U.S. stock markets were down this week, breaking a seven-week string of winners in 2013. What's difficult to determine is if the declines were due to a reaction to real news or a market that was looking for a reason to pause.
This week's proximate cause for decline was the release of minutes from the Federal Reserve Open Market Committee meeting. The minutes showed that there was less than total agreement on all of the Fed's monetary easing programs. Some members seemed to feel that the risks of additional easing (inflation, asset bubbles, savings disincentives, and so on) were not worth the benefits of additional easing policies. There were even hints from some members that some of the easing might need to be withdrawn before the economy has entirely recovered. (So much for cheap money forever.) The stock market's vote on the minutes came quickly, with the Dow falling more than 100 points within an hour of publication.
Economic Data Analysis Depends on the Time Frame
The economic news this week was nothing to write home about, either. Housing data, at least to the untrained eye, seemed to stumble, with a large decrease in housing starts, a decline in builder sentiment, and flat existing-home sales, comparing January with December. More normal weather (can't dig a foundation in a snowstorm), a lack of inventory, a shortage of land, and even a scarcity of labor, all weighed on the short-term data. However, I would add that the year-over-year averaged data looked fine, and some of the more forward-looking housing metrics, hidden below the headlines, were improving (builder outlook, housing permits). Higher home prices and warmer weather are likely to cure some of the short-term inventory and starts issues, but that could take another couple of months until we move into the big spring selling season.
Will the Payroll Tax Kill the Recovery?
It appears the effects of the payroll tax increase, higher gasoline prices, and delayed federal tax refunds more likely weighed on the February consumption results, while leaving January almost untouched. The triumvirate of negatives is likely to weigh on a lot of economic data for the next couple of months. However, given a strengthening housing market, improving exports to emerging markets, and employment growth that seems to be holding its own, I expect a decent U.S. economic performance in 2013 after a slow start. That said, those businesses serving the lower-income rungs may be in for some tough times given the disproportionate effect of the payroll tax and gas prices on low-income earners.
U.S. consumers are pretty adaptable, and I believe that they can eventually adjust and weather the storm. In the roundest of numbers, the payroll tax increase amounts to about 1% of disposable personal income, so if the savings rate stays steady and employment is flat, consumption should fall by about the same amount. However, the savings rate could justifiably fall (which means more spending) after a huge increase at the end of 2012. And early readings seem to indicate that employment is moving up at about a 1.5%-2.0% rate, so consumption growth is not hopelessly doomed after all.
The real issue seems to be if the immediate hit of the payroll tax increase slows consumption enough to cause meaningful layoffs. If there are relatively small effects across a very large span of industries, we may not see any big changes in employment. That's because workers are probably working a little above capacity and a small shrinkage in demand won't cause layoffs. Some labor markets are at least a little tight, and employers are unlikely to fire people for just a small change in demand, especially if it may be difficult and expensive to hire and retrain those employees later. However, if the effects are concentrated, then maybe large layoffs would be necessary.
My instinct is that the effects of the tax increase are relatively diffused. The lack of meaningful increase in initial unemployment claims seems to support that view. The data looks generally trendless, to maybe even down a little.
Perhaps the most vulnerable sector is restaurants. I can't seem to pick up an article on the payroll tax increase without some mention of cutting the numbers of restaurant meals eaten. We should get some good initial reads on that with the February employment report.
The Fed News: Nothing to Worry About
I don't think the news out of the Fed was nearly as bad as the market reaction. I do think higher interest rates are in the cards, but probably not until year-end, and certainly not until the economy is on some stronger legs.
Here is why I think the market overreacted:
I am reasonably sure that the Fed won't do anything to tighten until the economy improves, at least somewhat, and the uncertainty from the payroll tax increase and the sequester passes. In an improving economy the Fed will tighten, as early as December, but rates may not go up as much as many fear. Higher interest rates are not an all-bad thing for the economy. While the Fed had more debate about the latest easing programs than observers had expected, I don't think any committee members were clamoring for an immediate cutoff of current programs. With many Fed members very publicly worrying about the sequester and a slowing induced by the payroll tax increase, I doubt that their intentions are to withdraw support from the bond market. This is especially true as fiscal policies are growing tighter. With inflation rates low and fiscal policy growing more restrictive, there doesn't appear to be an immediate reason to raise rates.
Rates Aren't Likely to Go Through the Roof
Even if the Fed does decide to tighten monetary policy, I don't think rates are going up as much as many fear. With inflation running between 1.5% and 2.0%, I don't think the 10-year Treasury should be much higher than 3.5% or so given the normal spread between bonds and inflation. Right now the 10-year is trading at about a 2% yield. When investors think back to times of sharply higher rates, they forget that inflation was much worse, too.
I might add that the supply and demand situation for fixed income is different today. Some of the fastest-growing elements of our economy (think Google (GOOG), Apple (AAPL), Facebook (FB)) don't eat capital the way railroads and steel mills did. In addition, large corporations' balance sheets are flush with cash. Then on the supply side, baby boomers nearing retirement age are saving more and allocating more of their portfolios to fixed income.
Spending Is Driven by a Lot More Than Interest Rates
Much of the housing boom and the expansion in capital spending budgets occurred in environments where interest rates were much higher than the 3.5% or so that I am eventually anticipating. I would argue that growth outlooks, demographics, and general confidence are at least as important as rates in deciding whether to invest in a business or buy a home. And as I mentioned in my first bullet point above, the Fed isn't likely to push rates up until the economic outlook is better and more certain--in which case, I believe a better outlook trumps higher rates in terms of stock-market performance.
Are Higher Rates Really a Bad Thing?
While higher rates can do some serious damage to fixed-income portfolios, they may not be as harmful to the economy as many fear. On the positive side, higher rates could act as a catalyst, causing both businesses and consumers to get off the fence for major spending decisions. With a great deal of uncertainty in the economy, there is little incentive for businesses or consumers to act if the Fed promises to keep rates low forever. However, even the faintest whiff of rate increases ahead might drive the dilettantes off the fence. In fact, in 2012, every time rates showed signs of motion, housing activity and mortgage applications picked up. Interestingly, I received a postcard from a Realtor this week suggesting that now was the time to act with rates going up, and included a chart showing I could afford less as rates rose. I think this fear of missing out will begin to seep into the economy soon, with housing prices and now mortgage rates off of their bottoms.
Higher rates would help savers, too, who have seen their income streams decimated by low rates. While there is always a question if these saver types will spend all of the extra income, I think they might spend a higher-than-normal amount because of the recent repression in rates.
Also, many consumers' biggest loans are for their houses. Those are financed with 30-year mortgages that won't see an increase even if rates go higher. These rates are locked in for 30 years, and I believe that a lot of loans have been refinanced already. I also suspect that a 1%-2% increase in credit card rates that are already in the midteens won't make a huge difference, either.
There is also the possibility that higher rates will begin to puncture some of the speculation in commodities. Recall that high commodity prices drive up inflation sharply. If inflation accelerates too quickly and goes much over 4%, a recession almost always results. The Wall Street Journal openly postulated in Friday's edition that at least some of the recent oil price increases were due to speculators. Indeed, oil prices have fallen sharply since the Fed minutes became public.
Consumer Prices Show No Increase Again
Helped by lower energy prices, consumer prices have declined or stayed the same for three months in a row. Even the year-over-year, averaged data has continued to show declines, as shown below:
Inflation is one of the key metrics in determining the end of a recovery, and the U.S. economy seems pretty safe now with 1.7% year-over-year inflation when averaged over three months. Most notably, food prices were flat after several months of big increases. Most categories showed inflation of 0.1% or 0.2% in January, except those shown below:
However, we may have seen the last of the stunningly good inflation news for a while. Gasoline prices were up almost $0.50 a gallon so far in February, which probably means that overall inflation will spike in the February report, perhaps as much as 0.5% (however, gasoline prices spiked last February, too, so the year-over-year data may not change nearly as much). Although it may take awhile to work its way through the system, crude oil prices are now down big because of the Fed minutes (discussed above) and weakness in Europe. Eventually, that should move gasoline prices down, too.
Housing Data Stagnates
Builder sentiment as reported by the National Association of Home Builders fell unexpectedly from 47 to 46, creating some worries about the housing industry. Again, in the context of an index that has moved from single digits two years ago to almost 50, I have no apprehension about one small downtick. I was just a little concerned that labor, material, and land shortages were all beginning to weigh on results, according to the association.
Also, while both the buyer traffic portion and current production portions of the three-part index were down, the more forward-looking portion of the index, the six-month sales expectations index, was up.
Home Starts Move Down on Volatile Apartment Sales; Permits Up
Looking at the raw data, a drop in housing starts from an upwardly revised 973,000 in December to 890,000 in December looks pretty dire. However, that's due largely to a spike in apartment buildings in December and a fallback in January. Single-family homes continued their slow but steady increase, moving from 608,000 units to 613,000 units. Looking at the year-over-year averaged data also provides a much less spooky point of view.
Also, the permits section of the report, which is a little more forward-looking, was also a lot more hopeful. Permits to start a new home increased from 909,000 in December to 925,000 in January. Even the year-over-year rate was up and exceeded the growth in starts.
Existing-Home Sales Up Fractionally, but Inventories Take a Dive
Existing-home sales moved from 4.90 million in December to 4.92 million in January and shy of the recovery high of 4.96 million units reached in November. Given the weather, the payroll tax issues and an inventory shortage, the news wasn't at all disappointing. As has been the pattern, unit sales were up 11% year over year, and transaction values were up a more rewarding 22%. In the meantime, inventories fell from 2 million to 1.8 million units in just one month. Year-over-year inventories are down 23%. Months of available supply, at 4.2 months, is in danger of dropping below the four-month supply level that is considered healthy or normal. This should keep the pressure on prices firmly upward in 2013. Frankly, I would like to see a better mix of unit growth and price growth, but that may prove very difficult in the short run.
Next Week's News Likely to Be Mixed
Next week will have the second reading on GDP growth in the fourth quarter, which should move from negative 0.1% to a positive 0.5%. While that size change isn't unusual, the optics of having a gain instead of shrinkage could help lift consumer and investment sentiment. Improved export data and revised retail sales data will be responsible for the upward shift.
Personal Income Data Won't Be Pretty
Expectations are for personal income to fall 2.2%. That's for one month, not annualized. A combination of early dividends and bonuses paid in December instead of the usual January dates is weighing on the data. I will try to break out this effect next week. Real disposable income that includes taxes and the payroll tax increase will look even worse. Despite the lowered income numbers, expectations are for a 0.2% or 0.3% increase in spending, basically matching December's results. Again this is January data, and most of the spending impact is likely to be in February.
Auto Sales Could Be a Bright Spot
Despite all the economic worries affecting some consumer sectors, auto sales are expected to basically hold their own in February with annualized sales of 15.2 million units versus 15.3 million units in January and a recovery high of 15.5 million units. Overall expectations for 2013 are in a range of 15.0 to 15.8 million for the full year, compared with 14.5 million units in 2012.
Boeing Issues Will Weigh on Manufacturing Data
Durable goods orders are expected to be down as much as 5%, and the ISM manufacturing data from purchasing managers is expected to be down from 53.1 to 52.5, with Boeing (BA) playing at least a small role in each. Boeing aircraft orders were small, likely to be at least partially due to the issues with the 787. A huge backlog means that a short-term lack of orders won't hurt much. However, while Boeing isn't stopping production of its 787 for now, the company isn't accelerating production, either. Boeing had hoped to move from five aircraft a month to something at least a little closer to 10 over the next year or two. A slower production ramp-up will hurt U.S. manufacturing in general.