Markets this week were remarkably tame despite more saber rattling out of Russia, as Europe sinks closer to a deflationary environment. In fact, prices were down in Spain for July and only up 0.3% for the Eurozone. That's not month to month; that is year over year. That, in turn, got the bond market excited with the prospects of the European Central Bank doing something new. The yield on the U.S. 10-Year Treasury sank back to 2.33% from 2.40% a week ago. Ultrasafe German bond yields also fell. This, in turn, buoyed U.S. and emerging equity markets. European equity markets did less well as more worries about the Russian/Ukrainian situation surfaced. The fear is that Europe, which is already not doing that well, will be hit the hardest by sanctions imposed on imports from Russia and the retaliatory effects of reduced exports to Russia. Lower rate talk and geopolitical issues also drove commodities generally higher, though oil prices remained remarkably subdued.
Economic news out of the United States was generally bullish, including improved pending home sales, Goldilocks-like home price increases and an upwardly revised (and higher quality) GDP report for the June quarter. However, new home sales slipped again and consumers continued to boost their savings rate at the expense of current consumption. I don't believe this skinflint behaviour, which is in its seventh month, can continue for much longer.
Also this week, the U.S. congressional budget office affirmed that the fiscal deficit would be 2.9% of GDP for fiscal year 2014, which ends next month. And the deficit is likely to remain close to that level for the next four years before beginning to move higher as the baby boomers age, retire, and grow ill. Still, the deficit in 2022 is now targeted at 4% or so of GDP; that is well below the more dangerous 6% level forecasted by the same organization just two years ago. It's hard to believe that the deficit was close 10% of GDP just 10 years ago. Of course, this is all under current law, and the formal budget for 2015 has yet to be approved by congress. We will hear more on this in the weeks ahead, but no one is expecting another shutdown as the November elections are quickly approaching.
Consumer spending sags, even as incomes continue to grow
Consumer spending, adjusted for inflation, shrank by 0.2% in July, slightly below expectations. Those expectations were already low because it was well known, previously, that retail sales were flat even before adjusting for inflation. Meanwhile incomes improved slightly and some prior months were revised upward (and most consumption data was little changed). On a month-to-month basis, income growth has exceeded spending growth in six of the past seven months, which is highly unusual.
I keep thinking that this cannot go on indefinitely. If the U.S. consumer is known for anything, it's spending close to every last dollar. Weekly shopping centre data has suggested some improvement over the past several months, but it still hasn't really turned up in the monthly retail sales report or the consumption report just yet. The year-over-year data looks much better, but some portions of the data during the winter months were distorted by tax increases the prior year. Still, the past three months of averaged data should be relatively clean and show a much less distressing picture of consumer spending. Furthermore, wage income, which is particularly prone to being spent, appears to be accelerating. (Income growth includes dividends, rents, and small-business profits that are not spent nearly as quickly as wage income.)
The category data doesn't look nearly as bleak, with many items showing nice gains and a relatively concentrated list of items that didn't do so well. And the items that didn't do so well are quite volatile and could just as easily bounce back in another month. Although it probably isn't a good statistical way to look at the data, autos and utilities combined accounted for the entire 0.2% decline in consumption. Also weak were gasoline, which seems odd given falling prices, and groceries, which still seem to be suffering from sticker shock related to generally higher prices due to several different droughts. Bright spots included financial services, furniture, women's clothing, and televisions.
With relatively weak sales a year ago and potentially a stronger back-to-school season this year, I am hoping that consumption will look substantially better in August and September. As I mentioned earlier, the weekly shopping centre report suggests that this is already happening.
Quality and quantity improved in the most recent GDP
GDP for the second quarter was revised upward from an already strong 4.0% to 4.2%. This is better than estimates of a downward revision to 3.9%. That performance is also the second best of the entire recovery.
However, part of the reason that the second quarter looked so good is that the first quarter looked so bad, declining by 2.1%. Even averaging those two quarters together, the economy grew just over 1% in the first half of the year. The largest change in this set of revisions was a 0.3% reduction in the inventory contribution. Inventories are generally viewed as a low-quality way of boosting GDP. Offsetting the inventories' negative effect on GDP was an overall 0.4% increase in business investment. Net exports also added 0.2% to GDP. Consumption, residential spending, and government were all unchanged from the previous report. The far right column of the table below shows what has changed since the previous estimate. This revision was mercifully smaller than the huge revision that was experienced in the second quarter.
The table above shows the growth rate of each GDP component and its relative size. It's always interesting to note that some categories are extremely volatile and can have a dramatic effect on GDP, even if they are relatively tiny. Exports would certainly be in that camp. Other categories like consumption have much smaller relative changes but are massive portions of GDP, such as consumption, especially the consumption of services. As noted in previous reports, consumption returned to normal levels in the second quarter, overall business investment picked up, and the housing market was finally a contributor again. Even government made a decent contribution after years of declines or lackluster results. The only detractor from GDP was net exports, although that is pretty typical of an improving U.S. economy. Unfortunately, slowing world economies could hold back this sector for several quarters into the future.
As much as I liked the GDP revision, the underlying strength of the economy is nowhere near the 4.2% that this report implies. Weather strongly and negatively affected the first quarter and aided the second. Also, inventories and net exports have been on a real yo-yo the past several quarters, and this just happened to be one of the rebound months. With year-over-year consumption growth of 2.2% and private sector employment growth of 2.1%, it seems that the true underlying growth rate of the economy remains around 2%.
Looking ahead, I am still forecasting 2.0%-2.5% growth in real GDP for full-year 2014 and 2015. Given the decline in the first quarter, that means the economy must grow at 3.4% in the back half of the year to reach my forecast. That sounds a bit optimistic, but the economy still doesn't appear to have caught up from the winter slump, and consumers for some odd reason have at least temporarily boosted their savings rates. That almost never lasts long.
Full steam ahead for existing-home sales
Recently, existing-home sales have begun to come out of their funk. Last year's interest rate spike caused existing-home sales to jump and then fall off a cliff as the spike did nothing more than pull ahead sales that would have fallen in later periods. Though the trend line in existing-home sales had been close to 5 million annualized units, they temporarily spiked to 5.4 million units in July before collapsing to 4.59 million units in March. Bad weather didn't help matters, either. Now those existing-home sales have returned to above the previous trend at 5.15 million units for July, as we discussed last week. In fact, the July 2014 existing-home figures were better than at any time during the recovery except the temporary spike a year ago.
This week's pending home sales data suggests that there is more good news ahead. The index moved up 3.1% sequentially to 105.9 (a reading of 100 means that pending home sales are at the same level as they were in 2001). With a one- to two-month lead, pending home sales are a very good predictor of existing-home sales. The pending home sales report suggests that home sales could move into the 5.2 million-5.3 million annual rate zone for August. Because of last year's housing spike, the year-over-year averaged data continues to look a little funky. Still, it's pretty easy to see that the trend is in the right direction with smaller declines in both pending and existing-home sales. It looks like both metrics will move into year-over-year growth mode sometime in the fourth quarter.
New home sales still in a funk
A combination of high prices, low inventories, spot shortages, and poor geographic positioning have all weighed on new home sales for some time. This report measures only single-family homes and does not include multifamily units that have been increasing their overall market share. The report this month included an upward revision to the June data but a disappointing number for July. Averaging the data for the two months suggests that the market was just about where analysts had anticipated, even though the July number by itself looked a little disappointing. July's unit sales dropped 2.4% between June and July to 422,000 units. The year-over-year data looks better, but last summer was unusually weak as buyers flocked to existing homes (which close much quicker) to beat higher interest rates.
Single-family housing starts, which are reported separately, have been acting better than the new home sales report. The new home sales report includes homes under construction, complete homes, and homes not even started. The starts report just includes homes started. Also, there is a large gap between single-family sales and single-family starts because the starts report includes individuals who own a lot and contract to have a home built separately, or builders that are occupying homes while they are under construction. The gap is unusually wide at the moment with single-family starts at 632,000 and new home sales at 429,000.
Why the wide gap? Sales of tract homes, which are mainly what the new home report captures, remain decidedly unpopular, with their distant locations and large sizes. More popular are so-called teardowns, where homes in close, desirable neighborhoods are purchased, torn down, and replaced with a home with more modern amenities. I have noticed this phenomenon in my neighborhood, with homes built in the 1950s now being torn down. Over the past 15 years, the nontraditional, nontract homes have averaged about 24% of new home sales. Currently, that figure is at 32% on a three-month averaged basis and 35% on single-month calculation. I might also mention that some investors have also bought up existing homes and fixed them up to a newer look and feel. Sales of those refurbished homes are aiding existing homes and detracting from the sale of new homes. However, some of my younger colleagues in the office suggest that these fixed-up homes are relatively expensive, even compared with new construction.
Home price growth moderation still intact (written by Roland Czerniawski)
Both FHFA and S&P/Case-Shiller reports have been released this week, and both are signaling a continued slowdown in home price increases. FHFA, which only includes homes financed with Fannie Mae and Freddie Mac mortgages, reported a 0.4% sequential price increase in June. On a year-over-year, three-month average basis, prices have grown 5.5%, a substantially lower pace compared with the 8.3% peak growth observed last September. The Case-Shiller 20-City Price Index, which is constructed from a slightly different mix of homes, actually contracted 0.2% in June, and the year-over-year growth came down all the way to 8.1%. That is almost 6% lower than the increases we witnessed late last year. The 
CoreLogic CLGX report, which was released three weeks ago and included a preview of July's data, showed that more of the same can be expected next month.
While the pace of home price increases is slowing, prices are still rising nonetheless. As we have mentioned over the past few weeks, our team views this as a positive development that helps to recover some of the underwater mortgages without drastically ruining affordability. Because of the rapid price increases we experienced throughout 2013, we expect that the price growth moderation will continue at least through the end of 2014.
Durable goods report a mixed bag
The headline durable goods number was a stunner, increasing 22.6%, driven by strong orders at Boeing BA. Unfortunately, those orders will not ship for many years. Expectations had been of this metric to increase 12.6%, so the Boeing-related surge was even bigger than expected.
The auto sector also soared with orders up 10.6%. Excluding transportation orders, orders didn't look so hot, registering a 0.8% decline following an unusually strong (and upwardly revised 3.0% rate for June). Both the averaged and year-over-year data provide a much brighter, and in my opinion, representative view of the data. Growth is now back to where it was a year ago before the sequester/budget fight and poor weather derailed the improvement. Remember that even one lost day of production represents 5% of a month's production.
Keep in mind that orders eventually turn into production and shipments, which aid both employment and the GDP calculation.
I also like to look at the nondefense capital goods orders less transportation equipment part of the report as a gauge of business sentiment (much as I use weekly shopping center data and auto sales to judge the level of consumer confidence). Again, the month-to-month and year-over-year data provide a slightly different picture.
Both of the tables above suggest that the manufacturing sector is doing well, though we may be past the period of rapidly accelerating improvements.
Investors keying on employment report, auto sales, and the trade report next week
Though the investment community is very focused on the employment report, I think the auto sector will be the key report next week. Auto sales tend to jump around a lot because of how the calendar falls and manufacturers' sale incentives. In July, auto sales dipped back to 16.5 million seasonally adjusted annualized units from 17.0 million the prior month. If the normal pattern is followed, a weak month should be followed by a relatively stronger month. That's probably why the consensus expects sales to increase 0.2 million to 16.7 million units in August. With production creeping up, I suspect the automakers are hoping for a better month, too. The year-over-year numbers are expected to show little growth before adjustment, as August this year includes one less selling day than a year ago. When that is factored in, year-over-year sales growth should approach 4%. However, forecaster TrueCar thinks the improvement will be highly concentrated with a huge gain at Chrysler and a small gain at Hyundai and Nissan (before selling day adjustments), with others showing small declines. After the day adjustment, only Volkswagen and Toyota are expected to show declines.
As usual, the employment report is a hard call without a lot of metrics to hang our hats on. The consensus seems to be that July's report was flukishly low and a rebound is likely in August. Unemployment claims also looked better in August, and the job openings report for June is solid. Still, shifting timing for auto manufacturers' summer shutdowns will weigh on this report. Consensus is for job increases of 225,000, up from 209,000 the previous month. Not to be superstitious, but August employment numbers have almost always been a disappointment, at least on the first version of the numbers. Shifting school and auto manufacturing schedules have wreaked havoc on the seasonal adjustment factors. The year-over-year data will provide a better gauge of job market health. And everyone is now watching the hourly wage growth figure, which has been deeply disappointing this year, despite a dramatic improvement in the unemployment rate.
The trade report is expected to show little change in July and remain at about $41.5 billion. With retail sales soft, imports may be weak. However, given the situation in both China and Europe, exports are also likely to be a bit soft. These two offsetting trends are likely to keep the overall deficit little changed.
Investors will also look to ISM's purchasing manager forecast to see if the positive trends in manufacturing can continue. Although they are often different, the flash version of the data from Markit suggests that some improvement is in the cards. The consensus is for the metric to increase from 57.1 in July to 57.4 for August.
