Weekly Economic Vital Signs - Weakening But Sustainable Growth

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by: Lawrence Fuller
Summary

This is a weekly series focused on analyzing the previous week's economic data releases.

The objective is to concentrate on leading indicators of economic activity to determine whether the economy is strengthening or weakening, and the rate of inflation is increasing or decreasing.

This week, we examine durable goods orders, existing home sales, and the PMI Composite Flash index.

Durable Goods Orders

Orders for durable goods rose 1.2% in December, but when we exclude transportation, the increase was just 0.1%. What is troublesome is that the component which measures business investment (capital spending) fell 0.7% in December, while November's figure was revised down to -1%. Orders for machinery, computers and communications equipment were all weak. While orders were weak in December, shipments rose 0.5%, which is the figure used to calculate GDP growth. That bodes well for the fourth quarter, but the weakness in new orders means growth will slow moving forward.

Last week's Philadelphia Fed survey confirmed the weakness in business spending, showing that factory activity in that region contracted in February for the first time since May 2016.

Existing Home Sales

The bad news is that existing home sales declined 1.2% from December to January to a seasonally-adjusted annual rate of 4.94 million, which is 8.5% lower than a year ago. Price appreciation has started to slow with median home prices up 2.8% year-over-year. The rise in mortgage rates over the past year has clearly stunted sales growth, but rates have started to come down modestly, which should be a net positive. The improvement in real wages is also a tailwind for what has been a real weak spot in the economy.

One small positive is that January was the sixth consecutive month in which supply was up on a year-over-year basis. Supply constraints have been the reason most often cited for weak existing home sales. If the improvement in real wage growth continues, and the increase in supply further slows the rate of home price appreciation, this could be a source of economic growth in 2019. To show just how weak existing home sales have been, examine the relationship between sales and population growth, as shown below. This can be viewed as a negative in hindsight, but it must become a source of growth moving forward at some point, provided the macroeconomic landscape remains favorable.

Flash Composite PMI

The initial read from Markit's survey of the manufacturing and service sectors (approximately 1,000 companies) shows strength from the more important service sector and continued weakness from manufacturing. The composite index rose to 55.8 in February from 54.4 in January.

The strong upturn in the service sector activity, led by new orders and hiring, was the strongest since June of last year. Survey respondents cited the steepest increase in backlogs in more than four years. Yet they also cited an increase in input cost inflation, which is leading to an increase in prices charged.

On the other hand, the read on manufacturing weakened to levels not seen since September 2017. This was blamed on global trade uncertainties. The sector is still growing, albeit at a slower rate.

Conclusion

The rate of economic growth is clearly weakening, which is one of several reasons why we are seeing a decline in year-over-year forecasts for corporate revenues and earnings. The fourth quarter of 2018 will undoubtedly be disappointing, in large part because the third quarter (3.4%) benefited from an enormous boost in inventory building (2.3%), which we haven't seen in several years. This still represents growth, but it isn't repeatable anytime soon, making forward comparisons more difficult. The government shutdown will also be a significant headwind to the fourth-quarter growth figure.

At the same time, trade was an enormous drag (-2.0%) in the third quarter, which could be a source of growth in the future if the U.S. and China can reach an agreement on trade. The rate of growth in government spending, led by defense, doesn't appear to be slowing anytime soon, while consumer spending remains resilient. With real-wage growth now picking up steam, I don't see any indication that the largest contributor to our rate of economic growth, personal consumption expenditures or consumer spending, will wane in the near term. I expect growth of 1-2% in 2019.

What does concern me is the increase in the rate of inflation we have seen in recent months. The year-over-year increase in the core rate (excluded food and energy) is now 2.2%. The welcomed strength in real-wage growth is a precursor to a rising rate of inflation. If the rate of inflation increases, it should lead to higher long-term interest rates. Given how indebted our economy is today, rising long-term interest rates would be a death knell for growth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.