The market endured yet another week of Fed-watching as investors mindlessly moved markets upward when more quantitative easing looked possible and downward when it looked like the tapering of bond purchases was around the corner.
The reaction is almost like Pavlov's dogs responding strictly based on conditioning to past actions and not any type of reasoning. More easing means the economy is weak, but is that truly a good thing?
I have to admit that easing and tightening measures by the Fed have been nearly perfect predictors of the stock and bond markets in the short run and the fact that it keeps working reinforces this bias. My guess is that this game ends badly; inevitably bond purchases will end and rates will move somewhat higher. There is an exceptionally high probability that bond purchases will end in the next 12 months. Frankly, at some point there won't be enough bonds left to buy. There is a meaningful contingent of Fed governors who believe QE is an experiment that has gone just a little too far. And while the positive effects of QE on markets remains undeniable, GDP growth remains mired in the 2% range.
Economic data this week remains soft with even more furlough-induced softness likely for the next 30-60 days. Manufacturing data continued to look soft: pending home sales fell below year-ago levels, consumer and producer prices remained under pressure, headline monthly retail sales fell, and auto sales missed expectations.
One of the few pieces of good news this week was that the federal budget deficit fell dramatically in fiscal year 2013, dropping from US$1.1 trillion to US$0.7 trillion in just one year, which is the largest dollar drop in history by a factor of two. The other really good news is that health-care inflation continues to run far below long-term projections. And manufacturing, while not robust, seems to be at least bottoming.
Meanwhile, consumers don't seem too stressed and continue to spend cash at retail outlets at the same lethargic-growth pace as they have for the past three years, when excluding autos and gasoline, on a year-over-year averaged basis. Like an ocean liner, the U.S. economy continues to move forward despite a lot of efforts to stop it.
There are some potential upsides to the year ahead including less fiscal drag, but more on that in future columns. For now, don't panic, and expect the data to get a little worse before it gets better.
Mixed messages from manufacturing yet again
Purchasing Manager Data from the ISM and actual production data continue to diverge, muddling the manufacturing picture. In terms of industrial production data, I always strip out the utility and mining industry data, because these two categories are largely driven by weather and not the underlying strength of the economy.
Both the month-to-month and year-over-year manufacturing industrial production data were nothing to write home about. Both figures remain sluggish and below long-term averages. In reality, the manufacturing-only index has yet to reach its pre-recession highs of more than four years ago. The manufacturing numbers remain consistent with soft durable goods orders and shipments, and sluggish export data. The year-over-year data is moving up again, at least for the most recent month and at a snail's pace of improvement.
However, the ISM purchasing data has been improving since May, and this week's data for September made another short-term high. Mix issues (numerous small vendors in the housing and auto industries) seem to be the most likely causes of an overly optimistic PMI report. That said, the PMI data should at least mean that we have seen the worst of the production slowing for now, even if we don't boom ahead. Anecdotal evidence suggests significant improvement in European results. Even 
GM GM reported improved auto sales in Europe after years of declines. The ISM comments that were presented with the raw numbers were also quite positive this time, after several months of good numbers but dour qualitative comments.
The industrial production dispersion by industry group was exceptionally wide in September. Auto production was up an impressive 2%, apparel up 1.5%, and machinery up 1.5% month to month. On the other hand, printing was down 1.1%, and textiles and furniture were down 0.7% each. Such wide variances wreak havoc on dispersion indexes (like the PMI) that just measure changes, and not the magnitude of those changes.
I am hopeful that we have seen the worst of the manufacturing data for this year. But I am not anticipating quite the boom that the PMI numbers are projecting, either. Also keep in mind that it is consumers and not manufacturers who are the true drivers of short-term economic results.
Pending home sales continue to fall
As I suspected, pending home sales continue to plummet. On a single-month basis, pending home sales were down both month to month and year over year. This is not a one-month phenomenon, either, as the data below suggests. Weaker existing-home sales have already begun to follow suit, and more deterioration is likely in the short run.
The short-term pop in existing-home sales, caused by a rush to beat rising rates, could boost GDP growth by 0.2% in the third quarter and subtract a like amount in the fourth quarter, as sales dip back to more sustainable levels. Higher mortgage rates, and much more important, higher prices, have begun to affect affordability in a dramatic way. We should have more data on the affordability front during the next couple of weeks.
The media is likely to paint a picture of a collapsing housing market in the weeks ahead, however I caution that some of this summer's data was not as strong as it seemed, and now the weak data we are seeing is just a mirror image of that overly strong summer data — the true state of the data lies somewhere in the middle of these two extremes. I fear even the Fed is being taken in a little bit, as recent Fed comments noted soft housing data as one reason for the continuing the delay regarding tapering bond purchases.
Low Inflation, too much of a good thing?
In line with my expectations consumer prices came in at 0.2% inflation, but slightly above my 0.1% estimate; outside of gasoline, most energy prices moved up a little more than I expected.
There were several flat or down categories for the month including groceries, apparel and used cars.
Medical cost growth remains dramatically below long-term projections
Continued softness in medical inflation was one of the most hopeful signs in the report. Medical commodities, namely drugs and supplies, were up 0.1% for the month and 0.2% on the year as more drugs roll off patent. But even the services component was up just 0.3% month to month and 3.1% year over year.
Keep in mind that most long-term doomsday projections for health-care expenditures (and even CBO budget projections) are based on medical cost inflation of 5.5% or more. Recent trends in that number have been in the 2.5%-3.0% range for the last several years, which if sustained would solve a lot of the long-term budget and entitlement issues that we have all been talking about. Each month of soft medical price inflation builds a lower base for prices, even if inflation rates go higher again at a later date.
Inflation rates beginning to look like Japan
It's hard to believe that back at the beginning of the year my clients were clamoring for reports on how to beat rising inflation, and there was a lot of interest in inflation hedges. Six months later, I find myself worrying that we are painfully close to experiencing deflation again. Despite a recovery, year-over-year increases in U.S. inflation are again approaching recovery lows. Inflation for all of 2013 might be as low as 1.5%; matching the Social Security increase that will be parsed out in January. Inflation is even lower in Europe at less than 1%.
The good news is that both businesses and consumers are not putting off purchases, and waiting for lower prices like what happened in Japan. Still, we are a lot closer to the edge than I would like to see. I expect to see a lot of bargain prices during the holidays because of relatively soft retail sales — outside of iPhones and iPads, which will continue to siphon demand away from conventional retailers). The moderate energy price increases are likely to keep a lid on price increases in the short run.
Retail sales stuck in neutral, headline monthly data down
Retail sales is a very important metric, representing about a third of consumption. It is also more volatile than services that comprise the other two thirds of consumption. As I always say, manufacturers will not build and hire unless consumers are buying. The good news is that consumers are still buying; the bad news is their rate of buying is almost unchanged for the last three years.
The retail sales report for September did not make happy reading. A slump in auto sales (or perhaps a data/holiday issue) caused retail sales to drop 0.1% in September; ex-autos, sales increased 0.4%, matching expectations. At 4.1%, the year-over-year data was more of the same, with growth ex-autos and gasoline almost dead in the middle of the 3.5%-4.5% range of the last year, but slightly down from July and August. Adjusted for inflation, the 2.5% growth rate matched the average of the last 12 months.
Budget deficit falls sharply
As I cited earlier, the final report for the Federal budget deficit was released this week and the deficit dropped US$1.1 trillion to US$0.7 trillion in just one year. In dollar terms, that is the biggest reduction in history and is almost twice as big as the previous reduction (2012).
The deficit reduction was a combination of the sequestration process, higher payroll taxes, higher income taxes, lower medical spending, a stronger economy, and low interest rates. More reductions are likely for fiscal year 2014 because of another quarter of tax increases for the December quarter (the new rates were in effect for only three quarters of fiscal year 2013) and an additional half-year of sequestration benefits.
While this news is good for the long-term deficit, it probably hits short-term economic growth hard, taking at least 1% off of yearly economic growth rates in 2013 and potentially less (but not a lot less) in 2014. Of course that all assumes that current deficit reduction laws remain in force for the full year. That is certainly far from a given.
Auto sales look a little light, but no disaster
David Whiston, one of our auto analysts, summed up the auto reports on Friday as follows:
Automakers reported October U.S. light-vehicle sales that showed a slump from the government shutdown but activity increased throughout the month. Industry sales increased 10.4% from October 2012 to more than 1.2 million. According to Automotive News, the seasonally adjusted annualized selling rate, or SAAR, rose to 15.22 million from 14.41 million in October 2012 but declined from September's 15.26 million. This SAAR was the best for October since 16.21 million in 2007. After hearing commentary from all the dealers and automakers during earnings season, we are not seeing any red flags to consumer demand. We continue to expect full year sales to be in the mid-15 million range, but some upside to this number is not unrealistic. The test for the industry will be December, which is always the largest sales month of the fourth quarter and one of the best months of the whole year. We remain optimistic on U.S. auto demand as credit is very plentiful in all credit spectrums at low rates, and there is plenty of desirable product in the showroom.
From an economic standpoint, we barely stayed in the Goldilocks range of 15 million-16 million cars sold at a seasonally adjusted annual rate. Between the furlough, which hurt the first half of the month, and odd holiday timing issues, the numbers remain difficult to decipher. Still, I would have liked to have seen something like 15.5 million units or more. As Whiston points out, October and November aren't huge car months, and it will really take until December to detect the true trajectory of auto spending.
Next week: Preliminary Q3 GDP and delayed November employment report
Next week's video will encompass further information on both the upcoming GDP reports and the employment report. For the record, consensus estimates are for a GDP growth rate of 2.1% for the third quarter and the total employment growth of just 135,000 people.
Expectations for the employment report have dropped meaningfully during the last few days, following weak payroll data from ADP and initial unemployment claims that still looked elevated. The ADP report showed private-sector growth of just 130,000.
The market may not react badly to an even-softer official number next Friday, believing the data was influenced by private-sector reactions to public-sector furloughs that have now been fully reversed. (My government-employed daughter already has the back pay in her checking account.) And of course, a soft number raises prospects of even more QE, which would also soften the blow.
The GDP number has been a little goofy, moved more by accounting issues and odd category movements than real economic changes. The consumer portion of the data would suggest GDP growth is lower than the second quarter's 2.5% growth rate. Exports shouldn't make much difference to the report, and housing (especially brokerage commissions on existing homes that temporarily soared) could provide room for an upside surprise. Business spending will look soft, and some data will be missing in action (construction data, delayed because of the furlough). Inventories remain a puzzle to me but have been growing larger lately, at least in nominal dollars. Production, whether for inventory or actually sold, is counted as production in the GDP report.
It seems like there is some potential for upside in current estimates of 2.1% growth, but the odds of outguessing the government at its own game are tough. A better-than-expected number could scare the QEternity (QE forever) crowd. Again, the parsing of the data categories will be a lot more important than the headline number, which could come out just about anywhere, given inventory and government category uncertainties.
