What Does the Economic Data Mean?

by Paul J Nolte CFA, Dearborn Partners. August 31, 2006

The first leg of a heavy economic data week has come in without too much fanfare. The key inflation data was a bit under expectations, while spending continues at a relatively brisk pace (still above earnings growth). This all still fits with the Fed's decision to pause and may allow them to once again stand aside in September. Given the results of the minutes of the last meeting, it is VERY clear that inflation data is the primary focus and puts added emphasis on the CPI and PPI data in September (August data). If we look backwards to what was reported a year ago, inflation figures were very high on a month-to-month basis in the three months beginning in August. As long as the inflation is below 0.5%, the year-to-year figures should decline – even if the monthly figures are above expectations. Simply put, we will be replacing relatively high inflation numbers with relatively low numbers, so the Y/Y rates will fall.

If we look at just one component of inflation that everyone has been watching – oil. Pump prices are actually LOWER than a year ago, and 5-10% below a month ago levels. Again, comparing Y/Y changes in oil today vs. a year ago, we will see a dramatic decline in the rates of increase – again pointing toward lower inflation rates. A quick look at inventory levels, the surprises from the DOE have generally been on the high side. In fact, natural gas storage levels all year have been at least 10% above prior year levels, and the five-year average storage levels. Judging by the action in the oil market over the past two weeks, we would expect lower oil prices over the next six months – barring serious impairment due to hurricanes. (We view 2005 more of an anomaly than the "new" normal.)

Tomorrow we also get the granddaddy of economic news (at least it has been over the past six months), the unemployment report. Expectations are for job growth of around 125,000 and an increase in average hourly earnings of 0.3%. Arguments have raged about the overall level of job creation – it has been WELL below what has, until recently, been considered normal job growth. As recently as 2000, normal job creation was in the 200k range, below that pushed unemployment rates higher, and above pushed unemployment lower. The economy has been creating well below that 200k benchmark for over six months, yet the unemployment rate has actually declined – pointing to a hefty number of people actually leaving the job force. We would argue that the employment picture is actually worse than what the numbers are indicating – a higher unemployment rate AND a lower earnings growth rate. We believe that the risks are for the non-farm payrolls to come in below expectations. Our check of clients and businesses indicate that earnings growth is barely 3%, however many employees are also being asked to pick up a greater portion of healthcare costs – so the NET paycheck is marginally better than the prior year.

The low net earnings growth figure is one of the main reasons for the use of housing appreciation to maintain spending. At some point the consumer will slow their spending habits; however, based on the figures released this morning - it is not this month. Based on the personal income and spending numbers, consumers continue to spend more than they earn, pushing the savings rate further into negative territory. While there are some glaring errors in the income figures (gains from investments is a biggie), the consumer has not slowed their spending in the face of higher energy prices, lower earnings growth or the flattening of housing prices.

Housing has been a primary focus for investors/economists, especially those who are projecting the next nail in the economic coffin. The housing market is indeed falling – and rapidly. The dynamic of the housing market is very different from that of the stock market and the effect will be more muted, but for a longer time – effectively keeping a lid on truly robust economic growth for the next couple of years. The affordability index has fallen through the floor, as income growth has not kept pace with both the rise in rates and housing prices. Both interest rates and housing prices have moderated, while earnings growth remains moderate. Going through the mathematics of what gets the index back to a median will take a decline in the prices of housing as well as in mortgage rates. We are beginning to see rates decline, and we expect more in the future – in fact, we are calling for the Fed to begin cutting rates in the first half of 2007. As it has taken time for the rate hikes to grab the economy, we also expect the rate cuts to take time to begin having a positive effect on housing – so we can easily project pressure from housing on the economy well into 2008.

So, with the above as a backdrop, what does it all mean for the financial markets? We have been pounding the table for the past month (and generally favorable most of the year) on bonds, as we believe rates will move lower during the remainder of the year. If we are to believe the bond market, they are beginning to discount a rate cut early in 2007 and 10 year bonds are now trading 50 basis points below fed funds rates as risks of a recession increase. We still believe bonds are the best place to be for the remainder of the year, as bond yields could move to 4.5% on the 10-year by the end of the year. The stock market is another matter altogether. EVERYONE knows the stock market struggles during September/October and we are due for a four-year bottom to occur sometime during the next 60 days. Unfortunately, the stock market does not always comply with what the consensus wants. If we look at the money invested in short funds at Rydex – investors still have a larger than normal position in the short funds as compared to long funds. Looking at the International Securities Exchange index, a ratio of call and put options bought on the ISE – counting only those opening an options position rather than closing one, investors are clearly buying put options. Current levels are very similar to the market bottom in the first quarter of 2003.

Today's Market

As we enter the last third of the market, the trading range continues to confound nearly all investors, providing false breaks on both the up and downside. If the expectations are for a decline over the next two months and a fourth quarter rally, based on these few indicators – the markets may actually hold up in the coming months before declining into yearend as investors reassess their views of the economy and how much stimulus may be needed to get things going once again.

Today, even with the heavy calendar of economic data that point to a Fed that actually has made the right decision, the financial markets struggled to move much from the centerline. Gold was the big winner and oil finished higher after spending much of the day lower. Small and mid-cap stocks have gained some traction over the past few days, but much of the quarter so far has been a large cap affair, as the S&P500 gained nearly 3%, while small stocks are unchanged. We still favor the stability of consumer, healthcare and utility issues as well as a healthy dose of bonds. The markets are not priced to provide above average returns, so investors would be smart to stay conservative.

Paul Nolte

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