The market seems to be in worry mode lately. This week, market participants who had been previously watching the U.S. Federal Reserve closely suddenly woke up to the reality of a government shutdown, debt ceiling fights, and a potential default on U.S. debt. I suppose the fears are real, as markets have typically plunged almost 5% in prior shutdowns, followed by huge rallies once things got smoothed out.
That happy-type of ending isn't very visible this time around. Right now, it doesn't seem as if any serious negotiations are going on in Congress. I am not so sure that the market has really priced that in, even with this week's stock market decline. Unfortunately, even a short shutdown could have an effect on economic activity in the fourth quarter.
All the uncertainty about exactly when the Fed might do its tightening left a lot of portfolio managers at least a little confused this week, which is never helpful. We now have no real clues as to when the Fed might taper unless the economy clearly breaks out in either direction. That doesn't appear to be in the cards with this week's data.
The consumption and income data this week showed more of the same slow, uninspiring growth. There was a ray of hope in continually improving personal income data and stellar consumer balance sheet improvements. However, short-term retailer news, both from the weekly shopping center data and Wal-Mart (WMT) was not so good. Housing price data remained strong, if just a touch slower in some cases, while pending home sales continued to drop and new-home sales bounced much less than hoped. Manufacturing data, at least according to Markit's Purchasing Manager Surveys, seemed to hold its own, as did durable goods orders when excluding aircraft.
Reported August Consumption Data Suggest More of the Same for the U.S. Economy
Although some analysts are encouraged about improving month-to-month consumption data, the much more reliable year-over-year data suggests more of the same for consumption and the U.S. economy. However, income data is beginning to show some nice, steady improvements that might help fourth-quarter spending data.
On the other hand, the anecdotal evidence about the consumer isn't good so far in September. Initial reports also seem to suggest a softer holiday shopping season than last year.
Year-over-year averaged consumption growth remained stuck in its slow but unsatisfying rut of 1.9% growth when adjusted for inflation. That remains well ahead of income growth of just 1.1%, with the higher payroll and income tax rates subtracting close to a full percentage point off of income growth. In fact, wage growth before taxes is a healthier 2.2%.
Anecdotal and Weekly Data Suggest September Consumption Growth Might Slow Temporarily
Morningstar's retail team has reported that retailers have been talking about sales softness since July. Then the Wal-Mart rumors about building inventories and slowing sales hit the tape this week, delivering a late-week smack to retail stocks.
The holiday season is currently looking a little soft, according to both Morningstar's consumer team as well as ShopperTrak, an industry data expert. Our team summarized the holiday season outlook:
"We anticipate average comparable-store sales growth of roughly 2%-3% across our coverage universe during November and December, which is generally consistent with early industry forecasts (ShopperTrak expects retail sales in the U.S. during November and December to rise by 2.4% compared with the approximately $580 billion generated last year). This compares with average comparable-store sales growth of approximately 3% in 2012 and 4% in both 2011 and 2010. We believe that both in-store transactions and the average transaction size will experience a deceleration, the result of a more cautious consumer and aggressive promotional activity."
My favorite retail metric, weekly retail sales, remains in the dumper with year-over-year growth for the latest week of just 1%, the lowest weekly read since this spring. Even the five-week moving average is slipping again and is at just 2.2% year-over-year growth.
Short-Term Consumption Likely to Slump, but Things Could Still Look Better by Year-End
With incomes on the mend and inflation still under great control, I am optimistic that the slowdown will not last all that long. I would also suggest that adjusted for inflation, the sales deceleration may not be as bad as it seems. Also, retailers might be in a price-cutting mode in an attempt to keep up sales, which would be great news for the consumer (and push up inflation-adjusted sales growth rates). In brief, I am probably more pessimistic than some in the short run and more optimistic about the intermediate term.
Higher Consumer Net Worth Partially Explains Why Consumption Has Exceeded Incomes for Most of Last Year
This week, the Fed released the consumer balance sheet data for the second quarter. The report goes a long way in explaining the disconnect between consumer spending and reported incomes. Consumer net worth, year over year, increased 7.2% following growth of more than 8% for the first quarter. The 60-year average of net worth growth is a much more subdued 2.7%. The income report by itself doesn't directly capture these large gains.
To put the net worth numbers in some perspective, June quarter to June quarter, net worth increased by $7.7 trillion while real disposable income increased $0.2 trillion. That's not a typo. However a lot of those gains are locked up in retirement accounts or in homes, so the general rule of thumb is that just 3%-5% of growth in net worth eventually turns up in spending. Using that rule of thumb, net worth growth could have driven spendable income up by $0.2 trillion-$0.4 trillion, still more than the growth in real disposable income of $0.2 trillion. Again, the timing and the amount of asset price appreciation that turns up in consumption is more of a reasoned guess than a science. And those asset numbers can just as easily move in reverse, as we all learned this week.
Housing Equity Up More Than 50%, and Consumer Loans Not Growing
There were a couple of other tidbits in the Fed's report on net worth. We all have known that real estate prices are up a lot and that the total amount of mortgages is down. However, more stunning is that homeowners' equity (the value of a home less the outstanding mortgage balance) is up 50% from $6.2 trillion (2011) to $9.3 trillion at the end of June. Owners' equity as a percentage of a home's value had moved from 39% to 49.8%.
The other interesting tidbit is that consumer debt is unchanged from both the first quarter and the same quarter a year ago, indicating that it is not a debt binge that is driving consumption faster than incomes. In fact, right now, consumer debt is 5% lower than it was way back in 2008.
Higher Interest Rates Temporarily Drive Home Prices Higher, but New-Home Sales Lower; Pending Home Sales Suffer a Hangover
This week's housing data continues to show distortions due to higher interest rates. Overall prices picked up a little steam in the most recent data (July) as homebuyers were more worried about getting deals closed than getting the absolute best deal.
However, new-home sales, like housing starts, remain well below this spring's peak, but at least a little better than last month. Buyers flocked to easily available existing homes rather than chancing higher rates for a new home that might take much longer to close on. Existing-home sales (that is, actual closed contracts) are at a recovery high, reflecting that reality. However, slowing pending home sales data suggests that the existing-home sales party might be coming to an end. My fear is that the scare of higher rates merely pulled sales forward rather than generating truly new sales. Overall, I continue to believe that the housing market is in decent shape, despite what are likely to be some volatile months ahead.
Pricing Data Remains in Good, if Not Perfect Shape
This week, the triumvirate of home price data points was closed out with announcements from both the Federal Housing Finance Administration and Case-Shiller. Both metrics showed improvement in year-over-year price data. Both indexes also showed lopsided price gains with markets near the West Coast showing results far higher than the rest of the country. Still, almost every market managed to show some year-over-year price growth. Markets with the previous largest declines and the lowest inventories are the markets that are doing the best. However, markets showing slower price depreciation during the crash and lukewarm recoveries still managed to pull themselves above pre-recession highs. For example, some markets in Texas and Colorado are now showing prices that are at a new record high. Everyone in these markets is technically, and on average, above water on their home purchase price.
Note, the Case-Shiller and CoreLogic (CLGX) metrics are more volatile and seem to weight some of the more-volatile markets more in their indexes. Also, the FHFA data includes only homes where the loans can be sold to Fannie Mae and Freddie Mac, which tend to be higher-quality mortgages, also explaining the lower volatility in both directions. I believe that the 8% figure reported by the FHFA is a little more representative of the true seller experience than the 12% data reported by Case-Shiller and CoreLogic. And as good as the recent data has been, the FHFA Price Index is still 9.6% below its peak, and the Case-Shiller Index is 21% below its peak, despite higher incomes and lower interest rates since the last peak. Furthermore, slowing pending home sales and slightly higher inventories, in units, suggest that pricing growth is likely to slow from here. Still, I believe home prices could be up 5%-7% in 2014, following 10%-12% growth in 2013 and 6%-8% in 2012.
New Home Sales Bounce Some, but Less Than Expected
Like home starts announced last week, new-home sales for August, a related subset, bounced from truly awful July numbers as some of the negative effects of higher interest rates began to burn off. However, the numbers were still lower than expectations. Worse, they are below recovery highs both in terms of units and percentage change from a year ago.
Homebuilders Seeing Light at End of Tunnel
In their quarterly earnings reports, the major homebuilders noted the impact of tighter home prices and relatively tight lending policies. The good news is that July seemed to take the brunt of the impact with August looking relatively better. Some of the builders also reported an easing of lending standards, which would be a first for this recovery. In one of his recent reports, our housing analyst James Krapfel summed up the earnings reports and the lower lending standards better than I could:
" Lennar's (LEN) and KBH's August quarter earnings reports point to a fading sticker shock effect. Higher mortgage interest rates clearly had a negative effect on demand for both--Lennar's net new order growth slowed from 27% in the May quarter to 14% in the August quarter, and KBH's net new order growth fell from 6% in the May quarter to down 9% in the August quarter. However, we were encouraged by Lennar's commentary that July was the slowest sales month of the quarter, and August was the best. Its statement aligns well with improved new-home sales data in August versus July. We believe the sticker shock effect of materially higher rates with appreciated housing values is beginning to subside, and that pent-up demand and slowly easing credit standards will allow industry housing sales, still 36% below historical averages, to continue their trajectory back to midcycle levels. We also note that JPMorgan (JPM), Wells Fargo (WFC), and the mortgage insurers have eased credit standards over the past several months. Among the changes include JPMorgan's reduced down payments requirements for primary residences (to 5% from 10%) and second-home loans (to 10% from 20%) for borrowers in Florida, Arizona, Nevada, and Michigan; and Wells Fargo lowered down payment requirements for jumbo loans (to 15% from 20%)."
Pending Home Sales Falter, Bad News for Existing Home Sales
Pending home sales are a leading indicator for actual closed sales, also known as existing-home sales. It appears that in everyone's rush to close sales in an unusually short time frame, the time to move from a pending sale to closed sales shrank dramatically, effectively draining the pipeline. The gap between pending home sales and existing-home sales is one of the widest I have ever seen and is likely to cause a short-term collapse in existing-home sales to 5 million units or fewer after hitting 5.48 million units in August. I will be very curious to see how the market interprets that data. My view is that the data wasn't as good as the 5.48 million units suggested by the August report, nor as weak as the potential data for upcoming months might suggest. So I won't panic when the next report comes out.
Markit Flash Report Suggests the World Manufacturing Economy Is Holding Its Own
The Markit data wasn't all good news, but all three major regions remained above 50 in the September Flash Report, suggesting that more firms were seeing growth than decline. However, in some cases the rate of growth was slower ,and in others, the more predictive new orders part of the index was softer. I still believe it will be hard for these indexes to move much higher without better support from consumer buying, which, as noted above, is slipping.
Employment Report and Auto Sales the Key Releases Next Week
While the major focus next week will be on the employment report, the auto sales report is probably the most important, in my opinion. A lot of consumer data has been mediocre at best, but auto sales have been a true bright spot for most of the year. August was a stunningly good month for auto sales, hitting a recovery high of 16 million light-vehicle sales, according to the U.S. Bureau of Economic Analysis. A favorable calendar (the Labor Day holiday weekend sales numbers were included in August reports) may have inflated August's numbers, so I am very curious whether sales will drop in September. This will provide a critical read on consumer mindsets in September. Expectations are for a small drop back to 15.8 million units, but I think the results could be slightly worse, given all the uncertainty and the calendar shift. As long as we don't fall back under 15.5 million units, I won't be too worried. A spike over 16 million would be reason to get a lot more optimistic about the economy.
Given the steady state of consumer spending, it's hard to expect much change in employment growth relative to the 12-month average of 184,000 jobs added and last month's job additions of 169,000. The bullish camp is pointing to strong purchasing managers' reports and recovery-low initial unemployment claims data to push employment growth well over 200,000 jobs. I am less optimistic, with expectations of 160,000 jobs, as the loss of mortgage-processing personnel and not-so-wonderful residential construction numbers as well as sequestration effects weigh on the data. Also, at some point I would expect that the disconnect between poor retail and restaurant sales and rising employment rates in those industries will rectify itself with a meaningful drop in employment data for those industries. The consensus estimate is for job growth of 180,000 jobs.