Thursday, July 3, 2014

July Macro Update: Employment and Housing Brighten

In May we started a recurring monthly review of all the main economic data (prior posts are here). Our key message has so far been that (a) growth is positive but modest, in the range of 3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

This post updates the story with the latest data from the past month. The overall message remains largely the same, with caveats: employment and housing are recent bright spots. Sustained improvement in these measures bear a close watch in the months ahead.

We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The June non-farm payroll (288,000 new employees) was at the upper of a 10-year range. This follows prints of 84,000 in December and 217,000 in May. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).

This is not a recent phenomenon. The 1980s and 1990s bull markets were the same, only the range was higher. If anything, the swings in extremes were greater.

For this reason, it's better to look at the trend; in June, trend growth was 1.8% yoy, up fractionally from 1.7% in May. The trend in NFP employment has not much exceeded 2% growth yoy since 2000; the monthly prints shown above have been noise within a growth trend between 1.5% - 1.9% since the start of 2012. It wasn't much different in the 2003-07 bull market, so be careful assuming a trend with much higher growth than 2%. In order to reach the 3% growth of the 1990s, NFP will need to start printing 400,000 per month.

Released together with NFP is a report on average hourly earnings. In June, this showed growth of 2.0% yoy. Wage growth is not accelerating; 2% is the middle of its range since late 2009. In fact, this month's growth rate was the lowest since December.

Similarly, the employment cost index shows modest growth in compensation. For 1Q14, it was 1.7% yoy. It is also not accelerating.

These employment and wage reports suggest only modest pressure from labor on inflation.

CPI and core CPI (excluding more volatile food and energy) are growing at 2.0% yoy. Neither has been much above 2% since 2Q 2012; each time it has approached 2%, like it did in the past month, the rate has declined in the months ahead. In other words, there has been no sustained acceleration in inflation, yet. This is in contrast to 2003-07, when inflation was consistently closer to 3%. Consensus expectations are that inflation will now accelerate; the high-end of the range print this month implies that this bears watching closely.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; core and total PCE are now 1.5% and 1.8% yoy, respectively. Neither has been above 2% since 2Q 2012. Like CPI, there has been no sustained acceleration in inflation, and the rate is well below levels in 2003-07. But the jump in the past month bears watching closely.

Next, let's look at several measures of demand growth. Regardless of which data is used, real demand has been growing at about 1.5-2.0%, equal to about 3-4% nominal.

On an annual basis, real (inflation adjusted) GDP growth through 1Q14 was 1.5%, down from 2.6% in 4Q13. This is near the low end of the post-recession range (1.3-3.3%). It's positive, but lower than what the US is used to; prior expansionary periods since 1980 experienced growth of 2.5-4.5% yoy.

Stripping out the changes in GDP due to inventory gives you real final sales. In 1Q14, this grew 1.5% yoy. In 4Q13, prior to the effects of winter, it was 1.8%. Both are on the low end of the range (1.7-2.7%) since 4Q 2010. This is a better measure of consumption growth than total GDP. It's not accelerating: since 1Q13, yoy growth has been 1.7%, 1.7%, 1.7%, 1.8% and 1.5%.

Similarly, the real personal consumption expenditures component of GDP grew at 2.0% yoy in 1Q14, at the low end of its range (2-3%) since 2Q 2010, but below the 2.5-4.5% that was common in prior expansionary periods after 1980.

Real retail sales grew 2.1% yoy in the past month. The range has been closer to 1.5-4% yoy for most of the past 20 years.

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) grew at 3.8% yoy in May. This continues to be sluggish. During the heart of the prior bull market, growth was over 5%.

Industrial production is an important measure but it travels in a wide range. The typical range has been 1.5-4.5% yoy through the past 15 years; last month it was near the high end at 4.3%. During much of the 1990s, the range was much higher: 3.5-7%. Excluding mining and oil/gas extraction, the manufacturing component of industrial production is growing at 3.8% yoy.

Finally, let's look at two measures of housing. After a weak winter, housing data has improved markedly. This is a large potential positive for the economy.

First, new houses sold declined 6% yoy in April and then rebounded with 17% growth in May. This was the widely expected recovery from winter weakness. The overall level of sales is still meager relative to prior bull markets. There appears to be some acceleration in sales; whether this is sustained after a pick up from winter is now the key watch out.

Second, after a decline in winter, housing starts is now back to growth. Growth was 9% yoy in May. The overall level of construction is well off those during the prior two bull markets, but the trend is up.

In summary, the major macro data so far suggest a positive, but modest growth. This is consistent with corporate sales growth.  SPX sales growth the past 3 years has been positive but has only averaged about 2% per annum. That's the trend, although there is considerable variation around trend each quarter. This variation is usually noise; the low growth of 1Q14 and the high growth of 4Q14 are recent examples.

The consensus expects growth to accelerate to 3% in 2014; we agree.

The difference between SPX sales growth of 2% and domestic macro growth of 3-4% is the ex-US activity of US corporations; European economic (and earnings) growth has been close to zero.

With valuations at high levels, the current pace of sales growth is likely to be the limiting factor for equity appreciation. This is important, as the consensus expects earnings to grow at more than 10% in 2014 and 2015.

Modest growth should not be a surprise. This is the classic pattern in the years following a financial crisis like the one experienced in 2008-09. It is also what the flattening spread in yields have been signaling for several months. Of note: this spread may have bottomed in the past two months. Watch it going ahead.

If there is a bright spot, it's that macro expectations usually improve in the second half of the year; it has already started to improve and this will likely carry into 2H14. That doesn't mean growth above 3-4%, but data that meets or exceeds lowered expectations.