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Good--but Not Great--Economy Confounds Bulls and Bears

Robert Johnson, CFA

With little economic news and the corporate earnings cycle winding down, the market treaded water through Wednesday with little change in stock and bond markets. Then the market moved down sharply on Thursday as a stronger-than-expected GDP report caused participants to re-evaluate exactly when the Fed might begin to taper. On Friday, after an above-average jobs report, the market moved surprisingly higher.

I didn't think this week's economic data was particularly strong. Weekly retail sales annual growth remained at the 2% level, and initial unemployment claims are about where they were a quarter ago, despite the ups and downs of the California computing glitch.

Even the GDP report lost some of its luster, when so much of the 2.8% growth came from net exports and inventory increases. Worse, consumer spending growth rates continued to slump, and businesses' spending for equipment actually decreased for the quarter. Hardly anything in the data would give the Fed warm fuzzies about the current state of the U.S. economy.

The ISM report on the services industry was about the only report that was unequivocally strong. However, I have never found that report particularly useful or predictive. The service portion of the GDP report was light, even in the face of several positive ISM services reports.

The Bullish Case for 2014 Is 3.5% GDP Growth, but I Am Not a Believer
My take is probably a little more pessimistic compared with most forecasts. A popular analysis today says that the economy really grew 3% in 2013, but government austerity measures cut more than a percent off the growth rate. Therefore, a loosening of the fiscal noose could cause GDP to jump by a percentage point in 2014, producing growth of close to 3%. Add in some improvement in the world economies, and that growth rate could jump to 3.25%-3.5%.

There is some logic to that analysis, but government spending increases aren't likely to come until later in the year, if at all, and are likely to include more taxes as well, limiting the potential impact. State and government spending increases are more likely to focus on better funding pensions than increasing employment or spending on buildings, also limiting growth.

In addition, while oil, housing, and autos are likely to remain important contributors to growth, the rate of that growth is likely to slow down in 2014, perhaps meaningfully. Auto sales have soared from 10.4 million units in 2010 to an estimated 15.5 million units in 2013. Next year, I doubt that auto sales will get much above 16.2 million units, which represents a declining growth rate. I am not so sure what will replace that growth. Higher interest rates will not help 2014 growth, either. Don't get me wrong, 2014 is no disaster--just more of the same slow but unsatisfying growth.

Employment Report a Pleasant Surprise, But No Barn-Burner
Between the furlough and a couple of below-average reports in August and September, everyone braced for the worst with regard to the October jobs report. The private sector, expected to increase jobs by only about 130,000, instead added 212,000 jobs, slightly better than the 196,000 job average over the last year. Upward revisions to the prior two months counted an additional 70,000 private-sector jobs.

However, the report was less than inspiring in aggregate. There was almost no hourly wage growth, and hours worked were flat, which will keep income growth in check. Year-over-year job growth remained stuck around the 2% level, where it has been for some time. Unfortunately, the real strength was again in retail and leisure and entertainment, which are not generally the best-paying jobs.

GDP Report a Mixed Bag
The headline third-quarter GDP growth rate of 2.8% came in ahead of the consensus estimate and second-quarter results, which both showed growth of 2.5%. For some perspective, the long-term average GDP growth rate is 3.1%. My preferred year-over-year GDP growth calculation (versus the government's method of annualizing quarter-to-quarter growth) shows a softer 1.6% growth rate.

Despite the powerful headline number, the composition of that growth was far from optimal.

The news was not all good as consumer spending and business spending on equipment both showed deterioration. Given my belief that the consumer drives short- and medium-term economic growth, the slowdown in consumer growth rates is not good news. One silver lining for consumers is that most of the slowing occurred in the services sector--the housing and utilities sector in particular--with big-ticket durable goods growth still steady at elevated levels.

Businesses seemed even more skittish with an outright decline in their spending on equipment. With less spending by consumers and businesses, inventories made a surprisingly large jump, accounting for all of the upside surprise in the GDP growth rate, and then some. In other words, businesses seemed to ramp up production (which is what GDP measures) just in time to meet more consumer reticence, causing inventories to expand. Unfortunately, businesses often trim production in the subsequent quarter to bring inventories more in line with demand. The pattern of inventory expansions and immediate contractions is relatively common at this stage of a recovery. Further complicating the inventory picture is that this is a frequently revised data set.

Export growth exceeded import growth by a large margin, also providing a meaningful boost to GDP. While not a massive contribution at 0.3%, it is unusual to see net export growth this far into a recovery. It is one of those figures that stands out as a little too good to be true. Unfortunately, large positive numbers in the net export category are often reversed in the subsequent quarter. However, there is some hope that the increasingly positive U.S. energy position will keep net exports from being quite the drag that they usually are this late in an economic recovery.

In other good news, the government sector had no net contribution to GDP growth after three quarters of being a meaningful detractor. A small decline in federal spending was offset by state and local government increases. Between the furlough and a continuation of the sequestration process, I suspect there will be at least a temporary reversal, with federal spending again acting as a headwind in the calendar fourth quarter.

Residential and business structure spending continued to make decent contributions to GDP growth. However, while the contribution table shows that residential housing continues to make a 0.3%-0.5% contribution to GDP each quarter, that number is not accelerating and cannot be counted on for large GDP increases in the future. In fact, this quarter, the residential housing number included a large increase from commissions on existing homes that is not likely to be repeated in the fourth quarter. The third quarter witnessed the peak of homebuyer panic as buyers rushed to close home sales before rates accelerated even further.

Looking ahead, I suspect that GDP growth will drop to 2% or maybe a little less in the fourth quarter, as inventories turn neutral in the calculation, consumers remain stingy, and net exports make little if any contribution to GDP growth. This will wreck the pattern of quarterly improvements, though the year-over-data for the fourth quarter could look quite powerful, as last year's fourth quarter was hit hard by Hurricane Sandy.

For all of 2013, fourth-quarter to fourth-quarter growth is likely to come in around 2.1%, while the full-year-2012 to full-year-2013 growth rate will look softer at about 1.7%. I suspect the fourth-quarter to fourth-quarter growth rate for 2014 will be in the 2.0%-2.5% range again.

CoreLogic Shows Slowing Home Price Growth
Year-over-year home price growth remained over 12% in September according to CoreLogic (CLGX) reports earlier this week. Year-over-year increases have stopped accelerating, and the month-to-month growth was at its lowest rate for the year at 0.2%. Even the moving average data I prefer shows a slowing in trend, as noted below:

The slowing pattern of home price appreciation seemed to continue in October, as CoreLogic also reports the level of prices for one additional month based on its database of pending home sales data. The preliminary home price data showed just a 0.1% increase in October, and the year-over-year data slipping to a single-month growth rate of 11.2%. With affordability slipping by 25% or more during the last year and continued tight lending conditions, I am not surprised that price growth has stopped accelerating. Next year, I think home prices will be up 5% or less.

Overall, homes are now priced 17% below their record highs. However, the results are quite different state by state. The report notes that homes in 22 states are now within 10% of their all-time highs. However, Nevada, Florida, and Arizona all remain more than 30% below their peaks. As they play catch-up, these states are now showing some of the strongest short-term improvement in prices, distorting some of the data.

Weekly Shopping Center Data Still Looks Lethargic
I keep on believing that the consumer data will look better as the sticker shock from higher payroll taxes and higher income taxes begins to burn off, but the weekly shopping center data won't budge from its below-normal-trend rate. The five-week moving average is stuck at 2% versus the three-year trend of 2.5%-4.0%. I was hoping that lower gasoline prices and the return of furloughed government workers could give some new life to retail spending trends. So far, no luck on that front. My guess is that the new iPhone and video game consoles may be shifting some growth away from conventional retail spending.

However, recall last week that auto sales were also weak, suggesting that something is amiss with the consumer. There are small things I can point to for continued consumer softness, but none of them are really providing a satisfactory answer. The Supplemental Nutrition Assistance Program, also known as the food stamp program, was cut at the first of the month, but that shouldn't have had a big impact yet. The Social Security increase for 2014 will be unusually small at just 1.5%, but that was just announced and won't be implemented until January.

With capital gains forecasts for many funds now available, it is now clear that capital-gains distributions from mutual funds may be unusually high this year, after years of minuscule distributions. Most of that money is tied up and reinvested, but taxes will still be due. That in turn will force investors to put more money aside for taxes.

Busy Week of Data Coming Up
With the furlough delays and Monday's Veterans Day holiday, a lot of government data is being pushed out in four days, including the budget deficit, the trade balance, retail sales, and industrial production. There is almost no data the following week.

Retail sales and industrial production will be the most important reports of the week. As I alluded to above, consumer spending has been soft and has continued to soften. Headline retail sales were soft in September and are expected to be down in October on a month-to-month basis. However, a good part of the slowing is softer auto sales. Without autos, retail sales are expected to increase at a 0.4% rate for the second month in a row. Given the soft shopping center data, that rate sounds a little high to me. In any case, the report will require a lot of very careful analysis. iPhone and iPad releases could also do odd things to this report, as well as the trade report (expect a big bump in imports). Proceed with caution on this report.

Industrial production is important because everyone has been enamored of positive purchasing manager reports. The PMI reports are the main reason for optimism among economic forecasters. For almost four months, the PMI reports have looked great, while the manufacturing industrial production figures have been sluggish at best. It seems like analysts have caught on to the disconnect and are forecasting only a 0.1% industrial production growth rate for October. Auto production is usually a key driver, and with softer sales, I am not sure auto production will provide its usual outsize boost. Given the hefty inventory build discussed in this week's GDP report, I think the market is correct in not anticipating much growth in industrial production.

The trade balance is expected to show little change, which is about what the government estimated in this week's GDP report. I worry a little that iPhone imports could drive the trade deficit up a bit in the short run. I think there is a good chance that the report shows a monthly deficit of $40 billion or more, compared with $38 billion for the prior month. That would likely mean at least a small reduction in the next GDP estimate for the third quarter. The net exports figure in the GDP report had a little bit of a too-good-to-be-true essence to it.