LEI, Philly Fed, Housing And The 100 Days Of Summer
The most recent releases of Leading Economic Indicators, the Phildelphia Fed Manufacturing Report and housing starts were all just awful. The markets, however, continue to interpret bad news for "good news" in hopes that each piece of bad economic data will translate into further quantitative easing programs from the Fed. Unfortunately, the current rally may be a set up for disappointment.
The Leading Economic Indicator index fell 0.3 percent in June after an upwardly revised 0.4 percent boost the prior month. Weighing down on the June number were the new orders index (minus 0.16 percentage contribution), consumer expectations (minus 0.13 percent contribution), building permits (minus 0.10 percentage contribution), jobless claims, stock prices, and new orders for nondefense capital goods excluding aircraft. The importance here is that 7 of 10 indicators all showed weakness. Most importantly, the weakness is seen in areas which are most economically sensitive which are consumer related - expectations, orders, and permits.
As always it is the trend of the data that is more important than a single data point. The chart shows the year-over-year change in the leading index compared to economic growth. As you would imagine there is a high level of correlation between the index and GDP. While the annualized change has not fallen below the ZERO line indicating the onset of a recession - the steepness, and persistence, of decline does indicate further economic weakness in the months ahead. With only one exception going back to 1959, which occurred in 1996, has the annualized change of the index fallen to the current levels without the economy slipping into recession.
Furthermore, the coincident to lagging indicator has also dipped below levels that generally indicate a recessionary economy. Unlike the annualized rate of change in the LEI - the Coincident to Lagging indicator has never logged a false reading. At the current level of 90.50 it is below the 91 level which has usually signaled the onset of a recession.
Could this time be different. Absolutely. Before the current period, the economy was not being influenced by continued interventions from central banks and artificially low interest rates. Those interventions affect the two three largest components to the LEI which are stock market prices, money supply and the spread of interest rates. Regardless, while there is much ongoing debate about whether the economy either is in, or about to be in, a recession - there is little question that the economy is slowing.
No Love In Philadelphia
In the city of "brotherly love" there was little showing in the latest release of the Philadelphia Manufacturing Survey. The index remained in contractionary territory during the latest month with a reading of -12.9. This is the third month in a row of contractionary readings. However, in a blow to those hoping for a rebound in employment, that component slipped from a postive reading of 1.8 last month to a -8.4 currently. Furthermore, the average work week has remained in negative territory for 4 months in row and currently sits at -17.3. Expectations of future hiring also took a sharp dive from 18.7 to 11.3.
Overall, there was broad deterioration in both current and future components of the index. The current New Orders index was mired at -6.9 while Future New Orders slipped from 38.2 to 26.1. Current Shipments slowed to -8.6 while Future Shipments collapsed by 50% from 38 to 19. Delivery Times fell from -15.5 last month to -15.7 currently as Future Delivery Times deteriorated from -7.3 to -13.
In a further blow to GDP, and continuing evidence that corporations remain on the defensive, Current Inventories came in at -7.5 as Future Inventories fell sharply from -12 to -16. Business investment in the next six months, another important component to GDP, also tumbled from 19.4 to 3.3 as end demand continues to wane.
Finally, additional pressure on corporate profits continues as prices paid less prices received continues to press lower. The question for corporate profits, as discussed recently, is whether corporations are able to offset the declines in revenues with further cost cutting measures and accounting gimmicks to keep up with Wall Street expectations. History says this time is likely not different.
Existing Home Sales
In the ongoing housing recovery debate the recent release of existing home sales certainly did not add to the bullish case. There has recently been much commentary on the recent rebound in housing starts, permits and new home sales. There are two very large mistakes being made in extrapolating the current real estate bounce with a lasting recovery. The first mistake is that the bulk of the transactions are occurring at the lowest end of the price scale as private equity investors scoop up homes to turn into rentals. That is not the activity that leads to a long lasting economic recovery.
Secondly, if trends of the recent economic data continue to weaken and the economy does indeed slip into recession the rebound in housing will quickly end. The chart shows the "Economically Related Housing Index" which is a composite of components of the housing market that have the biggest net effect on the economy - New One Family Houses Sold, Started, Permitted and Completed. In comparison index is during a normalized economy - it is hard to make the case that the current bounce is anything more than that.
Existing home sales fell a surprising 5.4 percent in June to a 4.37 million annual rate which is the lowest of the year. Declines appear for both single-family homes and condos and declines sweep all regions.
There are two very important reasons for this. The first is that higher prices are pricing individuals out of buying. Wages have stagnated, credit remains tight and unemployment remains a major hurdle. The second, and witnessed by the renewed rise in shadow inventory held by banks, is that distressed properties are still weighing down the markets. With more than 30% of homeowners trapped in their mortgage due to negativity equity this is a situation that is unlikely to resolve itself any time soon.
Markets Continue to Play Out 2011
We have written several pieces about the markets retracing their steps from 2011. While remain invested - we do so cautiously with higher cash levels than normal. While the markets currently climb the "wall of worry" as bad news continues to spur hopes of further stimulative action from the Fed - the concern is that, as shown in the chart, the current rally is exactly the same set up as seen last summer just before the August swoon.
I am not saying the same thing is going to happen this year. However, the current market rally is pricing in any potential action from the Fed which, in turn, is likely to keep the Fed on the sidelines for a while longer. With the continued deterioration in the economy, consumer weakness emerging, yields surging in the Eurozone, the volatility index sitting near lows and markets overbought on a daily basis, the risks are mounting for a sharp correction.
Furthermore, these risks become much more prevalent in August as Europe effectively shuts down for summer vacation. This means there will likely be little action, if any, coming out the Eurozone to head off any potential risks. While the weight of evidence is definitely not investor friendly - you can either be more cautious with equity allocations, reduce portfolio beta and hedge off market related risk or "hope" that Bernanke "gets to work" sooner rather than later.