US Perspectives: Watch the Horizon, Not Your Feet

Many recent problem spots in the economy will rectify themselves in the third quarter--perhaps dramatically so.

Robert Johnson, CFA 05.07.2011
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After six weeks of declining markets and a generally softening economy, three key indicators--a surprisingly strong purchasing managers' report, reported increases in housing prices, and reported increases in pending home sales--drove the market up by over 6% in just a week. Commodity prices continued to fall for the most part, potentially putting more cash in consumers' pockets in the months ahead. And consumers kept spending, as the weekly chain store sales report posted its best sequential improvement since January. The Greek debt situation appeared to be kicked down the road for a few more months at least.


While the news last week was clearly better than expected, it wasn't like every indicator went straight up or was overwhelmingly bullish. It just wasn't as bad as people expected. After six weeks in the bomb shelter, it didn't take much to get people excited about the market. The market seemed not to care about a poor spending and income report on Monday, an initial unemployment claims report that remained stubbornly high, and auto sales that remained far softer than earlier in the year. May construction figures were also a downer, but again that was probably weather-related, and improving weather in June should mean better news ahead. I also continue to worry about second-quarter GDP forecasts that appear to be too high at 2.3% compared with 1.9% in the first quarter. Poor auto production and low construction spending will make it exceptionally difficult to get above the first quarter's growth rate. Those are problems that will rectify themselves in the third quarter--perhaps dramatically.


Watch the Horizon, Not Your Feet

These statistics all have a short-term focus. Over the longer term, I think auto sales have considerable room for improvement and housing has yet to give the economy any kind of lift. The manufacturing sector, while subject to many ups and downs, is poised for one of its best recoveries of the last 25 years. Consumer spending on debt service also continues to fall dramatically, giving consumers the wherewithal to buy some of those factory goods. So far, consumers have continued spending (ignoring the ups and downs of oil and autos) despite some pretty impressive headwinds. I am hopeful that our soft patch will turn out to have been driven primarily by a run of bad weather and the Japanese disaster in what has otherwise been a painfully slow but relatively steady recovery.


I also think our legislators will come to their senses and work out some type of compromise that will probably put government spending on a lower trajectory than any thought possible just a few months ago. Now the issue of government spending seems not to be whether to cut, but how much. If Congress falters along the way, we will probably have a really bad week in the market that will scare them into some kind of compromise in a hurry, especially since it's unlikely Ben Bernanke will ride to the rescue yet again.


Personal Income and Spending Data Uninspiring

For all 2011 through May, consumer incomes, when adjusted for inflation, were basically unchanged as sharply accelerating inflation eroded away most of the gains consumers made. Real, inflation-adjusted incomes did eke out 0.1% gain for May after falling 0.1% the previous month. Given the recent slowing in inflation and my expectation for better employment numbers this summer, I suspect June and July income figures to show better improvement than they did in May.


The consumption number, adjusted for inflation, fell 0.1% in each of the last two months, primarily due to falling auto sales. High prices and short supply have kept consumers out of the showroom. Gasoline and food volumes are also quite soft in response to higher prices, and that has also hurt the consumption figures. I tend to watch the chain-store sales figures, which don't include autos or as large an energy component, and the more recent data there look good but not great.


Inflation Rates Should Come Down in the Months Ahead

The commodity complex continued to unwind last week with agricultural products leading the way down and gasoline prices continuing to inch lower, even in the face of the July 4 holiday and slightly higher crude oil prices last week.


Gas Prices Headed Down


Price per Gallon (US$)



















7/4/11 (e)


Source: St. Louis Federal Reserve


Falling agricultural prices last week were driven by two U.S. Department of Agriculture reports that showed farmers' plantings doing a lot better than anticipated. Adam Fleck, our agricultural equipment analyst, summed up the reports as follows:


Last week, the U.S. Department of Agriculture released two important updates. The first, filed on Monday, noted that although growing progress for crops such as corn and soybeans is below last year's levels, the percentage of crop reported as "good" or "excellent" is still quite high for both commodities. Wheat, a third key U.S.-farmed crop, has seen markedly worse conditions than last year, although we believe rebounding Russian production of this commodity will likely offset the global impact of poor U.S. plantings. The second report, the USDA's midyear acreage update, surprisingly estimated corn planting at 92.3 million acres, a 5% increase from 2010 and up from the 90.7 million acre forecast from just a few weeks ago; farmers seem to have largely avoided the recent weather impacts that have plagued much of the country. This increased planting, combined with decent crop progress, could lead to an improved ending stocks forecast (due in the USDA's July 12 World Supply and Demand report). Similarly, although the USDA lowered its estimated soybean plantings, stored stocks of the commodity have risen 8% year over year, mitigating potentially lower harvests this year.


Don't Fear Falling Prices

Falling commodity prices are a very good thing. Commodity price increases have driven the consumer price index higher for close to a year. Higher commodity prices hit consumers, especially lower-income consumers, right in the wallet. Falling gasoline prices have finally led to better consumer spending, as I detail below.


News on the Manufacturing Front Much Better than Expected

June's national purchasing managers' index increased to 55.3 from 53.5 instead of decreasing as many economists, including me, had feared. Two regional reports announced a couple of weeks ago showed drastic declines that heightened everyone's fear levels. I am guessing that Toyota's ramp up, which occurred during the last two weeks of the month, was captured in the national report but came too late to have much of an impact on the earlier, regional reports (and from regions that may not be as auto-centric). I also suspect that bad weather (tornadoes) in the South may have depressed May figures nationally and June weather didn't have the same negative effect.


I've Never Been so Happy to Be Wrong!

The report seemed to allay market fears that the economy was falling back into another recession. Combining a better-than-expected industrial production figure out two weeks ago, a strong durable goods report the week before last week, and now a very positive purchasing managers' index, things are clearly looking up for manufacturers. All of this good news came despite the fact that the Japanese transplant manufacturers are not back on their feet yet. Toyota's increased production didn't kick in until mid-month, and Honda has yet to show much of a recovery at all, so theoretically there is room for more improvement on the auto front for another month or two.


The June PMI growth figure is consistent with real GDP growth of between 4.5% and 6.0% based on correlations formulated by the ISM. The fact that manufacturing has shrunk as a percentage of GDP probably explains why the ISM-based GDP forecasts have proven a bit high lately. Despite some odd second-quarter GDP anomalies, I suspect ISM data is pointing to a stronger second half of the year than is in most economic forecasts.


The report was relatively balanced, with a lot of categories improving a little bit rather than one large category dominating the results. New orders were up to 51.6 from 51, which is always good to see; those orders will turn into production and shipments in the months ahead. The employment part of the index moved to 59.9 from 58.2, spurring hope that the national employment report will show a rebound when it is released this week. The inventory reading dropped below 50 again, as manufacturers apparently were shipping more goods out of inventory rather than gearing up production. As long as demand remains sustained, it appears manufacturers will have to gear up production in the months ahead.


There was good news in the prices paid segment of the report as well. The price index peaked at 85.5 in April, then fell to 76.5 in March before falling to 68.5 in June. While still elevated and indicative of more increases, I was pleased to see at least some relief on the pricing front. Thirteen industries saw increased prices, three stayed the same, and two actually fell. The written comments, however, still showed widespread concern about high prices, though moderation in price increases was beginning to appear.


I should also caution that, as excited as the market was about the data, the increase to 55.3 from 53.5 still only recaptured a portion of the loss during May when the reading saw one of its biggest one-month plunges in history, to 53.5 from 60.4. Rail data (which can be an early indicator of manufacturing activity) on a year-over-year basis still remains in the doldrums. Overseas purchasing manager data continued to slow as well. Notably, China's index fell to 50.9 for June from 52 in May.


Housing: Some Improvement at Last, Could Help Consumer Psyches

After a drumbeat of bad news on the housing front for more than a year there are some early signs that just maybe we have hit bottom. Housing credits, which expired during the spring of 2010, inflated both prices and volumes and pulled ahead sales from future periods. On a year-over-year basis, pending home sales were up 13.4%, the first year-over-year increase in the index in more than 13 months. Pending home sales indicate a contract signing and usually turn up a month or two later in the existing home sales data when the deal finally closes and the mortgage is approved and funded. Pending sales also looked good on a sequential basis, increasing over 8% from April to May. Our housing analyst Eric Landry believes the pending home sales data are consistent with an existing home sales figure of well over 5 million units for June, compared with May's existing home sales of a meager 4.4 million units.


Case-Shiller Home Price Index Turns Up

Prices are finally heading back up again after a 4.5% decline over the past year, according the Case-Shiller Home Price Index (20-city index). Prices for April were up 0.7% from March, their first increase in eight months. Based on improving median listing prices as tracked by Eric Landry, the Case-Shiller index looks poised to increase for an additional two or three months at a minimum. Eric was one of the very few analysts that correctly predicted the April increase in the index.


Shoppers React to Lower Gas Prices, Better Weather

As many readers know, I have been focusing on the weekly and monthly reports from the International Council of Shopping Centers to keep an eye on the mood of the consumer. It's a quick, easy weekly statistic (though I do calculate a four-week moving average to flatten out some of the bumps). Last week the news out of this report was particularly strong, with 2.9% sequential growth compared with the prior week and 3% over the same period a year ago. The year-over-year figure has remained remarkably stable over the last year ranging from 2.5% to 3.5%.


The Council's commentary on last week's data was particularly bullish. Foot traffic growth showed its strongest reading since the week ending Jan. 24 and represents the third-best performance of the year. Falling gasoline prices and warmer weather were finally helping the numbers. Michael Niemira, ICSC vice president of research and chief economist, commented, "With falling gas prices, consumers finally started to spend a little more freely this past week giving retailers a much-needed sales increase...As we head into the final week of the fiscal month and the arrival of the Fourth of July, retailers selling seasonal goods and food should continue to see a sales bump."


Employment Data on This Week's Agenda

After last month's dismal employment report, economists are looking forward to a better June. After gaining more than 200,000 jobs (according to the establishment survey) for several months, employment growth slowed to a disappointing 54,000 in May. Forecasters are predicting a rebound to 125,000 jobs in June, which I think could prove conservative. For May, the household survey showed far better growth than the establishment data, and over time those two statistics tend to true up. The Manpower Survey and the Challenger Gray layoff report also suggested that the news was not so dire. The ISM survey noted above suggests improving manufacturing employment, too.


However, despite the favorable backdrop, seasonal adjustments weigh hard on both May and June. A lot of hiring is typically done in May and June as students finish college and high school classes, causing very noticeable bumps in hiring, requiring large negative seasonal adjustment factors. However, as the pool of experienced unemployed candidates has expanded and the minimum wage has increased, hiring isn't tied as closely to the school year as it used to be. Yet the seasonal adjustment factors are still high for the April-June period. It is interesting to note that, seasonally adjusted, May and June were two of the slower employment growth months of 2010.


Service Sector Update Due This Week

Certainly auto sales have not been robust due to the Japanese situation. These poor auto sales will sharply reduce consumption figures. Next week I will be watching to see whether consumers will be spending any of that auto money on services, which have experienced a relatively slow recovery. Given the generally slowing economy, the consensus is for a small decline in the ISM services index for June (the sister index to the manufacturing report released on Friday). Based on the auto situation, I think the services index could show a small improvement.



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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