Tuesday, July 14, 2015

July Macro Update: The Majority of Macro Data Trends Positive

Summary: This post reviews the main economic data from the past month.  Highlights:
  • Employment: The average monthly gain in employment during the past year was 245,000, the highest since the 1990s. Annual growth in employment is the best in 15 years. 
  • Wages: Hourly earnings growth in April and May was the highest since the recession; it fell to 2% in June. Sustained wage growth remains elusive.
  • Demand: 1Q15 real GDP grew 2.9%, the second highest rate in the past 5 years. Real personal consumption (70% of GDP) grew 3.4% in May, the highest rate of growth in 8 years.  
  • Housing: Housing starts in April rose to a new 8 year high. New home sales in May rose to a new 7 year high.
  • Inflation: However, the core inflation rate remains under 2%. It is near its lowest level in the past 3 years  
Bottomline: the trend for the majority of the macro data remains positive.

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A year ago, we started a recurring monthly review of all the main economic data (prior posts are here).

For most of that time, the consensus view has been that growth in wages and employment would soon accelerate and that this would lead to a meaningful increase in inflation above the Fed's 2% target. Our monthly review of the data has consistently shown this expectation to be premature.

The irony now is that economic data has seemingly turned negative over the past four months, to the point where many talk about a recession or QE4. We think this weakness is temporary, mostly driven by the huge drop in energy prices which has lowered inflation and depressed "nominal" price growth. "Real" growth remains positive.

More importantly, the fact that the consensus swings between extremes underscores how focused too many are on monthly data points, with the effect that underlying trend in the data is missed.

Bottomline: the trend for the majority of the macro data remains positive.

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 is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.

Employment and Wages
The June non-farm payroll was 223,000 new employees. Prior to March (a disappointing 119,000), NFP had been above 200,000 12 months in a row, the longest streak since 1993-95. April, May and June were therefore a bounce back to trend.

In the past 12 months, the average gain in employment was 245,000, the highest since the 1990s.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000. That has been a pattern during every bull market.  So while the March print of 119,000 was lower than expected, it fits the historical pattern. A low print was long overdue.

Volatility in NFP is not a recent phenomenon. The 1980s and 1990s bull markets were the same, only the range was higher. If anything, the swings were more extreme: NFP was negative in 1995, 1996 and 1997.

For this reason, it's better to look at the trend; in June, trend growth was 2.1% yoy. Annual growth continues to be the highest in 15 years.  Employment growth in 2015 has been better than at any time during the 2003-07 bull market.

Released together with NFP is a report on average hourly earnings. In June, this declined to 2.0% growth yoy; in April and May, the rate of growth was the highest since the end of the recession. This will be very positive if the acceleration in wages is sustained. Not yet.

The employment cost index shows an improving trend in compensation. For 1Q15, it was 2.7% yoythe highest since the recession; this is good news, especially as there is a trend of sequential quarterly improvements.

For those who doubt the accuracy of the BLS employment data, federal tax receipts are also accelerating, a sign of better employment and wages (data from Yardeni).

Despite improving employment, inflation has been decelerating in recent months and remains below the Fed's target of 2%.

With oil prices collapsing, CPI remained near 0% in May. The more important core CPI (excluding more volatile food and energy) grew 1.7%. Consensus expectations are that inflation will accelerate but it hasn't happened.

The Fed prefers to use personal consumption expenditures (PCE) to measure inflation; total and core PCE were 0.2% and 1.2% yoy, respectively, in May . 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.

For some reason, many mistrust CPI and PCE. MIT publishes an independent price index (called the billion prices index). It tracks both CPI and PCE closely.

Next, let's look at several measures of demand growth. Regardless of which data is used, real demand has been growing at about 2-3%, equal to about ~3-4% nominal.

On an annual basis, real (inflation adjusted) GDP growth through 1Q15 was 2.9%, the second highest rate of growth in the past 5 years. 1Q growth was at the high end of the post-recession range (1.5-3.0%). It's positive, but lower than what the US is used to; prior expansionary periods since 1980 experienced growth of 2.5-5% yoy.

Stripping out the changes in GDP due to inventory produces "real final sales". This is a better measure of consumption growth than total GDP.  In 1Q15, this grew 2.5% yoy, the third highest rate of growth since 2007 (8 years). A sustained break above 2.5-3.0% would be noteworthy. Not yet.

Similarly, the "real personal consumption expenditures" component of GDP (defined), the component which accounts for about 70% of GDP, grew at 3.1% yoy in 1Q15, the highest growth rate in 8 years. This is approaching the 3-5% that was common in prior expansionary periods after 1980.

On a monthly basis, the growth in real personal consumption expenditures was 3.4% yoy in May, the highest rate of growth since October 2006, more than 8 years ago.

GDP measures the total expenditures in the economy. An alternative measure is GDI (gross domestic income), which measures the total income in the economy. Since every expenditure produces income, these are equivalent measurements of the economy. A growing body of research suggests that GDI might be more accurate than GDP (here).

On an annual basis, real GDI growth through 1Q15 was 3.7%, the second highest rate of growth in the past 8 years (since 3Q06). This is right within the range of prior expansionary periods since 1980 (2.5-5% yoy).

Real retail sales grew 2.6% yoy in the past month. The range has been 1.5-4% yoy for most of the past 20 years. The latest month is therefore in the middle of the range.

Retail sales has recently been affected by the large fall in the price of gasoline. Retail sales at gasoline stations fell by 19% yoy. Retail sales excluding gas stations grew 4.8% (nominal) in May.

Core durable goods orders (excluding military, so that it measures consumption, and transportation, which is highly volatile) fell 1.1% yoy (nominal) in May. During the heart of the prior bull market, growth was typically 7-13%. You can see that weak growth in winter has been a pattern the past three years (arrows).

This is also a nominal measure and thus negatively impacted by the fall in the inflation rate. On a real basis, growth continues to trend higher over the past year (blue line is real; gray line is nominal; chart from Doug Short).

In May, industrial production growth was 1.4%. The manufacturing component (excluding mining and oil/gas extraction) grew 2.1%. The typical range for annual growth in Industrial Production has been 1.5-5% through the past 15 years: the current reading is therefore at the low end of the range. During much of the 1990s, the range was higher: 3.5-7%. It's a volatile series; manufacturing growth was lower at points in both 2013 and 2014 before rebounding strongly.

Finally, let's look at two measures of housing. Housing starts in April rose to a new 8 year high. New home sales in May rose to a new 7 year high. Overall levels of construction and sales are small relative to prior bull markets.

First, new houses sold was 546,000 in May, the highest since early-2008, 7 years ago. This is 19% higher than a year ago. The overall level of sales is still meager relative to prior bull markets. 30 years ago, 600,000 would have been at the low end of the range for monthly sales.

Second, overall starts in April increased to a new 8 year high; they remained near those highs in May.  The overall level of construction is well off those during the prior two bull markets, but the trend is clearly positive.

While housing starts were disappointing during the winter, they were not alarming. Building permits remained robust, demonstrating that the slowdown was likely weather related and that a rebound in spring construction was probably. This has turned out to be the case, with permits (red line) in May at a new 8 year high.

The rebound in starts has been widespread; in April, single family housing starts (blue line) were the highest, and multi-unit housing starts (red line) were the second highest, since the recession. May was only slightly lower.

In summary, the major macro data so far suggest positive, but modest, growth. This is consistent with corporate sales growth.  SPX sales growth the past year has been positive but only about 2% (nominal).

The consensus expects sales growth of about 2-4% per annum (nominal) thru 2016, excluding the volatile energy sector; the macro data presented here makes this seem reasonable (chart from FactSet).

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 2% in 2015 and 12% in 2016.

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 signaled for all of 2014. There are signs that this is now reversing in 2015 as growth becomes embedded.

There has been a tendency for macro data to underperform expectations in the first half of the year. That may now be reaching a turning point.

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