Inflation: Not entirely tame

Modest headline inflation is good news for consumers, but under the surface rising rent and groceries bills have taken a bite.

Robert Johnson, CFA 25 October, 2014 | 6:00PM
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This week, world equities rallied sharply, bond rates, though still depressed, moved up, while commodities continued to trudge ever downward. U.S. markets were by far the strongest, with the S&P 500 up over 4% in just one week. Meanwhile, emerging markets, suffering from low commodity prices and a still-faltering China, managed a much smaller 0.7% gain. Europe split the difference with a gain of over 2%.

I am at a loss to explain the gains, except maybe the sellers just got tired or that selling the previous week was overdone. The economic data was about as advertised, with few surprises and limited but nevertheless improving data sets. Earnings news was generally disappointing, especially for the blue chips, with   Coca-Cola  KO,   IBM  IBM,   Amazon  AMZN, and   McDonald's  MCD all delivering negative surprises.

Meanwhile, the 10-year U.S. Treasury bond moved up from 2.2% to 2.27%, which is not generally well-received by markets of any kind (well, except the U.S. dollar). Certainly the strength of the U.S. economy relative to any other market is beginning to show through to all but hermits living in a cave. That may be part of what this week's market activity was all about. Still, being the best of a relatively bad lot doesn't make for a great investment thesis.

On the bright side, the housing market did look better this week, with both existing- and new home sales exceeding expectations. While the improvements were small, it finally looks like housing is pulling out of its funk. Low rates, looser lending standards (announced this week), and continued low mortgage rates point to more improvements in the months ahead. I still think a lot of the strength will be in existing homes and not the new home market.

Inflation looked very low at 1.7%, according to this week's CPI report for September, and seems destined to fall even lower in the months ahead, putting more cash in consumers' hands for the all-important holiday season. In the manufacturing world, generally better headline purchasing manager data from outside the United States seemed promising to the market. However, overlooked were the more forward-looking components of the indexes that continued to deteriorate.

Inflation under control again, but not entirely

The headline Consumer Price Index inflation growth for September was a modest 0.1% (1.2% annualized), and the September-to-September growth rate was back down to 1.7%. Over the past year, inflation has ranged from as low as 1.1% in fall 2013 to a high of 2.1% this May. For some perspective, the median inflation rate has been 3.0% over the past 65 years and the average has been 3.6% (skewed by double-digit inflation during the 1970s). The current inflation is in the bottom quartile of inflation results dating to 1948. Not only is the data remarkably low, but it also has been surprisingly stable, hovering in a very narrow range the past three years, as shown more clearly in the shorter-term graph (the green line in the second graph below). This low volatility is probably even more comforting than the current low rate.

Longer-term inflation is approximately half the long-term trend

Inflation rates appear to be stabilizing after decades of wild swings

Housing inflation picking up steam, potentially driving new home sales higher

The graph above shows that after years of holding back inflation rates, the rate of housing inflation is boosting the rate of inflation. Month-to-month housing inflation was up 0.3% compared with the overall inflation rate of 0.1%. It's not just a one-month phenomenon, either, as year-over-year shelter price increases were up 3.0% versus 1.7% for the overall rate of inflation.

Unfortunately, shelter is the single biggest component of the CPI calculation, so big moves here are magnified. For some perspective, gasoline is 5% and food is 14% of the CPI calculation. The good news is that consumers, with locked-in mortgages, won't see the inflation in terms of higher mortgage payments. In fact, housing inflation is largely determined by what home owners think they can rent their homes for and not changes in home prices or even mortgage payments.

The bad news is that the pain is real for renters. Rents are up 3.3% year over year and continuing to accelerate. As supply of rental homes and units remains constrained and demand accelerates, the rent situation may get worse before it gets better. Furthermore, it could offset some of the gains that renters were seeing from sharply lower energy prices.

At some point, the continued upward drive in rents should help fuel demand for new homes for purchase. Low rates and slowing home price growth, as well as higher consumer incomes could tip the balance toward a new home purchase. That would be great news for homebuilders and the economy, both of which could use a little help.

Year-over-year inflation could drop even lower

The good news is that falling gasoline prices probably mean even lower inflation rates in the last quarter of 2014. Though gasoline prices fell in September, they fell dramatically more in October.

Natural gas prices have been falling again, too, in months when prices normally start rising. That should also help keep a lid on short-term inflation. Just based on the gasoline and natural gas situation, I won't be surprised if December-to-December CPI inflation ends up at 1.4% or less. That would be lower than last year's reading of 1.5%, and much lower than I thought just six months ago.

Category data shows that food prices are still out of control

The sector data continues to show a nice mix of increasing and decreasing prices, with no strong, generalized trend in either direction. Things are a lot scarier when all prices move in lockstep, either up or down. Currently, neither deflation nor inflation has the upper hand.

Outside of housing, as discussed above, rising prices for food remain one of the biggest problems in the report. Just when I thought things couldn't get much worse for beef eaters, prices rose another 2% month to month in September. That puts beef prices up a stunning 17% since January. Beef inflation is a very high and particularly visible number that probably is keeping consumers cautious in their other purchases.

If the early-stage Producer Price Indexes are to be believed, it is just a matter of time before consumer food prices begin moving down. Outside of the really big swing items noted in the table above, there were a lot of important categories in the middle that showed no change at all. Those include apparel, new vehicles, furniture, and recreational services.

September inflation data drives a lot of cost-of-living calculations

The September CPI report drives a lot of annual adjustments based on inflation over the past year. For example, the 1.7% increase in the CPI will mean a similar increase in Social Security payments in January. It's not much of an increase, but it is paired with no increase in at least one part of the Medicare insurance premium. The low rate also means only small increases in retirement saving limits. The 401(k) limit moves from $17,500 to 18,000 and the over age 50 catch-up provision increases from $5,500 to $6,000.

World PMI data headline numbers generally improve, but the reality is that problems remain

Investors watch world purchasing manager numbers very carefully for clues to the health of the world economy. The headline numbers around the world were generally good and better than expected. However, the data below the headlines was not nearly as good.

First, looking at the headlines, data from both Europe and China improved modestly between September and the flash data for October. It was a great relief that Europe not only didn't fall below 50 (the point where as many firms saw improvement as deterioration) but also moved up slightly. The free-fall that many expected did not turn up in the data. China also showed some improvement. The U.S. declined slightly, from very high levels, levels that still exceed the readings from both Europe and China by a wide margin.

The market tended to focus on the headline numbers and gave a collective sigh of relief. However, the underlying category data in both Europe and China were not good news for the more careful reader. New order growth in both territories slumped in October. In Europe, new manufacturing orders dropped below the key 50 reading, their worst showing in 15 months.

Also worrisome in Europe was the fact that the price of manufactured items fell at their fastest rate since 2010, even as input prices were little changed, portending a European profit squeeze. In China, both input and output prices fell, potentially meaning a slightly smaller profit squeeze than in Europe. New orders and export data also slowed, but remained above 50 in China. The U.S. data fell from levels that I believed to be unsustainable but still looked better than much of the rest of the world. I generally believe that ISM numbers have more predictive value in the U.S. than the more recent Markit data. Unfortunately, we are still 10 days away from the release of that data.

Existing-home sales improve, as I suspected

Existing-home sales jumped from 5.05 million units sold to 5.17 million, defying most analysts' expectations for a decline to 5.02 million units for the month of September. The pace of existing-home sales was the highest reading of the previous 11 months. However, the rate was still about 2%, below last year's reading that was inflated by a buyer rush to close home sales before mortgage rates moved higher.

September 2013 will be the last month when this rush caused an artificial spike in existing-home sales. From here on out those year-over-year comparisons will look wonderful. Year-over-year growth of 5%-10% in the final quarter of 2014 appears to be a real possibility.

Better locations and cheaper prices are giving existing homes an edge over brand-new homes over the past few months. The data below show the year-over-year declines in existing-home sales, but they have already begun showing an improving trend. Declining average sales prices are more an indication of more transactions in the low end of the market than an outright decline in prices. I have also included the past six months of unit sales, and price data that provides a different look at recent trends. My normally more reliable year-over-year data is distorted by last year's mad dash to close sales. The uptrend here is sharper than I might have guessed. Still, sales are up 11% over the past six months.

The trend line numbers are good enough so that commissions on existing-home sales will be a big contributor to the GDP calculation for the third quarter, nearly identical to the contribution in the second quarter. That sure beats the large detractions in fourth quarter of 2013 and the first quarter of 2014.

New home sales suffer a huge revision; now consistent with other housing reports

The original new home sales report contained a huge month-to-month change from the mid-400,000s to just over 500,000 units. That didn't square with a lot of other data, including housing starts, which showed a relatively flat performance. Lo and behold, the 505,000 August figure was revised down to 466,000 units in this month's new home sales report. When the report is pieced together, the market looks better than last year (though that is partially because of the rush to buy existing homes, at the expense of new homes, a year ago). The recent unit data looks relatively trendless, with not much improvement or deterioration.

Better days for new housing for the months ahead

 Last week I spilled a lot of ink on why the housing market should improve, but that the improvement might be more limited than many expect because of demographics and affordability issues. This week's data is consistent with those thoughts, with a nice improvement in existing-home sales month to month and listless trend in most new home-related data. However, the entire housing market, new and used, is likely to benefit from a few key trends, at least in the short run.

First, as noted above, rents continue to soar, which could help tip the balance for renters to shift to purchases. Second, mortgage rates are again on the decline, which should also help affordability. Finally, there are some very serious talks about changing some of the standards for Fannie Mae and Freddie Mac mortgages. In some cases the down payment requirements would be substantially reduced, perhaps as low as 3%. However, income requirements would remain relatively restrictive.

Again, I caution that a boom to 2.0 million new housing starts, or even 1.5 million units within the next year or two, is not the most likely case. Still, the housing market stars are finally beginning to align for it to see better times ahead, after a year of limited growth and disappointments in 2014.

FHFA data shows another month of home price moderation (by Roland Czerniawski)

This month's release of FHFA data continues to confirm our thesis that the pace of home price increases will continue to slow at least through the end of the year. October's release reported a 0.5% month-to-month increase in August, and year-over-year prices were up 4.8%. On a year-over-year three-month moving average basis, which is our preferred method of looking at this data, prices were up 4.9%, the slowest growth rate since October 2013. Overall, FHFA home prices are still 5.8% below their April 2007 peak. Regionally, seven out of nine census divisions reported positive monthly increases in August. New England and South Atlantic were the only divisions where prices declined this month. The Pacific region continues to be a strong gainer with 25 consecutive monthly price increases, and over the past 12 months, it recorded a 7.8% price gain. On the same basis, New England and Middle Atlantic are the slowest gainers, with 2.0% and 1.9% year-over-year increases.

We view the home price moderation as a positive development. The rapid price increases experienced in 2013 drastically limited home affordability, causing a dent in the housing market recovery. Slower price increases, while still helping consumers emerge from underwater mortgages, will improve affordability and promote a more sustainable housing market environment.

Pending home data, durable goods, GDP, and personal income on the docket for next week

Theoretically, next week's first reading on third-quarter GDP should be the most important of the week. It is the broadest report on activity and does the best job of adjusting data for inflation. Regrettably, wild swings, especially in exports and inventories, as well as seasonality and annualization issues, have rendered this report less useful. Still, any big fallout from expectations of 3.1% growth in either direction is likely to cause a market swoon (too low and earnings potential will be reduced, too high and worries will abound concerning Fed tightening). Current expectations are for 3.1% overall growth, down from the big weather rebound-influenced second-quarter result of 4.6% growth.

Pending home sales should give us some indication if lower interest rates, better employment data, and high rents are pushing up existing-home sales activity. Last month, this metric made a surprise drop, though existing-home sales did not follow suit. That is one of the rare misses for this normally helpful metric. I would expect pending home sales to be up at least 2% or 3% for the September period compared with August. Pending home sales generally lead existing home sales by a month or two.

Durable goods orders have been jumping all over the place lately, primarily because of auto and jetliner activity. I am hoping for a return to greater normality in September. The consensus is for headline orders to increase 0.2% after falling 18.4% the previous month. I will be taking a strong look at both orders and shipments of nondefense capital goods to determine if businesses are finally stepping up and making more investments in their businesses. Business spending has been a little light this recovery so far.

Consumer spending is expected to be up 0.1% in September after jumping 0.5% the previous month. Poor retail sales and softer auto sales earlier this month are why the expectation is so low. After adjusting for inflation, there may not be any consumption growth. Income growth should look better, with expectations for growth of 0.3%, driven by higher employment levels and longer work weeks (though not much more pay). There is an outside chance that a big jump in owner-equivalent rents combined with lower mortgage payments could provide a surprise addition to income growth. The net result of the higher income growth means that the savings rate increased yet again. This should provide the rocket fuel for a better holiday season than most are expecting.

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Robert Johnson, CFA

Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis for Morningstar.

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