The Real Story Behind The Bounce In Core Capital Goods
The Durable Goods report released for January was disappointing on the surface with new factory orders dropping by 5.2% for the month. However, there are a couple of things to remember about the durable goods report: 1) it is an advance estimate of the Factory Orders report that is released a couple of weeks later which always contains revisions to the durable goods report; and 2) the durable goods report is extremely volatile making month to month data points effectively useless.
However, in the report there were some important positives for the economy. Not surprisingly, in the wake of Boeing's "787 Dream-Mare," durable goods orders fell sharply as the transportation component plunging by 19.8%. However, stripping out transportation and looking at core capital goods orders we find a very healthy 1.9% advance in January following a 1.0% rise in December.
The increase in core capital goods orders was led by machinery rising 13.5%; electrical equipment climbing 1.4%; and "other stuff," pushing up 1.3%. Weakness, however, was seen in computers & electronics falling 5.3% and primary metals sliding by 3.6%. The big negative for in the report was shipments which fell by 1% in January.
Of course, the question we need to ask is whether the improvement in core capital goods orders is a "green shoot" of a potentially improving economic environment or simply a bounce within a larger negative trend? To answer that question we can look at the annual change in new orders for durable goods as compared the annual change in core capital goods orders.
What the data trends show us are two things. First, durable goods orders peaked, along with every other economic indicator, in Q1 of 2010. While there is not a long history of durable goods data to draw from what is relatively clear is that the trend of new orders is clearly negative portending to a weaker economic environment ahead. Secondly, while core capital goods orders have bounced over the last couple of months the trend of the data, while still very volatile from one month to the next, is still well contained within the current downtrend.
If we smooth the annualized data using a 3-month average we get a clearer picture of the overall trend.
As you can see, bounces within downtrends are not uncommon. Looking back to the previous two recessionary periods there have been relatively sharp bounces in core capital goods orders just before the onset of the recession. The current bounce, following the very steep decline in 2012, is mostly centered in the investment by businesses in equipment. This is very likely due to maintenance, replacement and further productivity increases to minimize the need for labor.
Rather than a "green shoot" the core capital goods orders for January is much more in line with the ongoing series of economic reports (see here, here, here and here) as of late that show businesses repositioning themselves for a weaker economy. Here is a short list of the headwinds that business owners are currently facing as it relates to their profitability:
- The $125 billion annual drag on consumers from higher payroll taxes.
- A potential economic drag from future spending cuts due to the sequester.
- Higher energy costs
- Higher income taxes on business owners in 2013.
- Rising health care and benefit costs due to ObamaCare
- Increased regulatory issues
- Global recessionary drags
With these issues impacting profitability, combined with an inability to pass higher costs on to the end consumer, it is not surprising that businesses continue to focus on ways to sustain profitability through increases in productivity. This leads to investment in equipment and technology that further reduces the need for full-time employment and ultimately reduces future wage growth.
The revisions to this data when the factory orders report is released in the next couple of weeks will give us more detail to work with. In the meantime the markets will likely continue to remain within the confines of the current bullish trend as liquidity continues to pour into the financial system. However, as we have stated in the past, it is ultimately the underlying economy and fundamentals which drive the financial markets.
The mistake that investors continuously make is the confusion of short term price trends as a long term indicator. Prices can ignore fundamentals for much longer than most can imagine and always long enough to drag in a bulk of investors. It is this short term price advance, especially when driven by artificial influences, that lead investors to disregard, or misinterpret, fundamental and economic data as it relates to the long term picture. This is why reversions of price to recouple with underlying fundamentals always leaves mainstream analysts and economists grasping for reasons why it should not have happened and investors much less wealthy.
The current advance in the markets still has room to go as long as the Fed continues to provide the support. The end result, however, will ultimately be the same.