Last week the US market was totally infatuated with 1) economic indicators and 2) Greek debt. When an indicator came in above expectations, markets soared. When one missed, markets collapsed. The soaring and collapsing could happen on the same day of the week!
I found it disconcerting that a "poor" economic indicator that nevertheless beat expectations was major cause for celebration. For example, the official government retail sales report showed May sales fell 0.2% versus the Wall Street Journal's consensus estimate of a 0.7% decline, so markets staged a huge rally Tuesday. Never mind that the previous month was revised downward or that sister publication MarketWatch showed the consensus of a 0.3% decline. (There were some things to like in the retail sales report, but more on that later.)
Markets reacted almost instantaneously to poor manufacturing data (industrial production and two regional purchasing managers' reports). But being a go-with-the-flow type of market, stocks soared on improved jobless claims and better housing starts on Thursday (with a sharp but temporary decline due to the Philly Fed Purchasing Managers' Report).
The market continued its good mood on Friday morning as the Europeans appeared ready to put another band-aid on the Greek bond situation, averting the crisis for another two or three months. Let me be very clear: Greece cannot repay those bonds out of the income it is generating. Those bonds will have to be restructured, in my opinion. The only question is who will bear the pain--bondholders (primarily European banks), governments, or European community agencies?
As market participants shift from one side of the boat to the other on an hour-by-hour, indicator-by-indicator basis, what's an investor to do? As an economist I will continue to focus on the consumer and the metrics that drive the consumer. Manufacturing only amplifies what is happening in the consumer world with a lag. Manufacturing isn't going to grow without consumers here or abroad buying those goods. Manufacturers don't produce things for the fun of it. Furthermore, manufacturing data are being hopelessly distorted by production impairments at Japanese plants in the United States and Japan. Housing data get plenty of attention, too, but that is too small to move the economic needle--new homes account for a mere 1% or so of GDP. Even home prices are not terribly relevant unless prices move into free-fall, as US banks are now in a much stronger capital position and consumers have been weaned from the concept of using their homes as cash machines.
Therefore, I am focusing on what consumers are spending, what's happening to consumer incomes, and what's happening to inflation. Consumer spending has clearly held up better than anyone expected in the face of higher gas prices. Incomes have begun improving on a non-inflation-adjusted basis, but most of those gains have been eaten up by inflation. The good news is that inflation appears to have peaked in the short run; the rate of increase has declined for two months in a row. Based on falling gasoline prices, falling crop prices, and potentially falling auto prices as the Japanese transplants come back on line later this summer, it looks like prices are poised to slow even more over the next several months. I spent most of last year and early this year fretting about the effects of higher prices on consumer spending (we are seeing some of this in recent statistics). Now as inflation looks better, I think consumers will have an improved second half. Falling initial employment claims, better restaurants sales, and a positive hiring report from Manpower all suggest that employment will continue to grow, enhancing customer incomes.
Although I am more sanguine on the economy, stock markets will have their own set of worries. I suspect this earnings season, which starts in about a week, could be more problematic than usual as producers and retailers faced rising input prices that they were unable to fully pass on to consumers, especially as various commodity price hedges and inventory buffers came to an end. Also, I surmise that as QE2, which was widely successful in raising assets prices, comes to a conclusion, those very same assets may decline. Stocks are one of those assets--the S&P 500 is up almost 22% from when QE2 rumours began last August--and I suspect the end of QE2 has given stocks a reason to pause, just like commodities and other so-called risk assets. Furthermore, there is a real potential for more negative headline economic indicators in the months ahead. I am particularly worried about auto production issues pushing second-quarter GDP growth pretty close to flat, which will send the Chicken Littles into a real tizzy.
Autos Temporarily Push Retail Sales into Negative Territory
Retail sales declined 0.2% in May due largely to sharply lower auto sales. As I suspected last week, the headlines generally highlighted the negative number ("Retail Sales Fall for First Time in 11 Months," one trumpeted). Excluding auto sales, retail sales increased a reasonable 0.3% compared to growth of 0.5% the previous month. Auto sales were hit because of higher prices and a lack of availability, both caused by disruptions at the Japanese auto manufacturers.
Besides autos, about half of the categories showed increases and half showed decreases according to the report. Electronics and furniture showed the largest declines after autos. Home improvement stores, miscellaneous retailers, and nonstore retailers led the way higher. One surprise in the data was strong restaurant sales, which increased 0.6% following a decline the previous month. I like seeing restaurant sales increase; it represents a backdoor measure of consumer confidence. It should also drive up restaurant employment numbers.
Consumers Eat Out More, Skipping Grocery Stores' Higher Prices
Speaking of food, grocery sales declined 0.5%, which is surprising given that food prices were up during the month. Consumers seem to be rebelling over higher prices at the grocery store.
Weekly Retail Sales Still Hanging in There
Weekly sales data continue to remain upbeat, with year-over-year same-store sales continuing in the 2%-3% range as they have for most of the year. These two retail sales indicators are the primary reason for my optimism on the consumer and the economy.
