Lower GDP growth no reason to panic

Underneath all the changes in the fourth-quarter GDP data, the U.S. economy is still the same slow-moving ocean liner.

Robert Johnson, CFA 2 March, 2014 | 12:20AM
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Developed-country equity markets rebounded this week, showing some reasonable improvement. The S&P 500 Index was up over 1% for the week, with other developed markets tracking just slightly behind. Emerging markets didn't fare as well, showing little change with ongoing concerns from China related to their lending policies and currency management. Not surprisingly, commodities were slightly down for the week, and interest rates ticked downward slightly with the U.S. 10-year Treasury bond now yielding 2.68%.

This week's data seemed to indicate that the economy wasn't making much progress in either direction, and the fourth-quarter GDP growth rate was downgraded to 2.4% from the previous reading of 3.2%. The bond market and commodity markets both seem to doubt the probability of any rapid improvement in the economy. Equity markets seem to be benefiting from the lack of many alternatives and declining interest rates since the beginning of the year, which came as a complete surprise to most investors.

The reduction in the fourth-quarter GDP growth rate didn't come as much of a surprise, falling from 3.2% to 2.4%. The news could have been worse, but business spending turned out to be better than expected, offsetting some of the downward revisions in consumer spending. The markets took the news in stride, as the drop was widely anticipated. It also potentially meant that interest rates could stay at low levels for a little longer.

The housing news managed to look a little better this week with new home sales showing a surprising jump and pending home sales of existing homes finally showing signs of stabilization. Home price growth also continued to cool, but not enough to create a lot of worries. In fact, low prices might be better for the economy and stimulate more demand. Recent data suggests that home prices are likely to grow at a more sustainable 5% rate in 2014 versus rates of between 8% and 13% in 2013, depending on the index used.

News on the manufacturing sector was inconclusive with month-to-month trends in durable goods orders improving while the year-over-year data continues to fade. Shopping centre data continued to stink and even the normally cheerful unemployment claims data ticked up again, which is never good news for employment. However, bad weather at least partially affected both of these last two metrics yet again.

In general, the economic data remained weak, as it has for the past three months. It is now clear that the problems probably stretch beyond the weather. Trying to separate weather effects from a slowing economy from the post-budget-crisis spike is exceptionally tricky. My analysis suggests that the economy will bounce back this spring, but I wouldn't be expecting any fireworks to the upside, either. I stand by my GDP forecast of 2.0%-2.5% GDP growth for 2014, not much different from 2013.

Earnings news this week was more of the same. Decent earnings growth, minimal if any revenue growth, and a sharp eye on expenses with some help from share buybacks characterize the rapidly concluding fourth-quarter earnings season. This week,   Home Depot  HD,   Lowe's  LOW, and   Best Buy  BBY, all reported. Revenue was down at Best Buy and Home Depot, and all three managed an upside surprise on earnings. Although good for shareholders, a focus on cost-cutting typically means employment cuts because employment is generally the biggest company expense. Earnings now appear to be on track to have shown growth of 8.5% in the fourth quarter, but revenue didn't even manage to grow 1% (actual 0.8%).

New worries for the radar
There are two new concerns that I want to put on readers' radars. The first is the ongoing drought in California. With 11% of U.S. crops and 50% of fruits and vegetables produced in California, the three-year-long drought can't help but have an impact on food inflation in a major way. With emergency measures now in place, some growers won't irrigate their farmland this spring and summer. Things have become so difficult in some parts of the state that farmers are now beginning to pull out portions of their almond groves. Food items including nuts, grapes, tomatoes, strawberries, and lettuce are among the many items that could be affected. Combined with lower defense spending and fewer communications-related purchases (NSA issues), softer produce sales could spell trouble for California, the largest state population-wise.

The other worry is related to corporate earnings. A stronger dollar is beginning to take its toll. For now the impact is mainly on converting the local currency back to U.S. dollars. Units demand hasn't collapsed because of the higher prices in local currency, at least not yet. A few emerging-markets countries with outsize currency declines are seeing the biggest hits and garnishing the most corporate comments. Venezuela was singled out by many companies, including   Procter & Gamble  PG. Other companies noting significant currency issues this quarter included   DuPont  DD,   Microsoft  MSFT   Johnson and Johnson  JNJ The impact ranged from 1% to 3% for these particular companies, according to a recent FactSet report.

Revised GDP as expected--no need for panic
As I had forecasted, the second reading of GDP growth was reduced meaningfully from 3.2% growth to 2.4% because of numerous estimate misses for unavailable data and revisions to previously released data. The table below shows both the original and new growth rates by sector. For the most part, the order of the growth rates was still similar, but in most cases that growth rate was lower. However, business spending did look better than previously thought while most other categories were the same or down.

The business categories are small and didn't make much of a dent in the downward revision in the other categories. The table below weights each of the categories by size and applies that figure to the growth rates above to get a net contribution to GDP growth. The final column shows the effects of this month's revision. This table shows that the biggest contributors to the downward revision in the GDP estimates were personal consumption, inventories, and exports.

For all the changes in the fourth-quarter GDP data, my conclusions remain barely changed. The consumer continues to be the key driver of the economy, making the largest contribution to growth. Net exports continue to be an important contributor to growth, but perhaps that growth will not be sustainable in the year ahead. Business spending such as equipment and software did look up a little in the fourth quarter and could be one of the more important variables to watch in 2014. Was the fourth quarter a one-time bump in business spending related to the end of the government shutdown and a budget agreement, or was it a long-term trend? Government and residential both looked bleak in the fourth quarter but should move back to something closer to flat-line growth in 2014, although not in the first quarter.

Weather is likely to strongly affect the data in the first quarter total GDP. I suspect growth will be less than 2% on an annualized basis compared with the third quarter's 4.1% growth and the fourth quarter's revised 2.4%. Not the prettiest of trends, but the second quarter should look better than the first with improving weather. For the full year, I am sticking with my 2.0%-2.5% estimate, and I believe that represents the long-term growth potential of the economy. No rocket ship from here--just more of the same slow-moving ocean liner.

More evidence that the worst of the housing slowdown may be over
This week's positive housing news was that new home sales made a nice jump in January, increasing from 427,000 annualized homes in December to 468,000 units in January, well above the consensus of 405,000.

To put that in perspective, 428,000 new single-family homes were sold in 2013. That is still at the very low end of the huge range of just 270,000 homes sold at the worst moment of the housing depression (February 2011) and 1,389,000 annualized units at the peak in 2005. The worst of the mini-slump last summer also now appears to be behind us. Sales in the first half of 2013 and the last quarter were fairly consistently in the 420,000-460,000 range. However, the combination of rising mortgage rates (which pushed buyers into faster-closing existing homes) and the government shutdown stymied sales in the third quarter of the year, with sales averaging just 388,000 units. So, the fourth-quarter rebound and now the best new home sales number of the entire recovery may indicate that the worst of the slump might be over.

Inventories have also continued to move up, which could help move sales along. Inventories were 150,000 units for January 2013 and have now moved up to 184,000 units in January 2014. Sales in the two periods were relatively similar, so buyers now have more choices and aren't quite as limited by a lack of inventory. Real estate brokers continue to complain that low inventories are depressing current sales. In general, higher but not excessive inventories improve sales. That was certainly true in spades for the cars, where a sharp rise in inventories was a key contributor to sales growth in 2013.

The year-over-year data doesn't look quite as rosy, but there are some good reasons for that. Balmy weather last year made January 2013 the very best month of the entire year. Meanwhile, this January was unusually cold, depressing sales in the Midwest, where January sales were down 14%. The averaged data below also reflects the hot/cold scenario. Transaction dollars, which include both units and prices, have also suffered, but not quite as much as the unit data that everyone mistakenly focuses on.

At least pending home sales didn't get much worse in January
Pending home sales are generally a good indicator of existing-home sales. Pending home sales (contract signing) generally close (existing-home sale) within two months. Between December and January, the pending home sale index fell 0.1% under pressure from higher mortgage rates, slow inventory growth, and high prices--and now the weather is taking its toll on pending and existing-home sales. The small 0.1% decline in the index is a welcome relief after moving down a cumulative 15.9 points between June and December (from 110.8 to 94.9). The year-over-year trend looks quite a bit worse, but that is more due to strength a year ago than any additional weakness this year.

Unfortunately, weather-related or not, the soft pending home sales data will keep a lid on closings for another two or three months, and slow closings will affect things like furniture, remodeling, and moving expenses two or three months into the future. Even the benefits to the economy of the current stabilization in pending home sales won't really help much until May's data, which we won't see until June. One other silver lining in this month's report is that the gap between pending-home and existing-home sales is closing, suggesting that the bottom in existing-home sales may be approaching. That's welcome news as those existing-home sales have collapsed, falling from 5.4 million units in July to 4.6 million units in January.

Home price growth continues to slow, but still elevated
No matter which of the popular home price indexes one chooses to use, the trend seems to show that year-over-year home price growth is beginning to slow.

The year-over-year data speaks for itself. It shows a peaking in price growth, and now, a modest decline. Although I am loath to use anything but year-over-year data, which eliminates those pesky seasonal adjustment factors, I believe that the rather drastic change in six-month growth rates may overcome that limitation. The six-month growth rate data shows that home price growth has been cut in half, which will eventually turn up in the annual data.

The data below for the FHFA shows that slowing relatively clearly. The Case-Shiller data would show a similar if slightly less dramatic picture. In both cases, the slowing in the year-over-year growth rates should show up by the time the March data is reported in May.

Housing markets covered explains the wide variance in home price growth
The curious may wonder, why do the three home price indexes show such sharply different rates of growth, even if the general trends are similar? The reason has to do with the group of homes that is being sampled. The Case-Shiller Index that I use is the 20-City Index, which is just that--20 cities. That list tends to have a Western bias and misses some big markets. While the geography is limited, the Case-Shiller Indexes cover mortgage and cash transactions. The FHFA data includes broader geographic coverage, but is limited to homes that move through the Fannie/Freddie mortgage process (homes with prime mortgages). It misses cash deals, and deals that did not move through one of the major guarantors. The     CLGX data reflects all types of purchase methodologies and broad geographic coverage.

Durable goods orders still trending badly, indicating tougher times for manufacturing
The durable goods orders report remains one of the most difficult reports to interpret, but if used properly, it can provide some clues, especially about business investing trends. The report measures: durable goods (which includes very long-term capital goods) orders, shipments, backlogs and inventories. If businesses are placing orders now for goods with longer lead times and high price points, it's indicative of their confidence in the future. And because the capital goods tend to take a while to produce, they can mean better production many months down the road. In other words, it should be a great leading indicator of economic activity. Unfortunately, the number has been hijacked by sectors such as autos, civilian aircraft, and defense aircraft, which can prove exceptionally volatile, at least in terms of orders. For example, in January orders were down 1.5% from December, which doesn't sound so hot. But excluding the volatile transportation sector, orders were up a much better-looking 1.1%. Better still, both numbers were above the consensus forecasts.

However, the numbers aren't quite as good as that quick read would suggest. First, I like to look at the year-over-year, three-month averaged data. Looking year over year takes out shifting seasonal factors and averaging the months removes the effect of short-term things such as weather, incentives, and tax law changes. I also focus on the capital goods segment and exclude defense and transportation equipment. The year-to-year trend is not pretty, as shown below.

The year-over-year data has been trending down since September, not exactly a real confidence-builder. There is a ray of hope in the averaged month-to-month numbers shown in the second column, which suggest the worst of the order-slowing may be behind us. Not booming, mind you--but a ray of hope.

Speaking of hope, the communications and computer group was particularly strong, showing order growth of 4.7% month to month, perhaps driven by the move to cloud computing. Several other manufacturing indicators have also picked up on the trend of an improving picture for tech manufacturing. However, a poor tech-related number for the previous month, December, also aided the month-to-month comparison. The fabricated metals sector also showed an increase, but it was a whopper at 7.4% month-to-month growth. Part of the large improvement is related to poor orders in December that may have been weather-related. Unfortunately, the other four major nontransportation-related sectors were down for the single month of January.

Personal income, manufacturing data, autos, employment, and trade all on tap for next week
Next week will bring a flood of data, but I am afraid that weather and other special factors may render most of these reports relatively worthless. Economists appear to have pulled their favourite forecasting tool, a ruler, for projecting next week's data. Almost every metric is expected to be little changed from the prior month's reading. I suppose that isn't a bad guess given the weather throughout February remained as cold and dreary as it was in December and January. And with economists missing a lot of forecasts by wide and negative margins over the past several months, the rocket-ship forecasts of unending growth are beginning to go by the wayside.

Employment growth should show some improvement
The one report that everyone expects to look a lot better is the employment report, which looked relatively dismal in January, with a slim 113,000 jobs added compared with the 190,000 average for 2013. The originally reported number for December was suspect because the ADP report and several other labor market indexes suggested that there wasn't much change between December and January. Therefore, economists are projecting a higher job growth rate in February, but still below trend with potentially 140,000 jobs added. I don't see any particular reason to quibble with the consensus, but I believe there is more downside risk than upside risk to the February consensus. I continue to fear that much of the employment growth in 2013 was retail, restaurant, and health-care-related and weather was not working in favour of any of these sectors in February.

Motor vehicle sales still expected to be under the weather
Motor vehicle sales, after a calendar-related goose in November, tumbled from a high of 16.3 million units to 15.3 million units in December and 15.2 million units in January. Some of that was probably weather-related, but analysts aren't holding out much hope for February, forecasting just 15.4 million unit sales for the month. Though weather was bad in February, it wasn't quite as snowy, and government tax refund checks rolled out a little sooner than last year. Furthermore, some of the automakers appear to have stepped on the incentives accelerator, which could move up sales a little more than the gloomy consensus is expecting.

Personal income and consumption
Based on a slow retail sales number and the past two months of poor employment performance, no one is holding out a lot of hope for much growth in consumption and income. Before inflation, income and consumption are both expected to grow by 0.2%. After inflation, which is what counts, both figures are likely to show no growth whatsoever. Based on the poor auto sales, weak retail sales, and the employment report, I see no reason to disagree with the consensus. If the consumption figure is correct, it would be worse than last month's figure, while income would be slightly better than the prior month's data.

Manufacturing data too close to call
The ISM Manufacturing report took a large tumble in January from 56.5 to 51.3, with much of the fall being blamed on weather. With the continuing appearance of the polar vortex here in the Midwest, economists aren't expecting much better news for February. The consensus is a basically flat result for February at a reading of 52. That seems a tad conservative given the large increase in an alternative measure provided earlier in the month by Markit. The durable goods order report was a little better than expected, too. Additionally, some of the delayed ramp-up of spring and summer goods production should manage to spike the ISM number in some month. However, the picture isn't perfect, either. The auto industry is still faltering a bit, and it seems to be the key driver of the ISM report. Home-related activity still seems a little soft, too.

Not much change expected in the trade picture
The net trade deficit is forecast to be unchanged at $38.8 billion, virtually in a tie with its level of the past 12 months. Both imports and exports have been showing sharply improving year-over-year growth rates since June, with exports improving at double the pace of imports. The trend in these metrics (and not just the level of deficit) will be important factors for U.S. economic growth in 2014. Short run, I do worry that the cold weather may have affected some energy production and altered, temporarily, some of the flow of petroleum-related products that have been very helpful in recently reducing the trade deficit.

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Robert Johnson, CFA

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

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