US Perspectives: Market Feels Giddy, I'm Getting Queasy

It certainly didn't hurt that the Federal Reserve intimated that they were willing to drive long-term rates lower, if the economy were to falter again. I think some market participants missed the "if" part of those statements and blithely assumed rates were going lower and fast.

In my opinion, a slow but steady growth in the economy combined with some inflationary pressures in food, apparel, public services and oil may keep the Fed from implementing another massive easing. And as this month's personal income report showed, lower rates aren't all gravy, either. About half of all wage gains in August were offset by falling consumer interest income.

Good Manufacturing and Income Data--but What's Under the Surface?

Personally, I thought this month's numbers were nothing out of the ordinary and continue to reflect slow but steady growth. Unfortunately, some of the numbers that were well-received by the Street don't look so good when you peel back the onion. The ISM manufacturing index remained well above 50 and shrank less than expected. Although a closer look showed the number of firms reporting inventory growth jumped to a 26-year high, new orders were almost back down to the neutral mark and the number of firms reporting shrinking backlogs beat those showing gains. Real disposable income, the fuel for consumer spending, showed very acceptable 2% growth or 2.4% annualized. Not bad. However, almost every dollar of that growth came from retroactive unemployment checks.

Consensus Third-Quarter GDP Forecast Moving Up

Meanwhile, consensus GDP forecast for the third quarter has moved off its low of 1.6% just a couple of weeks ago to 1.8%. I think this number is still too low based on the data I've seen so far. Growth of 2.0%-2.5% seems like a possibility compared to growth of 1.7% in the second quarter. The market could get a psychological lift from a GDP growth rate that is no longer decelerating.

The Market Feels Giddy, I'm Getting Queasy

The market seemed in a great mood last week and largely ignored the fine print in a lot of economic pronouncements. I'd say I am worried but not panicked. Real hourly wage growth is slipping again. Better employment growth and longer work weeks have offset some of this negative effect--for now. This Friday's employment report, which includes all of these data points, should provide some insight about the sustainability of consumer income growth.

Continued Stability in Consumption and Income

The personal income report for August again showed relative stability in both income growth and spending growth. Adjusted for inflation, both personal consumption expenditures and real disposable income grew by 0.2%, which annualizes to 2.4%. I would characterize growth so far this year as slow but steady.

With consumer spending representing 70% or so of the U.S. economy, consumer incomes and expenditures are the governor on the overall economy, both on the upside and the downside. In the short run, inventory changes, import levels, and private investment spending can push the numbers around, but over the long term consumer spending and GDP growth are joined at the hip.

Income Statistics Aren't as Good as They Look

That said, the August's 0.2% disposable income gain isn't quite as good it looks. Extended unemployment benefits were temporarily stopped in July and then retroactively paid in August. If that stop/start pattern hadn't occurred, there would have been no disposable income gain in August and no disposable income decrease in July. In other words, disposable income has shown almost no growth over the last two months. That's why I'll be monitoring this week's employment report so closely. By examining hours worked, real wage rates, and total employment level in that report, we should get a pretty good handle on the odds of returning to favorable disposable income growth for September.

Falling Interest Income Getting Big Enough to Notice

One interesting tidbit out of the incomes report was the unintended consequence of the Fed's low interest policy. Interest income was one of the very few categories to show a decline this month, and the amount was not inconsequential, either.

While employee compensation income, by far the largest personal income account, was up $25 billion in aggregate, interest income declined by a nontrivial $12 billion. This is the second month of double-digit declines. And apparently all the recently announced dividend increases haven't made it through the system, as this category was basically flat month to month.

Services Spending Still in the Doldrums

On the spending side, the massive services sector continues to pull up the rear. While the goods-producing part of the economy grew by 0.5% in a August, service revenues, which account for about two thirds of the economy, were flat with July's results. That slow growth is consistent with the year-to-date numbers as well:

One item holding back services growth is poor health-care revenue. Our health-care team analyzed this slow growth in our most recent quarterly outlook. A lot of people are very concerned about the manufacturing sector, as we discuss below, but slow services growth is an even more important factor in our slow recovery.

The market breathed a collective sigh of relief when the purchasing managers' surveys from both China and the U.S. came in pretty much on target Friday. The U.S. number fell from 56.3 in August to 54.4 in September. Any number above 50 indicates more respondents are seeing growth than shrinkage.

The good news is that we are still in growth mode; the bad news is that the rate of growth appears to be slowing. The reading was just above the consensus of 54, although there were forecasts of lower numbers winding their way through the rumor mill based on some sloppy regional reports released earlier in the month.

As happy as the market seemed to be with the number, there were clearly some signs of slippage in the report. The new orders component fell to 51.1 from 53.1, considerably off April's high of 65.9. Meanwhile, the inventories component grew to a 26-year record high. Paradoxically, higher inventories are counted as a positive in the calculation of the composite PMI because of the belief that holding more inventories is indicative of greater business confidence in the direction of the economy.

Despite what the index folks say, the large jump in the number of companies reporting growing inventories, combined with slower growth in new orders and fallings backlogs, seems to point to a less robust manufacturing sector over the next couple of months. At this point in the cycle, a slowing manufacturing sector is not a killer for the economy. However, I do need to see some better services numbers to offset manufacturing's slowing, and the September consumption report above was not particularly helpful on this front.

Manufacturing Looking Up in China

The news from China was more positive, as summed up by our industrial team's leader, Eric Landry:

The release of the HSBC China Manufacturing PMI was encouraging, increasing by a full point to 52.9 from August's 51.9. The results point to a slight improvement in activity at the world's largest low-cost producer, but importantly to a five-month high. The takeaway is that the downward trend in this important region witnessed earlier in 2010 may have lost momentum or even reversed. Also encouraging, the survey's new export component rose in September after a three-month decline, indicating a possible increase in demand from developed nations.

Given that China is viewed as one of the major engines of this recovery, the rising PMI was favorably received. Recall the week before last week that the European version of the index also showed an increase and that news was very favorably received by the market.

Home Prices Eke Out Another Month of Gains

Unlike some other housing price indexes I follow, the Case-Shiller 20-city index managed to show a small sequential gain of 0.6% for the three-month moving average for the period ending in July. I'd believed the index was due for a decline based on reports from the Federal Housing Finance Authority. Much like many of the other consumer numbers, those predicting the end of the world and those predicting a strong recovery have been equally stymied. I think we are in for few months of declines, with losses staying under the 5% mark in my opinion (the expired homebuyers' credit and employment continue to hurt, while affordability remains near record levels). To put that in perspective, we are still down 28% from the 2006 high and up 4% from the 2009 low.

My Eyes Are on the Employment Report

I think the odds favor seeing a positive headline employment report for the first time since May as the number of census workers being shown the door continues to decline, while the private sector will likely continue to show slowly growing employment. The consensus is for a gain of 5,000 jobs overall and 75,000 private-sector jobs. That compares to a headline loss of 54,000 total and 67,000 private sector additions for August.

Given that the initial unemployment claims are down month on month but the employment indexes in the various manufacturing reports have slowed some, I think these are reasonable expectations. However, hours worked and average hourly wage growth will be two other elements of the report that I'll be watching closely. Employment growth combined with these two elements should provide at least some guidance for what to expect from September's personal income report.

Pending Home Sales Report Will Indicate the Latest Trends in Real Estate

From a range of available housing indicators, this one is near the front end of the cycle (prices are at the end of the cycle) and should set the tone for the rest of the housing indictors due later in the month. Pending sales reflect signed contracts for purchase, although many of those deals will ultimately close in later months as the mortgage approval process slowly grinds forward. The market is expecting a rather anemic 4% growth rate for August versus 5% growth in July.

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