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Manufacturing Data Triggers Market Train Wreck

Robert Johnson, CFA

This week, equity markets seemed to shrug off more tapering talk and lackluster corporate earnings data. Until Thursday, that is, when Markit Purchasing Managers data suggested softer manufacturing results in the United States and dipped below 50 in China, indicating that more firms were seeing decreases rather than increases in activity levels.

The news wasn't really all that bad, but U.S. equity markets, which had moved close to 30% in less than a year, were likely looking for an excuse to sell. Largely overlooked was the great Purchasing Managers Index data out of Europe, which is a bigger trading partner with the United States than China. However, China is really important to other emerging-market economies, whose stock markets took a huge hit this week.

Suddenly, it became clear to market participants that not all emerging-market countries were in great shape. Countries with large trade deficits were particularly vulnerable (India, Argentina, Turkey, and Indonesia). Slowing world growth prospects and general turmoil drove government interest rates sharply lower, with the 10-year Treasury bond falling from close to its 3% rate at the beginning of the year to 2.75% on Friday.

I wasn't really thrilled with this week's other economic data, either. Existing-home sales fell to levels that left them basically unchanged from a year ago. Home prices began to look a little softer in November with almost no growth, according to the Federal Housing Finance Agency. Corporate earnings weren't that great either, with an above-average number of disappointments and bad news out of IBM (IBM) and Procter & Gamble (PG) leading the way.

Next week's forecasted fourth-quarter 3% GDP growth rate might lift spirits some, but first-quarter pressures continue to intensify. It looks like an extension of the expanded unemployment benefits program is not going to get off the ground, leaving 1.3 million former participants without benefits in January. Decreased food stamp benefits that began in November, affecting more than 40 million participants, have not been reversed yet, either. Higher health insurance premiums and deductibles will also weigh on 2014 results.

Some economists are cheering on the cold weather, the large increases in utility usage, and the potential help to the GDP calculation, but I'm not so sure. The benefits of higher utility usage will last only until consumers need to pay for that energy, depressing sales in other more labor-intensive categories of consumption and GDP. Weekly retail sales growth is in another one of its funks right now, suggesting that this energy crowding-out effect has already begun. Year-over-year shopping center sales growth has again dipped below 2% on a five-week moving average, year-over-year basis.

Also, the past few warm winters have served to reduce many of the seasonal factors that sharply increase usually weak raw wintertime sales data (seasonal factors also weight recent years' results more highly). Just as those slowly moving seasonal factors begin to reflect the warmer weather patterns, the Midwest is hitting the mother of all winters, which probably requires large seasonal adjustments. At least we won't have to deal with the spring slump we endured the past few years, as warm winters all but eliminated the spring-weather-related bounces that most economists assumed. Although weather complicates short-term economic analysis, keep in mind that bad weather generally shifts demand around, but does not destroy it.

I am still sticking with my 2.0%-2.5% GDP growth rate forecast for 2014, little changed from 2013. However, we may begin the year with a rough start in the first quarter. A lot of forecasters are hoping for something better than 3% GDP growth for the full year due to less government drag, improved exports, and more business spending, but there are important offsets to these positive factors. Auto and housing sales growth is likely to be far less in 2014 than in 2013. And even though some government pressures have indeed eased, new ones, enumerated above, will offset some of those improvements (food stamps, unemployment benefits, higher insurance premiums). This week's market collapse won't help business or consumer confidence, either.

Mixed Bag of World PMI Data
Purchasing manager data out of China triggered this week's stock market plunge (but probably wasn't the underlying cause). Largely ignored was fantastic news out of Europe, and lower but still-high results in the United States, as shown below.

As it's the second-largest world economy, many analysts watch China closely. The news here has been soft for some time. The days of routine 10%-12% growth out of China are behind us, at least partially because of the law of large numbers. Growth for full-year 2013 was 7.7%, its lowest level since 1999, in data reported earlier this week.

This week's purchasing manager data, which tends to be a forward-looking indicator, seemed to indicate that there was even more weakness ahead instead of the hoped-for rebound. Some of the government's mini-stimulus of the past summer seems to be over. In fact, the government appeared to continue to try to rope in lending practices at year-end, as short-term interest rates blipped up. Perhaps that is partially why the closely watched Purchasing Managers Index dipped to a six-month low. Other indicators, including oil imports and steel output, back up the notion that Chinese growth might be decelerating, not accelerating.

Given that China is a relatively unimportant export partner for the United States, slowing growth in China is not a big deal, in my opinion. Truthfully, a slowing Chinese economy could be a good thing for U.S. consumers. Slowing demand for commodities in China could keep a lid on commodity prices and inflation in the United States and in other developed economies.

Largely ignored in Thursday's turmoil was that the manufacturing PMI for Europe hit a 32-month high in the flash January report on manufacturing. Germany was particularly strong, but other countries showed meaningful improvement as well. However, employment portions of the index remained weak. Results from France continued to indicate contraction albeit at a slower rate than in prior months.

Existing-Home Sales Falter
Pending home sales data has been flashing warnings since July. Existing-home sales growth continued for a time and then went over the cliff in November and December. In fairness, summer data was inflated as fence-sitting buyers stormed the housing market in droves to buy a home before a combination of higher rates and higher prices made dwellings unaffordable. Some of that growth came at the expense of new homes, which take far longer to close. Even the averaged year-over-year data shows both decreased activity levels--and even worse--slower growth rates.

Averaged year-over-year data showed almost no unit growth after peaking at over 14% growth this summer. Transaction dollar value is still up nicely, as rising prices and a mix shift to higher-priced homes offset unit softness. Still, the year-over-year growth rate has fallen by almost two thirds, from 26% to 8%. Given slowing price growth noted below, that number is destined to fall further. These slowing growth rates are not good news for remodeling contractors, furniture sellers, or mortgage brokers.

Some economists are urging clients to ignore the poor December showing because of dismal weather conditions. Indeed, lousy weather was likely at least partially a contributing factor. Results were particularly bad in the Northeast and the Midwest, while results were better in the South and West. But it's not all about the weather. The closed purchases in December were likely begun in October or November when the weather wasn't so bad. Only if the weather was so terrible that one couldn't make the drive to the closing in the last few days of December should it have been much of a factor.

Pending home sales, which we will see next week, are the sales that should be affected by harsh weather. I also warn that it was downwardly revised existing-home sales in November that were the real disappointment in the report. November sales were originally reported as more than 5 million annualized units sold, and that was dropped to 4.82 million in the recently released report. That is one of the larger revisions we have seen in some time.

Home Price Growth Continues to Slow
Seasonally adjusted FHFA home price data showed home prices grew a meager 0.1% in November following a 0.5% monthly rate in October. Single-point November-over-November prices increased 7.6%. Even the three-month averaged, year-over-year data showed home price growth slipping to 8.0%. Four of the nine regions reported that month-to-month prices were down, and five reported increases, certainly not inspiring a lot of confidence. On a more positive note, prices in this particular index (which is much less volatile than the more frequently cited Case-Shiller data) is within 9% of its all-time high reached in 2007.

This month's report is certainly no disaster, but the period of truly heady growth and catch-up appears to be drawing to a close. Price growth of 4%-5% appears to be the most likely outcome for 2014 home prices, which still represents more slowing from here. Affordability remains an issue, so it's probably a good thing that prices don't continue to spiral upward.

New Home Sales, Durable Goods, GDP, and Personal Income All On Tap Next Week
The biggest news of the week will probably be the first estimate of GDP for the fourth quarter of 2013. Consensus estimates have grown sharply over the past few weeks, jumping from 2.0% to the current estimate of 3.0%, as stronger retail sales figures have dramatically boosted the estimates. Inflation-adjusted consumption growth in the fourth quarter of 3.8% is not out of the question. That would represent the second-highest consumption growth rate of the recovery, topped only by the 4.3% growth rate in the fourth quarter of 2010. With consumption representing 70% of GDP, the starting point for the GDP forecast is the 3.8% expected consumption number times 70% or 2.7%. Housing, business capital spending, and net exports should kick in something additional while, inventories and government are likely to be net detractors. Overall GDP growth appears destined to increase 3% or more in the fourth quarter following 4.1% growth in the third quarter, the first back-to-back above-average quarters of growth that we have had in some time.

I do caution that the second-half numbers were more than a little flaky. Almost half of the third-quarter gains were due to an inventory bulge, and the fourth quarter is benefiting from some very weird timing situations in the auto industry. Record cold and snow in parts of the country that have sharply boosted utility usage also helped the fourth quarter with more potential benefits in the first quarter. Unfortunately, I think those benefits will turn into an albatross around our necks later in the first quarter as consumers begin paying sky-high utility bills that will surely detract from other consumer expenditures. And although utility bills are inflating GDP, higher utility usage does little to boost employment.

Personal Income and Consumption Data for December Might Not be Pretty
The reversal of some of the great quarterly data might show up as early as Friday with the report on the "December only" data on income and consumption. Consumption and personal income are both slated to grow 0.2% before inflation. The consumption growth figure could be well below the great numbers we saw in October and November. Then the news gets worse. Inflation was considerably higher in December than the other two months of the quarter. That means that both consumption and income, adjusted for inflation, could be negative when comparing December to November. So those who get excited by the strong GDP report on Thursday will get doused with a bucket of cold water on Friday.

Durable Goods Orders Should Look Solid, Though Slower Than in November
November was a great month for durable goods as businesses upped their purchases after the federal budget settlement and the end of the October government shutdown. Good aircraft orders helped, too. The normal year-end rush in December, as managers face use-it-or-lose-it budget situations, will help the reported durable goods order numbers for December; however, some of that is accounted for in the seasonal adjustment process. Strong Boeing (BA) orders should be a plus, too. But I still expect overall order growth rates to drop from 3.4% growth month to month in November to a still-healthy 1.5% in December.

Pending and New Home Sales Likely to Look a Little Soft
This week's real estate data was generally soft, and I expect more of the same next week. The Pending Home Sales Index has fallen in a straight line from 111 in May to 102 in November, and existing-home sales followed suit a few months later. Both existing- and pending-home sales are hovering at the same levels as they were a year ago. That's consistent with the National Association of Realtors' ongoing forecast of almost no growth in existing-home sales for all of 2014. With a poor trend and bad weather, I suspect the pending index could fall below 100 for December.

New Home Sales Could Be Flat Again in December
New home sales did fairly well in 2013, even if sales temporarily collapsed over the summer, then in the single month of October recaptured all that was lost previously. November sales were basically flat with October's lofty levels. Now with colder weather, I suspect that we might be lucky to hold sales at that level in December. Consensus is a little more optimistic, projecting new home sales to increase from 464,000 in November units to 469,000 in December. Housing has been a key part of this recovery, but now seems to be slowing, which will weigh on GDP growth in 2014.