US Perspectives: Current Soft Patch Should Firm Up

Most of the issues that held the economy back this spring saw some improvement in June and even more in July.

Robert Johnson, CFA 26.07.2011
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Investors last week focused on the potential resolution of both the United States and European debt crises. Markets sank early in the week when chances of reaching agreements seemed bleak and rose most of the rest of the week as optimism about potential deals rose and the Greek debt situation was potentially resolved (for now). However, after the closing bell Friday, renewed concerns arose over domestic debt ceiling negotiations after talks about a comprehensive plan faltered. 


Positive earnings news, especially from IBM, McDonald's, and Apple also left the market feeling positive. But not all the earnings news was rosy; Caterpillar reporting a meaningful disappointment along with some other major industrials including Terex and Ingersoll Rand. One obvious trend in the earnings reports so far is that a weak dollar is helping volumes, and money collected in overseas markets is translating back into more U.S. dollars. A cheaper dollar added as much as 5%-10% to the revenues of many multinational companies based in the U.S. Despite a still-soft U.S. economy, stronger international demand and a weaker dollar are enabling many companies to report better-than-expected earnings. Mixed housing data and weaker overseas manufacturing data went largely ignored by Wall Street.


The China construction boom seemed to be losing steam last week, as both Terex and Caterpillar reported softening orders from China.


Sticking With My 2.5%-3.0% Real GDP Growth Forecast Despite Current Soft Patch

As I detail below, I continue to expect 2.5%-3.0% real GDP growth in 2011, although second-quarter growth could slow to 1%-2%. While the underlying economy is not as strong as I had hoped at the beginning of the year, I still strongly believe that the current soft patch is a result of the perfect storm of bad weather, high gas prices, and Japanese supply problems. Most of those issues saw some improvement in June and even more in July.


While some would point to the two most recent employment reports as signs of underlying economic weakness, I still hold that those reports were the result of overly aggressive seasonal adjustment factors and not a new weakening. Real wages do remain a concern, but falling inflation in June will provide at least some temporary relief.


Other worries are worldwide efforts (except in the U.S.) to tighten lending policies and raise interest rates, which both have the potential to slow the world economy and perhaps U.S. exports, heretofore a real bright spot in this recovery.


While the continuing debt crises are weighing on the consumer psyche, I firmly believe these issues will be resolved, but most likely at the last possible moment and, unfortunately, probably without a lot of meaningful cuts.


Housing Will Aid Economic Growth in 2012

Last week's video takes a more in-depth look at the housing market. The most recent data are mixed, but it certainly doesn't look like real estate is collapsing as many would have had us believe just a month ago. Rising rents, tighter supplies of new homes, a rising population, and record affordability are all laying the groundwork for an improving housing market in 2012. I believe a modestly revived housing market could keep the current slow-paced recovery going for some time.


Real Estate Prices Increase for Second Month in a Row

On the pricing front, the Federal Housing Finance Administration reported that housing prices increased for the second month in a row, rising 0.2% in April and 0.4% in May on a seasonally adjusted basis. Median prices in the existing home sales report (which is for June) showed a record-breaking increase of 8.9%, although that's a less-than-perfect measurement of prices as detailed below in our housing analyst's report for the week.


Another interesting note came from processor CoreLogic, suggesting that it is the distressed sales of foreclosed property that have been keeping a lid on prices. Their database suggests that year-over-year prices were down about 7%. However, measuring prices excluding those of distressed properties showed a far less painful 0.4%. Distress sales make up about 30% of sales in any given month. This is a trend that CoreLogic has been reporting on for several months now.


Foreclosure Sales Hurting Pricing, but Not a Source of New Supply

Foreclosures have been a major worry for many market participants for some time. The fear is that the excess supply from all these additional homes coming up for sale would totally swamp the market, creating a vicious downward spiral.


I have always contended that those people moving out of foreclosures had to move somewhere and therefore a foreclosure didn't necessarily indicate an increase in supply. Some of those foreclosed upon will most likely still end up in a single-family home, albeit a rented one. Last week there was a quote in the Wall Street Journal that captured that sentiment perfectly: "Do you really think a 38-year-old with two kids and two cars who was foreclosed on is really going back to an apartment? It's not going to happen," says Ivy Zelman of Zelman and Associates, a real estate market research firm.


The article goes on to suggest that the purchase and rental of single-family homes may just be the way to get out of our housing quagmire. With a lot of cash buyers every month, I would suggest that this trend is already well under way.


Eric Landry, our chief housing analyst, summed up last week's news as follows:  

Increase in housing starts not a reason to get overly excited just yet, but signs point to better times ahead.

June total starts of 629,000 SAAR were an impressive 15% above May levels and 17% above last year's depressed levels. Some of the increase is undoubtedly due to weather conditions, as the North's 32% increase and the Midwest's 25% gain led the South's 11% increase and the West's 5% bump. In addition, apartment activity is taking center stage as developers pour capital into a space that's now enjoying excellent fundamentals.

The 5-plus unit category gained 32% from May and 105% from last year's depressed level. Single-family production wasn't as impressive, with a 9% sequential gain and only a negligible 0.4% year-over-year increase. Total permits issued were 624,000, or only about 2% higher than May and 7% above last year's period. Single-family permits were about unchanged from May and actually down 4% from last year.

In and of themselves, June starts and permits are hardly reasons for investors to get giddy about the state of the housing market (except for the apartment world, which appears set for a sustained run of healthy production). We've maintained repeatedly that fluctuations within the 500,000-650,000 range represent mere noise and that until we get evidence that activity is breaching the higher end, investors shouldn't put much emphasis on monthly production numbers.
However, when analyzed in conjunction with what we believe is a solid seasonal firming in existing home pricing over the past couple of months and a pronounced decline in listed inventories, there's a pretty solid basis for at least a glimmer of optimism. And while most of the investment community expects continued declines, we think smart investors ought to be thinking about ways to take advantage of an inevitable increase in home production in the years ahead. And if we're right about firming prices in the coming months, that increase in production may come faster than many think.


June existing home sales disappoint in terms of volume but reveal encouraging home price trend.

Total existing home sales of 4.77 million SAAR were down 0.8% from May levels and 8.8% below a year-ago period that included the last remnants of tax-credit-fueled closings. Single-family activity, at 4.24 million SAAR, was about unchanged from May and down 7.4% from last year. Condo sales were off 7% from May and 18% lower than June of last year.
The June results were well below what we were expecting, given the relatively strong showing of pending home sales in May. The National Association of Realtors mentioned an unusually high number of cancellations in June, so we may see volumes bounce back in coming months if indeed June suffered an anomaly.
Stubbornly high inventories were also disappointing, as total units for sale increased 3.3% from May and were only down 3% from the year-ago period. These inventory numbers show less progress than our estimates, which are rolled up from several of the largest metros in the country and indicate less standing inventory. However, we're in agreement with the NAR that home prices are now in the midst of a strong seasonal upward trend. June median selling prices increased 8.9% sequentially, the largest month-to-month gain in the history of the series. Granted, the unusual amount of cancellations could have artificially benefited median prices last month, but we doubt the effect was the only thing driving price, as June was the fourth consecutive month to enjoy a sequential gain.  

Second-Quarter GDP Likely to Look a Little Soft

This week's GDP report seems likely to indicate modest 1%-2% growth for the second quarter compared with 1.9% in the first quarter. My expectations are a little below consensus of 2.3% because of the dramatic drop in auto production (due to Japanese supply-chain issues) in the second quarter compared with very strong production levels in the first quarter. Auto-related numbers flow through a lot of accounts including consumption, business investment, and inventories, so tracking the exact effect of the production slowdown gets pretty tricky.


What we do know is that auto production added 1.2% for first-quarter GDP and will probably end up subtracting between 0.5% and 1.0% in the second quarter. That's a lot of ground to make up, 1.7% (1.2% + 0.5%) at a minimum, just to maintain the 1.9% growth rate of the first quarter.


A swing in defense spending that depressed first-quarter GDP and sharp improvement in the balance of trade, as well as increased inventories, together have the ability to salvage the GDP growth rate in the second quarter. But these are notoriously difficult categories to forecast and the import/export numbers are just estimates for June.


In addition, I am not so sure how well the market will receive the news that personal consumption fell from 4% growth in the fourth quarter of 2010 to 2.2% in the first quarter of 2011 to potentially as low as 0.5% in the second quarter. Almost all of the recent decline is due to poor auto sales, which I believe are closely related to the poor supply of Japanese autos and the resulting high prices for remaining inventory. However, that won't stop the headlines trumpeting the lowest growth in consumption of the entire recovery.


The good news is that the worse the results are in the second quarter, especially on the auto side, the better the news for the second half will be, when those Japanese plants come closer to full production. I suspect that growth in the third quarter will show a sharp acceleration to 3.5% or so with a similar gain in the fourth quarter. That would pull up full-year 2011 GDP to a range of 2.5%-3%.


GDP figures will also be revised for the past several months with the issuance of the second-quarter GDP report. I suspect they will suggest the recession was a bit deeper than previously believed and the recovery even slower.


New Home Sales Aren't Likely to Show Much Growth

A lot of last week's housing news was relatively positive, but I don't expect a lot of good news out of the new home sales report. I suspect that poor starts in earlier months and low builder confidence ratios are likely to keep new home sales relatively flat at 320,000. At this level, sales are close to the record bottom and a long ways from the top run rate in 2005, which was in excess of 1.3 million units.


Case-Shiller Home Price Index Likely to Show a Gain

Based on median listing prices tracked by our housing team and a positive report from the Federal Housing Finance Agency last week, I expect the Case-Shiller index to show its second monthly gain (and its first gain when the numbers are seasonally adjusted). This could provide at least a little cheer to the housing market. Based on our leading indexes, I suspect there could be a couple of more positive reports after this one.


Durable Goods Orders Will Be Off May's Strong Pace

Nondurable goods orders had a nice spike in May, growing 2.1% sequentially from April. I suspect those orders could fall back a bit and may perhaps not show any growth at all. The new orders component of the ISM dropped below the 50 level in June, which would be consistent with a small decline. I think we might do a little better than that based on rebounding Japanese auto manufacturers and better aircraft orders. Stripping out aircraft, durable goods orders should be able to grow at least a few tenths of a percent.


Watch the Chicago PMI on Friday

The Chicago PMI has been the best of the regional reports at helping to forecast the National PMI, which comes out the following Monday. Regional results have been mixed so far. International PMI data for June, announced last week, continued to slow. Therefore, the Chicago report may provide some important clues.



This is an edited version. The article originated from Robert Johnson’s column at


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

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