Economic Data Rocks The Proverbial Boat

This week the market was totally infatuated with 1) economic indicators and 2) Greek debt. When an indicator came in above expectations, markets soared. When one missed, markets collapsed. The soaring and collapsing could happen on the same day of the week!

Apparel prices jumped 1.2% as manufacturers began to pass along some of the increases in basic commodities like cotton. However, like groceries and autos, the higher prices of clothes caused relatively anemic demand at the retail level. Clothing volume (not sales dollars) likely showed a decline in May based on retail sales growth of 0.1% and clothing inflation of 1.2%. Hotel prices also jumped a surprising 2.9% as it appears that business demand for hotel space continues to expand.

The prognosis for the consumer price index in the months ahead looks good as gasoline prices and oil have continued to fall in June. Food prices also seem to be abating, too, especially fresh fruits and vegetables. With new crops coming in this summer, Russia lifting its export ban, and now the possibility that corn-based ethanol products will lose their subsidies, the price news going forward should be better. Auto prices should also begin to move down as Japanese production comes back in the months ahead. A silver lining in recent home price declines is that the weakness has kept rent increases lower than what I might have suspected.

Consumer Financial Obligations Ratio Improves AgainOne consumer metric that I follow closely is the financial obligations ratio, which compares consumer financial payments to income. The Federal Reserve updates this series once a quarter and just updated it with the first-quarter report on Friday. Obligations measured include mortgages, rents, car payments, lease payments, credit cards, and other loan payments. This ratio peaked at almost 18.9% of income in 2007 and has subsequently dropped to 16.4% for the first quarter of 2011, its lowest level since 1994 and below the 30-year average of 17.2%.

The series low was 15.7% in 1981 and has been as high as 18.9%. The ratio is down nearly 1% from a year ago, providing yet another source for consumer spending growth. A combination of income growth, lower interest rates, and lower loan balances is responsible for the dramatic improvement. Since most of the debt is fixed rate mortgages, and as incomes continue to rise, I believe the ratio could make a run at its all-time low over the next year or two.

While many economists continue to focus on underwater homeowners and their ability to draw down home equity loans, it cannot be forgotten that new homeowners are spending substantially less than the last generation did on their mortgage payments. Remember that since the crisis began (2007) more than 20 million homes out of a base of very roughly 75 million homes have changed hands at reduced prices with lower interest rates. Each year the proportion of homeowners with cheap homes and low interest rate loans continues to expand.

Industrial Production Looks Flat, but Let's Peer Beneath the SurfaceAlthough Industrial Production grew only 0.1% from April to May (and was basically unchanged between March and April), manufacturing, excluding autos, grew a more robust 0.6%. The volatile utility sector, which has been down four of the last five months, is really taking its toll on the index. Some combination of weather, greater energy efficiency, and weakening business demand seem to be weighing on the utility data. For May utilities were down 2.8%, weighing down the overall industrial production index. The manufacturing portion of industrial production, excluding the negative utility results and the positive mining numbers, presents a more positive picture

Manufacturing Bounces Back

May

Tornadoes throughout the South, a major manufacturing region, explain a significant portion of April's weakness. May and especially April were also strongly affected by reduced auto production by Japanese transplant manufacturers.

Last week we talked about overall auto production, and this week I want to show the data by manufacturer so readers can see just how dire the situation became, especially for  Toyota . Final data for May just became available, and I am estimating June data based on this week's production data and mechanically converting it to monthly data. I am very hopeful that the second half of the month will look better and that the table below represents a worst-case scenario.

 Units Produced in U.S. (thousands)   Toyota Honda Nissan February 117 109 85 March 122 119 112 April 72 67 72 May 29 60 84 June (estimate) 35 65 118 Monthly production, not seasonally adjusted.Source: Automotive News, Morningstar monthly estimate based on most recent week

By Category, Manufacturing Looks to Be StrengtheningOutside of autos, only a few categories showed much weakness. Food and tobacco (a relatively large category), electrical equipment (a smallish category), and printing and wood products (tiny categories) all showed declines. Furniture, petroleum products, machinery, computers, and textiles all grew faster than 1%, some significantly so.

Regional Purchasing Managers' Reports Look WeakPoor auto-related data may also explain great deal of the weakness in two regional purchasing managers' reports this week that upset the market. Both the Philly Fed and Empire State reports moved into negative territory for the month of June. Those two regional reports bode poorly for the national report at the beginning of next month. That may upset the market further, especially if the report shows a drop below 50.

Housing Starts Show Modest Increase, but Not Enough to Be Excited AboutEric Landry, our housing analyst, summed up this week's housing data as follows:

Total starts in May increased 3.5% from April levels on a seasonally adjusted basis (SAAR), but remained 3.4% below year-ago levels. The increase was driven by an 8.9% sequential increase in five-plus unit structures and a 3.4% increase in single-family starts. Regionally, the West was the big winner, with an 18% sequential increase in its SAAR, while the North and Midwest both declined midsingle digits. Permits performed more impressively, with total permits issued increasing 8.7% from April's SAAR and up 5% from the year-ago period. Five-plus units drove the results, gaining 15% against April and 28% against last year's period. As we've mentioned many times before, we wouldn't get excited until both permits and starts broke out of their narrow range, or something arose that indicated such would happen in the not-too-distant future. April's results are a step in the right direction as they have ticked up from very anemic levels, but are far from indicating any kind of an uptrend.

I found it disconcerting that a "poor" economic indicator that nevertheless beat expectations was major cause for celebration. For example, the official government retail sales report showed May sales fell 0.2% versus the Wall Street Journal's consensus estimate of a 0.7% decline, so markets staged a huge rally Tuesday. Never mind that the previous month was revised downward or that sister publication MarketWatch showed the consensus of a 0.3% decline. (There were some things to like in the retail sales report, but more on that later.)

Markets reacted almost instantaneously to poor manufacturing data (industrial production and two regional purchasing managers' reports). But being a go-with-the-flow type of market, stocks soared on improved jobless claims and better housing starts on Thursday (with a sharp but temporary decline due to the Philly Fed Purchasing Managers' Report).

The market continued its good mood on Friday morning as the Europeans appeared ready to put another band-aid on the Greek bond situation, averting the crisis for another two or three months. Let me be very clear: Greece cannot repay those bonds out of the income it is generating. Those bonds will have to be restructured, in my opinion. The only question is who will bear the pain--bondholders (primarily European banks), governments, or European community agencies?

As market participants shift from one side of the boat to the other on an hour-by-hour, indicator-by-indicator basis, what's an investor to do? As an economist I will continue to focus on the consumer and the metrics that drive the consumer. Manufacturing only amplifies what is happening in the consumer world with a lag. Manufacturing isn't going to grow without consumers here or abroad buying those goods. Manufacturers don't produce things for the fun of it. Furthermore, manufacturing data are being hopelessly distorted by production impairments at Japanese plants in the United States and Japan. Housing data get plenty of attention, too, but that is too small to move the economic needle--new homes account for a mere 1% or so of GDP. Even home prices are not terribly relevant unless prices move into free-fall, as U.S. banks are now in a much stronger capital position and consumers have been weaned from the concept of using their homes as cash machines.

Therefore, I am focusing on what consumers are spending, what's happening to consumer incomes, and what's happening to inflation. Consumer spending has clearly held up better than anyone expected in the face of higher gas prices. Incomes have begun improving on a non-inflation-adjusted basis, but most of those gains have been eaten up by inflation. The good news is that inflation appears to have peaked in the short run; the rate of increase has declined for two months in a row. Based on falling gasoline prices, falling crop prices, and potentially falling auto prices as the Japanese transplants come back on line later this summer, it looks like prices are poised to slow even more over the next several months. I spent most of last year and early this year fretting about the effects of higher prices on consumer spending (we are seeing some of this in recent statistics). Now as inflation looks better, I think consumers will have an improved second half. Falling initial employment claims, better restaurants sales, and a positive hiring report from Manpower all suggest that employment will continue to grow, enhancing customer incomes.

Although I am more sanguine on the economy, stock markets will have their own set of worries. I suspect this earnings season, which starts in about two weeks, could be more problematic than usual as producers and retailers faced rising input prices that they were unable to fully pass on to consumers, especially as various commodity price hedges and inventory buffers came to an end. Also, I surmise that as QE2, which was widely successful in raising assets prices, comes to a conclusion, those very same assets may decline. Stocks are one of those assets--the S&P 500 is up almost 22% from when QE2 rumors began last August--and I suspect the end of QE2 has given stocks a reason to pause, just like commodities and other so-called risk assets. Furthermore, there is a real potential for more negative headline economic indicators in the months ahead. I am particularly worried about auto production issues pushing second-quarter GDP growth pretty close to flat, which will send the Chicken Littles into a real tizzy.

Autos Temporarily Push Retail Sales into Negative TerritoryRetail sales declined 0.2% in May due largely to sharply lower auto sales. As I suspected last week, the headlines generally highlighted the negative number ("Retail Sales Fall for First Time in 11 Months," one trumpeted). Excluding auto sales, retail sales increased a reasonable 0.3% compared to growth of 0.5% the previous month. Auto sales were hit because of higher prices and a lack of availability, both caused by disruptions at the Japanese auto manufacturers.

Besides autos, about half of the categories showed increases and half showed decreases according to the report. Electronics and furniture showed the largest declines after autos. Home improvement stores, miscellaneous retailers, and nonstore retailers led the way higher. One surprise in the data was strong restaurant sales, which increased 0.6% following a decline the previous month. I like seeing restaurant sales increase; it represents a backdoor measure of consumer confidence. It should also drive up restaurant employment numbers.

Consumers Eat Out More, Skipping Grocery Stores' Higher PricesSpeaking of food, grocery sales declined 0.5%, which is surprising given that food prices were up during the month. Consumers seem to be rebelling over higher prices at the grocery store.

Weekly Retail Sales Still Hanging in ThereWeekly sales data continue to remain upbeat, with year-over-year same-store sales continuing in the 2%-3% range as they have for most of the year. These two retail sales indicators are the primary reason for my optimism on the consumer and the economy.

Consumer Price Index Shows Slowing InflationConsumer prices increased 0.2% in May, as I suspected. Price increases are down nicely from the 0.5% level experienced in February and March.

 Price Increases Moderating as Gasoline Prices Fall   January February March April

May

% Increase in CPI 0.4 0.5 0.5 0.4 0.2 Source: Bureau of Labor Statistics

Energy-related categories are the only ones that showed outright declines. Price increases moderated (not declined) for restaurants, some medical categories, and transportation. As I suspected, both new and used auto prices increased sharply as dealers raised prices on existing inventory. I believe the sharp 1.1% increase in new auto prices was the main thing some economists missed when they were predicting no inflation in May. I think prices should moderate as the Japanese transplants come back online this summer and perhaps offer incentives to get buyers back in the showroom.

Return to DiscussNext21Prev

Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.

Securities mentioned in this article Ticker Price($) Change(%) Morningstar Rating Morningstar Analyst Report With Morningstar Analyst reports you can get our expert Buy/Sell opinions on over 3,900 Stock and Funds Robert Johnson, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies. Video Reports Johnson: No Double-Dip More Videos... Most Popular Related News Also in Investing Specialists Sponsored Links Buy a Link Now Sponsor Center Please Wait... STOCKS USA_TM E0_USA_TM &primaryKeyword=STOCKS 2 {CommentWebService} OAS_AD('Bottom'); Content Partners Site Directory Site Map Our Products Corrections Help Advertising Opportunities Licensing Opportunities Glossary RSS Mobile Portfolio Affiliate Careers Company News International Sites: Australia Canada China France Germany Hong Kong Italy The Netherlands Norway Spain U.K. Switzerland Stocks by: Title Ticker Popularity Interest Funds by: Title Symbol Popularity Interest Articles by: Title Date Popularity Interest Stock Groups by: Popularity Interest Favorites Title Fund Groups by: Popularity Interest Favorites Title Article Groups by: Popularity Interest Favorites Title Premium Stocks by: Title Ticker Popularity Interest Premium Funds by: Title Symbol Popularity Interest Premium Articles by: Title Date Popularity Interest Independent. Insightful. Trusted. Morningstar provides stock market analysis; equity, mutual fund, and ETF research, ratings, and picks; portfolio tools; and option, hedge fund, IRA, 401k, and 529 plan research. Our reliable data and analysis can help both experienced enthusiasts and newcomers. © Copyright 2011 Morningstar, Inc. All rights reserved. Please read our Terms of Useand Privacy Policy.Dow Jones Industrial Average, S&P 500, Nasdaq, and Morningstar Index (Market Barometer) quotes are real-time. var HeaderBox = initBoxQuote("AutoCompleteBox","AutoCompleteDropDown"); HeaderBox.IdleDisplayMsg = ""; HeaderBox.LocalRegion="USA"; HeaderBox.SetPreference('USA','EN',32); var FooterBox = initBoxQuote("AutoCompleteBoxFooter","AutoCompleteDropDownFooter"); FooterBox.IdleDisplayMsg = ""; FooterBox.LocalRegion="USA"; FooterBox.SetPreference('USA','EN',32); //clears all content/image boxes-------------------------------------------------------------------------------------- var imageIDs=new Array('siteDirectoryContent', 'siteMapContent', 'productsContent'); //content boxes .mi_row3{display: none} var _gaq = _gaq || []; _gaq.push(['_setAccount', 'UA-16669347-1']); _gaq.push(['_setDomainName', '.morningstar.com']); _gaq.push(['_trackPageview']); (function() { var ga = document.createElement('script'); ga.type = 'text/javascript'; ga.async = true; ga.src = ('https:' == document.location.protocol ? 'https://ssl' : 'http://www') + '.google-analytics.com/ga.js'; var s = document.getElementsByTagName('script')[0]; s.parentNode.insertBefore(ga, s); })(); var Name = $('meta[name=DC.Creator]').attr("content").split(','); var Title = $('meta[name=DC.Title]').attr("content"); var URL = window.location.href; var Author = Name[1] + " " + Name[0]; var PubDate = $('meta[name=DC.Date]').attr("content"); _gaq.push(['_trackEvent', 'Article Title From Morningstar', Title, URL]); _gaq.push(['_trackEvent', 'Author Name From Morningstar', Author, URL]); _gaq.push(['_trackEvent', 'Article URL From Morningstar', URL, Title + "(by " + Author + " on " + PubDate + ")"]); _gaq.push(['_trackEvent', 'Publish Date From Morningstar', PubDate, URL]); _gaq.push(['_trackEvent', 'Article Title', Title, URL]); _gaq.push(['_trackEvent', 'Author Name', Author, URL]); _gaq.push(['_trackEvent', 'Article URL', URL, Title + "(by " + Author + " on " + PubDate + ")"]); _gaq.push(['_trackEvent', 'Publish Date', PubDate, URL]);

By Category, Manufacturing Looks to Be StrengtheningOutside of autos, only a few categories showed much weakness. Food and tobacco (a relatively large category), electrical equipment (a smallish category), and printing and wood products (tiny categories) all showed declines. Furniture, petroleum products, machinery, computers, and textiles all grew faster than 1%, some significantly so.

Regional Purchasing Managers' Reports Look WeakPoor auto-related data may also explain great deal of the weakness in two regional purchasing managers' reports this week that upset the market. Both the Philly Fed and Empire State reports moved into negative territory for the month of June. Those two regional reports bode poorly for the national report at the beginning of next month. That may upset the market further, especially if the report shows a drop below 50.

Housing Starts Show Modest Increase, but Not Enough to Be Excited AboutEric Landry, our housing analyst, summed up this week's housing data as follows:

I found it disconcerting that a "poor" economic indicator that nevertheless beat expectations was major cause for celebration. For example, the official government retail sales report showed May sales fell 0.2% versus the Wall Street Journal's consensus estimate of a 0.7% decline, so markets staged a huge rally Tuesday. Never mind that the previous month was revised downward or that sister publication MarketWatch showed the consensus of a 0.3% decline. (There were some things to like in the retail sales report, but more on that later.)

Markets reacted almost instantaneously to poor manufacturing data (industrial production and two regional purchasing managers' reports). But being a go-with-the-flow type of market, stocks soared on improved jobless claims and better housing starts on Thursday (with a sharp but temporary decline due to the Philly Fed Purchasing Managers' Report).

The market continued its good mood on Friday morning as the Europeans appeared ready to put another band-aid on the Greek bond situation, averting the crisis for another two or three months. Let me be very clear: Greece cannot repay those bonds out of the income it is generating. Those bonds will have to be restructured, in my opinion. The only question is who will bear the pain--bondholders (primarily European banks), governments, or European community agencies?

As market participants shift from one side of the boat to the other on an hour-by-hour, indicator-by-indicator basis, what's an investor to do? As an economist I will continue to focus on the consumer and the metrics that drive the consumer. Manufacturing only amplifies what is happening in the consumer world with a lag. Manufacturing isn't going to grow without consumers here or abroad buying those goods. Manufacturers don't produce things for the fun of it. Furthermore, manufacturing data are being hopelessly distorted by production impairments at Japanese plants in the United States and Japan. Housing data get plenty of attention, too, but that is too small to move the economic needle--new homes account for a mere 1% or so of GDP. Even home prices are not terribly relevant unless prices move into free-fall, as U.S. banks are now in a much stronger capital position and consumers have been weaned from the concept of using their homes as cash machines.

Therefore, I am focusing on what consumers are spending, what's happening to consumer incomes, and what's happening to inflation. Consumer spending has clearly held up better than anyone expected in the face of higher gas prices. Incomes have begun improving on a non-inflation-adjusted basis, but most of those gains have been eaten up by inflation. The good news is that inflation appears to have peaked in the short run; the rate of increase has declined for two months in a row. Based on falling gasoline prices, falling crop prices, and potentially falling auto prices as the Japanese transplants come back on line later this summer, it looks like prices are poised to slow even more over the next several months. I spent most of last year and early this year fretting about the effects of higher prices on consumer spending (we are seeing some of this in recent statistics). Now as inflation looks better, I think consumers will have an improved second half. Falling initial employment claims, better restaurants sales, and a positive hiring report from Manpower all suggest that employment will continue to grow, enhancing customer incomes.

Although I am more sanguine on the economy, stock markets will have their own set of worries. I suspect this earnings season, which starts in about two weeks, could be more problematic than usual as producers and retailers faced rising input prices that they were unable to fully pass on to consumers, especially as various commodity price hedges and inventory buffers came to an end. Also, I surmise that as QE2, which was widely successful in raising assets prices, comes to a conclusion, those very same assets may decline. Stocks are one of those assets--the S&P 500 is up almost 22% from when QE2 rumors began last August--and I suspect the end of QE2 has given stocks a reason to pause, just like commodities and other so-called risk assets. Furthermore, there is a real potential for more negative headline economic indicators in the months ahead. I am particularly worried about auto production issues pushing second-quarter GDP growth pretty close to flat, which will send the Chicken Littles into a real tizzy.

Autos Temporarily Push Retail Sales into Negative TerritoryRetail sales declined 0.2% in May due largely to sharply lower auto sales. As I suspected last week, the headlines generally highlighted the negative number ("Retail Sales Fall for First Time in 11 Months," one trumpeted). Excluding auto sales, retail sales increased a reasonable 0.3% compared to growth of 0.5% the previous month. Auto sales were hit because of higher prices and a lack of availability, both caused by disruptions at the Japanese auto manufacturers.

Besides autos, about half of the categories showed increases and half showed decreases according to the report. Electronics and furniture showed the largest declines after autos. Home improvement stores, miscellaneous retailers, and nonstore retailers led the way higher. One surprise in the data was strong restaurant sales, which increased 0.6% following a decline the previous month. I like seeing restaurant sales increase; it represents a backdoor measure of consumer confidence. It should also drive up restaurant employment numbers.

Consumers Eat Out More, Skipping Grocery Stores' Higher PricesSpeaking of food, grocery sales declined 0.5%, which is surprising given that food prices were up during the month. Consumers seem to be rebelling over higher prices at the grocery store.

Weekly Retail Sales Still Hanging in ThereWeekly sales data continue to remain upbeat, with year-over-year same-store sales continuing in the 2%-3% range as they have for most of the year. These two retail sales indicators are the primary reason for my optimism on the consumer and the economy.

Consumer Price Index Shows Slowing InflationConsumer prices increased 0.2% in May, as I suspected. Price increases are down nicely from the 0.5% level experienced in February and March.

May

Energy-related categories are the only ones that showed outright declines. Price increases moderated (not declined) for restaurants, some medical categories, and transportation. As I suspected, both new and used auto prices increased sharply as dealers raised prices on existing inventory. I believe the sharp 1.1% increase in new auto prices was the main thing some economists missed when they were predicting no inflation in May. I think prices should moderate as the Japanese transplants come back online this summer and perhaps offer incentives to get buyers back in the showroom.

Be Seen. Be Heard. Become a Morningstar Contributor.Reach a readership of advisors, professionals, and active investors. Submit your commentaries for publication on Morningstar.com.

Read Full Article »