Europe stumbles once again

A possible bank default and soft industrial production figures have rekindled some nervousness about the European recovery.

Robert Johnson, CFA 14 July, 2014 | 11:50PM
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This week there wasn't a lot of economic data out of the United States, and the data that we did get was mixed. The job openings report for May affirmed that last week's hot labour report for June was probably no fluke. Properly adjusted, the U.S. federal budget deficit was flat year over year and is on target to be at or below the magical 3% of GDP level that everyone watches. Although the single-week shopping centre growth pace was off a little bit last week, the five-week average year-over-year growth rate is still at 3.6%, the best reading since May 2012. Still, housing affordability slipped yet again in May, and that is not good news for the housing recovery.

Furthermore, the Federal Reserve formally announced it was planning to end its entire long-term bond-buying program by October. At one point the Fed was buying back as much as US$85 billion of mortgage bonds and long-term Treasuries each month. However, other central banks including the European Central Bank, China and Japan are still in loosening mode and have offset a lot of the Fed's tightening efforts. The U.S. Fed remained elusive as to when it would actually begin to raise short-term rates. Most economists expect some type of upward move by the middle of 2015.

But this week's market moves were not about the United States. There was another European banking scare, this time in Portugal, which is a bit smaller than Greece. Still, one potential default (or at least non-payments) by Portuguese bank Banco Espírito Santo, stirred the usual contagion fears on Thursday.

It didn't help that most European country-level industrial production figures softened by a percent or more, raising more questions about the strength of the European economy. That shrinkage mirrors recent softening in European Markit purchasing manager surveys, so this is not a one-off situation. Europe's recovery has been extremely dependent on exports and export partners, the U.S. and China, are now both growing more slowly than expected. This week, disappointing export and import data from China suggested that the situation could worsen.

As might be expected, slowing growth expectation drove down stock markets of all stripes this week and across all geographies. U.S. and emerging markets were off about 0.5% with a lot of European indexes off as much as 2%. Bonds showed lower yields this week, at least in stronger economies (the United States and Germany) but not the peripheral bond markets (Portugal and Italy). The U.S. 10-Year Treasury bond saw yields drop from 2.65% last week to 2.52%. Commodities in general were soft with grains continuing to fall sharply and oil-related products generally off, too. The PowerShares Commodity Index was off almost 2.7%.

European industrial production sags

There were a lot of hopes that the economy in Europe would continue to accelerate in 2014. However, the Industrial Production reports for most European markets fell meaningfully in May, with most markets down by close to 2%. Even powerful Germany was down 1.8%. Although Markit purchasing manager data has been down in recent months, the index still showed more companies expecting growth than declines. Most forecasts were for growth in industrial production in most major markets. I am not so sure I want to hang my hat on one month's worth of data, but it's clear that Europe's economy is not accelerating as many had hoped.

JOLT report signals an overall labour market improvement, but many job openings remain unfilled

My colleague Roland Czerniawski was instrumental in analyzing last week's employment report in my absence and provided the following analysis of this week's Job Openings and Labor Turnover report.

The May JOLT report, which is released by the Bureau of Labor Statistics every month, showed the continued improvement of the labour market. The number of job openings was higher than most expectations, increasing to 4.64 million in May. This is the fourth consecutive increase and the highest level of job openings since the prerecession high in March 2007. The number of hires decreased slightly from April and continues to trend up at its anemic pace. The number of quits, on the other hand, increased to 2.53 million. The number of quits is a widely followed metric and is considered especially indicative of the labour market's health. While the quits continue to trend up, they still remain significantly below the prerecession level of around 3 million. This means that the labour market recovery is far from done, and that the workers have not regained all their confidence lost during the recession.

The report also points out that the rapid increase in new job openings is not matched by the number of hires and quits, as shown on the chart above. This, consequently, clearly indicates that employers are struggling to fill the new positions. The explanation of this puzzling phenomenon has two parts. First, there could be a mismatch between workers' skills and the requirements for the new job openings. In other words, employers might not be satisfied with the type of candidates applying for the jobs. (Strict hiring processes in many industries that often take months to complete don't make things any better here.) The second part of the answer might have to do with the employees themselves who are just not confident enough to quit and transition into new roles just yet. Considering that the pace of wage growth has yet to impress, unsatisfying pay could be one potential factor scaring candidates away from making job transitions that are often costly.

For now, employers continue to draw new hires from the unemployed part of the labour force. The number of unemployed workers per job openings declined further to 2.1, all the way down from the 6.4 peak recorded in October 2009, as illustrated on the chart below. While this trend is encouraging, it clearly won't be sustainable for much longer as we get closer to the 1.4-1.8 prerecession norm. At that point, employers will have to attract new candidates with higher pay, which should finally lead to a meaningful acceleration in wage growth. Overall, it seems obvious that the labour market that was hit hard during the recession is gradually shifting from lack of jobs to the lack of workers with the right set of skills. This issue will only deepen going forward as the most experienced part of the labour force, the baby boomers, begin to retire.

Federal budget surplus shrinks in June, but still on target for substantial shrinkage in fiscal year 2014

The overall budget surplus shrank from US$117 billion in June 2013 to US$70 billion in June 2014. June is a relatively high collections month and generally runs an overall surplus. The sudden shrinkage in the monthly surplus would normally be a little worrisome. However, June of last year included a one-time, US$50 billion payment from Fannie Mae (related to a tax accounting issue due to the return to profitability). Putting that one-time event aside, the surplus was modestly bigger than at the same time a year ago. Also, there was a US$20 billion swing in the student loan program, related to changes in reserves, which, combined with the reduction of the Fannie Mae payment, would have meant the surplus in June was in reality US$23 billion better than in 2013 for the month of June.

Most notable in the June report was that tax collections finally began to show a sharp improvement. Total collections were basically unchanged for all practical purposes in both April and May, which didn't square with sharply improved employment and income data. Finally, the June data showed the improvement I had been looking for as collections jumped by US$37 billion, a very impressive 13% increase. Contributions from withheld and individual tax payments were up 14% and corporate taxes were up 11%. Excluding the swing in Fannie Mae payments and smaller reserve adjustments to the student loan program, expenses were up just US$7 billion or just 4% in June.

Looking at nine months of data for fiscal year 2014 (fiscal year from October to June), the budget deficit fell sharply (improved) from US$510 billion in 2013 to just US$366 billion in 2014. If the deficit showed no improvement in the past three months of the fiscal year, an exceptionally conservative assumption, the full-year 2014 deficit would be US$536 billion (3.1% of GDP). More likely is some continued improvement with my single-point forecast now at US$500 billion and 2.9% of GDP.

Nine-month government receipts up 8.2%

Overall receipts have been boosted primarily by higher tax rates, new taxes and the return to normal Social Security tax rates. A stronger economy, better wages and higher employment didn't provide very much help until very recently. The table below shows that individual income tax collections and Social Security withholding dominate the federal government revenue sources. Corporate taxes and everything else (customs, estate tax, and so on) are dwarfed by money collected from individuals.

Total government outlays up just 1.2% for the nine-month period

I would have expected limited growth in expenses early in the fiscal year with both the sequester and the government shutdown. However, expenses have still remained remarkably constrained even after those issues were settled. Falling military spending and substantial reductions in payments made to the unemployed (as the unemployment rate fell sharply) are the primary reasons that spending increases have looked so muted. The only thing showing much growth is Social Security payments (cost of living plus more baby boomer recipients) and Medicaid, which has seen a large jump under expanded eligibility provided by the Affordable Care Act. Payments from Fannie Mae and Freddie Mac (which are recorded as reductions in expenditures) is down year to date and will drop even more sharply in fiscal year 2015, providing a bit of a headwind for next year.

Improving budget situation is a mixed bag

Overall, I cheer an improving deficit situation. It means less government borrowing and allows for capital expenditures by businesses, which are arguably better allocators of capital than government. All things being equal, smaller deficits mean lower interest rates, a stronger currency and lower inflation.

The bad news is that government austerity continues to pressure economic growth. While the private sector has regained every job lost in the recession, government employment (at all levels) is still down by over half a million people.

Housing affordability continues to slide

I was hoping for some good news on the housing affordability front, but we didn't get that on Friday. Year over year, affordability fell (the index went down) from 179 to 159 for May. I was hopeful that the effect of higher interest rates would moderate; modestly higher incomes and slowing price increases would all help. However, rates, as of May, weren't down quite as much as I expected month to month and are up sharply year over year. Income growth was modest (2%) and the median home price was up 5%.

Rolling all of this together, affordability slumped 11%, year over year for May. No wonder existing home sales have been relatively soft. The good news is that despite the slump, affordability is still well above its 25-year average of 135 and boom-time lows of 102.4 and a recession-related high of 210 in April 2012. If affordability doesn't slip back to under 140 or 150, the housing market will probably be in good shape. If not, the road ahead could be a little bumpy.

Trade deficit improves month to month but still represents a potential drag to second-quarter GDP

The trade deficit for June shrank from US$47 billion in April to US$44 billion in May. While better, it's still worse than the US$40.7 billion average of the past 12 months. The early months of 2014 have not been kind to this metric as cold weather led to more imports of oil products and less U.S. supply to export. That's the primary reason that trade has stopped improving. Now I am a little afraid that importers rushed to beat a potential West port strike (the contract expired on July 1) in June. Of course, some of that will end up sitting in inventory (which helps the GDP calculation). Nevertheless the very best case is trade being neutral to GDP in the second quarter (after taking 1.5% off first-quarter GDP) but it could end up taking off over 1% yet again.

Good weather could mean a bumper corn and soybean crop

I have been worried sick about the recent droughts and the potential impact on food prices. In fact, food prices, especially beef, are up sharply in the Consumer Price Index. Fortunately, drought conditions have broken in much of the country. Below are the percentages of land mass in a given state that is not subject to drought and the areas suffering modest to severe drought. Higher numbers are obviously worse.

I didn't pick the states above randomly; they are the six largest agricultural producing states. The improved weather, if it lasts, should dramatically improve crop yields in 2014. That should reduce prices for food, with a lag. Corn and soybean prices are already down a lot. That should help chicken prices fall first, followed by pork and finally a year or more out, beef. (That's because of differences in animal gestation and maturity cycles.)

Next week, retail sales, industrial production and housing starts all on deck

After a slow week, the statistical mills begin to accelerate production next week. Probably tops on my list is the retail sales report due on Tuesday. The shopping centre data has been improving lately as have some other broad retail sales metrics. Income and employment data have also been advancing lately and that almost always eventually produces better retail sales growth. The only fly in the ointment is that individual retailers, including Coach COH, the Container Store and Gap GPS, have shown mildly disappointing results and are blaming a generally weak retail environment. I think some of these problems are more company-specific than any manager wants to admit. Therefore, I have no particular reason to quibble with expectations that retail sales will be up 0.6% in June after growing 0.3% in May.

Housing starts are not expected to budge in June compared with May and remain stuck at 1.01 million units on an annualized basis. Permits data was weak last month, suggesting a less than robust starts report this month. Still, I am hoping to see some progress on the single-family market, which hasn't shown much growth recently. I will also be looking to see if prices came down (or at least if builders were offering additional lower-priced units) and at inventory levels, both problem areas in prior reports.

Industrial production growth in June is expected to slow after a stunningly good 0.6% increase for May. While the purchasing managers' surveys and employment suggest another good month, it would be unusual to see two really strong months in a row. Also, hours worked data wasn't quite so strong. Therefore, expectations are for industrial production growth of a still-respectable 0.3%, but I have seen some forecasts that are even lower.

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Robert Johnson, CFA

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

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