestic and international customers in any given month. Imports were also indeed down, though much less than exports were.
Rather than reflecting a broad decline in U.S. demand, the entire amount of the October import shortfall can be accounted for by falling oil prices and decreased iPhone shipments. These kind of blasé shifts of everyday commerce aren't nearly as exciting as talking about a collapsing world economy. (By the way, shipments of goods to Europe were actually up from September to October.)
Post-Sandy Rebound Boosts Production
A combination of a sharp increase in auto production and a bounceback from Sandy boosted industrial production 1.1%, more than offsetting October's storm-reduced 0.7% decline. Year-over-year data is up about 2.5%, which is still a little below the 3% trend that I would like to see.
I surmise that November production was not completely back to normal as the first few days of the storm also affected November, not just October. The PMI data below suggests an even sharper rebound next month. Most categories showed substantial improvement from October, but autos were by far the standout, increasing 4.5% sequentially. Actually, a lot of durable goods categories looked particularly strong, suggesting that fiscal cliff issues may not have scared businesses as much as we had all feared.
World Production Data Looking Up
After a very dismal summer for leading manufacturing indicators, recent data indicate some marked improvement not just in the U.S. but also around the world.
Though the ISM purchasing managers' manufacturers survey is considered the gold standard in the U.S., Markit provides data from around the world, including U.S. data. Both data sets are scaled in such a way that a reading of 50 suggests as many manufacturers are seeing increases as are seeing decreases. The theoretical downside limit to both indexes is 0 if no company sees an improvement or 100 if every last company saw improvement.
Practically speaking, the index generally stays between 30 and 70. Both surveys ask if things are getting worse or getting better, but not the order of magnitude. The index is extremely easy to compile and can be produced way before detailed manufacturing shipments are available because it just asks for up or down answers.
I always caution readers, however, that actual manufacturing shipments can do better than PMI data suggests if a handful of companies do very well and the remainder see tiny decreases. The Markit data suggests that both China and the U.S. are expanding production, and doing so at an ever-increasing rate. Europe is still reporting more losers than gainers, but the percentage of gainers continues to grow. The worst may be over even in Europe. And the trend is now looking like more than a one-month flash in the pan.
Sandy Rally in Economic Data to Hit Next Week
Next week brings the potential of yet another increase in the GDP calculation for the third quarter with the expectations that the rate will be lifted from 2.7% to 2.9%, at least partially due to revisions in the trade report for September.
However, the third quarter has moved decisively into the rearview mirror, and analysts will be scrutinizing next week's personal income and expenditure report much more carefully, as these will be key indicators of the fourth-quarter GDP outlook.
Unfortunately, Sandy is likely to inflate November's numbers by as much as the deflated October, leaving us no clearer outlook on exactly where we are now. This will leave the month of December as the tie-breaker for fourth-quarter results.
At the moment, consumption is expected to increase 0.4% (compared with a 0.2% decline in October) while income is expected to increase 0.3% in November (following 0% growth in October). Adjusted for inflation (which is actually deflation this month) consumption could be up a stunning 0.6% (7.2% annualized) and income up 0.6%. For now, I really would ignore the income number, which the government manually adjusted last month for unknown storm effects. Even before the Sandy data debacle, the income number was proving highly unreliable.
The first round of wage data used in the income report is based off of employment data that has been subject to extensive and frequent revisions lately. The income all seems to make better sense after actual payroll data is compiled, usually a couple of months after the end of a quarter. Unfortunately, that definitive news on a given month could come as late as five months after the fact, rendering the data nearly useless for economic forecasting.
Triumvirate of Real Estate Data Due
I have been expecting some type of slowing in housing data for several months but have proven to be consistently wrong, along with the rest of the market. Economists are expecting most of the real estate market to be flat or down a little next week, which still means that year-over-year comparisons will look excellent (last fall was a weak period for real estate).
Whatever the individual readings are, the overall trend in housing is up. Pauses or small vibrations around the new higher levels of activity are nothing to worry about. Just as it took forever for real estate markets to look better, it will take a long time to turn the trend back down again.
Builder sentiment is expected to stay flat at 46, a record high for the recovery. Housing starts are expected to slump from 894,000 to 864,000 as the volatile multifamily sector backs off of its recent frenzy. Based on higher pending home sales reports, the market is expecting existing-home sales to move from 4.8 million units on an annualized basis in October to 4.9 million units in November.