Reading Indicators

March 21, 2015

Losing Patience With Market's Fed Obsession

Better to spend your time focusing on underlying economic fundamentals.

By Robert Johnson, CFA and Roland Czerniawski

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The market's absolute fixation on the U.S. Federal Reserve continued this week. Stocks,
bonds, and even commodities all soared this week as it appeared the Fed was adopting a
more dovish tone at its latest meeting. European and emerging markets did almost twice as
well as U.S. markets with weekly gains approaching 5% outside the United States. The Fed
pulled in both its economic forecasts and individual interest rate projections. This seemed
to reduce the odds of a Fed rate increase at its June meeting, with most forecasters now
believing rates will be moved up in September, and some even suggesting a rate increase
may be off until 2016. Again, all of this would just be delaying the inevitable and setting us
up for an even bigger fall once it does begin moving rates up.
On the economic front, the market didn't seem too upset that both housing starts and
industrial production, two key components to the recovery, didn't look so hot at first blush.
On the good news front, Greece seemed to take a more conciliatory stance toward the EU,
which seemed to assuage some market fear this week and is perhaps one of the reasons
European markets finally crushed performance in the United States.
The Fed Blinks
Every time it seems as if the Fed is moving toward a rate increase, the rug seems to be
pulled out from underneath it. The Fed statement after its March meeting suggests that
it is worried about the pace of the economy and the impact of the strong dollar. Inflation
doesn't appear to be much of a worry to it. Unfortunately, the market had already built in
and assumed that strong economic conditions are likely to force the Fed to raise rates as
early as June. Now everyone is unwinding those positions. Now markets are likely to go into
another funk as economic data begins to improve and the next Fed meeting approaches. I am
growing a little weary of this on-again, off-again pattern and will spend my time focusing on
underlying economic fundamentals. That's what's driving the Fed anyway.
The Fed moved its economic forecast back from a range of 2.5%3% to a range of
2.3%2.7% for 2015. That was a forecast that we always found to be too high. Our own
forecast is still even lower at 2.0%-2.5%, with growth in the first quarter potentially at the
low end of that range. Oddly, the Fed dropped its unemployment forecast to 5.0%5.2% from
5.2%5.3% at the same time it lowered its economic forecast. That doesn't make a lot of
sense to us.
We agree that a lot of short-term month-to-month data, including retail sales, industrial
production, and housing starts, do look suspiciously soft. The year-over-year data suggests
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a plateauing in growth, not a decline, and that there isn't a lot of reason to worry. Weather
conditions have certainly managed to mess up economic reports yet again, artificially
depressing results in the short term. As the bad weather lifts, I suspect the economy will
accelerate again, paradoxically causing the market to panic once more over the timing of the
first rate increase.
In my mind, the Fed can't play with its rate decision much longer if it wants to take a slow
and gradual approach to rate increases. While inflation remains low now, the labor shortages
we are forecasting and a rapidly closing output gap could make inflation an issue again
sometime between late 2016 and 2018. Waiting until the inflation is fully visible would be a
huge mistake, in our opinion.
One trend a bit worrisome to us and the Fed is that employment growth seems to be
accelerating at the very time economic growth is taking a pause. Sometime in the near
future, economic growth will have to accelerate or employment growth will need to slow.
Businesses don't hire workers for the fun of it. Annual budget and hiring cycles that are hard
to back away from, especially early in the year, suggest that it may be the hiring portion of
the equation that needs to change.
A Closer Look at Housing Data Suggests Some Improvement
Unfortunately, media outlets are focusing on the 17% month-to-month drop in housing starts
for the month of February in isolation. The gloom-and-doomers are now piling on, contending
that by combining this week's industrial report, last week's retail sales report, and now
the housing report, one might guess the U.S. economy is losing serious steam. In previous
columns we warned not to expect much from these reports, which volatility and weather are
battering. A lot of outlets are at least mentioning the weather issue. And the effects are real.
On some level, the worse the weather in the short run, the bigger the bounce will be this
spring and summer.
Less mentioned is the fact that month-to-month numbers have been highly volatile instead
of trending in one direction or the other. Lately, many statistics have surged for a month or
two and then shown little net monthly change, or even some declines. However, looking
at year-over-year averaged data, it's possible to see some stability and maybe even some
improvement.
Looking specifically at housing again, starts were indeed down a seemingly meaningful 17%
month to month. However, year-over-year, averaged data, which includes bad Februaries in
both years, seems to be showing some improvement in both starts and permits.

Losing Patience With Market's Fed Obsession | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | March 21, 2015

Even though the year-over-year starts data look similar to permits (7.2% versus 6.7%), the
permits data is more impressive for its consistency. I have taken a real shine to permits data
because it tends to be less volatile than starts data and is better at staying on the right side
of trends. We note that a permit on a home can be pulled, even in relatively bad weather.
However, if the ground is too frozen, snow-covered, or muddy, the actual start may need
to be delayed. Note that permits never turned negative in 2014 even with record-setting
weather conditions, but housing starts did. Starts growth rates got into the double-digit
range over the summer; permits never made it out of single digits.
Permits Data Well Above Starts, Growing, and at a New Recovery High
In units, permits hit 1.09 million units, the best number of this housing recovery and up about
3% month to month. That's not a bad report for a month with admittedly terrible weather.
Because permits were so far above starts, 1.09 million versus 0.89 million, starts would
seemingly have just one way to go: back up.
Weather Certainly Limited Starts
The relationship between weather and the starts data showed up in spades in the regional
starts data, too. Starts in the hard-hit Northeast territory (which includes Boston) were down
over 57%. Starts in the Midwest were down 37%. Things were better in the West, which
shows a smaller 18.2% decline, while the South, by far the biggest housing market (more
than 50% of the total) was down by just 2.5% in February compared with January.

Losing Patience With Market's Fed Obsession | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | March 21, 2015

Both starts and permits, in units, were above their 12-month averages in January. February's
starts plunge puts it below its average, but less volatile permits are still in good shape.
Still, we aren't lighting the world on fire just yet as permits in both categories have been
relatively stagnant over the past several months. That doesn't trouble me much. It's another
case of data that jumps one month and then just sits. Longer term, acceptable affordability,
easier credit, and millennials who are finally beginning to make purchases that were delayed
because of the recession should move both starts and permits upward.
Homebuilders Still Optimistic (by Roland Czerniawski)
While the homebuilder sentiment ticked down 2 points in March, the sales expectation
component of the survey remained relatively high at 59. It is the buyer traffic that remains
depressed at 37, but some homebuilders are beginning to see improved conditions. Lennar
LEN, a leading U.S. builder, reported its earnings results this week. The Wall Street Journal
has done a nice visual summary of those results; the gist of it is that the results looked
encouraging and that residential construction could show signs of life going into this spring
season.
More important, we are now seeing more confirmation of the hypotheses we've been writing
about over the past few months. First of all, it's great to see that the price for new singlefamily homes is finally coming down, which is something we thought had to happen in order
to better suit the growing cohort of younger buyers. That also should narrow the huge gap
between pricing for new and existing homes. Second, as we suspected, the slump in oil
prices has unfortunately begun to weigh on the Texas region and its large housing market.
Losing Patience With Market's Fed Obsession | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | March 21, 2015

Lennar reported that its sales in Houston are down 10% and 15% year over year in January
and February, respectively. Finally, the strong preference for renting seems to continue,
and it has typically been a detractor from the single-family residential construction. Lennar,
however, announced that it will experiment with building single-family homes for rent.
If other builders were to follow such a strategy and introduce it on a large scale, it could
provide a meaningful boost to the residential construction sector. For now, the impact of this
initiative will probably be minuscule, and it signals continued strength in the rental market.
Demographics Mean More First-Time Homebuyers
Demographics, at least relative to first-time buyers, are improving, too. First-time
homebuyers are typically around 31 years old. That age cohort shrank from its peak of over
4.3 million people (those born around 1960) to a low of 3.2 million (those born in 1976). It's no
coincidence that the housing market was in a funk in 2007 when that small-size age cohort
from 1976 was turning 31. The number of native borns turning 31 in 2015 is now back up to
3.7 million. In very round numbers, we are halfway back to the birth peak. Although births for
a single year aren't likely to get back to their baby boomer highs, they should get very close.
New 31-year-olds should steadily increase each year through 2021, recovering to 4.2 million
potential first-time buyers. That group represents the echo of the baby boomers. Over the
past five years, that nicely expanding age cohort was in its 20s, helping explain some of the
interest in apartment living and strong multifamily starts and permits.
Industrial Production Disappoints; Again, No Need for Despair
In last week's column, we predicted that the industrial production report is likely to
disappoint investors. It did. Industrial production grew a paltry 0.1% overall between January
and February, falling below expectations for growth of 0.3%. Just as disappointing was a
revision to the January data that now shows a 0.3% decline instead of a 0.2% increase.
These disappointments come despite the fact that utility demand surged by over 7% in a
single month because of cold weather. Excluding utilities, which make up 10% of the index,
industrial production would have been down 0.6%.
The utility section is one that I generally like to ignore, because it doesn't tell us anything
about the strength of the economy, just how cold it was. And generally what goes up must
come down, so next month utilities could be a huge drag on the index. Plus, utility demand
doesn't generally do much for utility-based employment, either. Also, if consumers are
spending more on utilities, they won't have the cash to spend on other goods and services.
A lot of people are asking why the consumer isn't doing better with gas prices being so low,
and part of the answer might be high utility bills. Unfortunately, the lingering effects of high
utility bills can last two or three months given long billing cycles. February natural gas may
not need to be paid for until April or even later.

Losing Patience With Market's Fed Obsession | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | March 21, 2015

Offsetting the strong utility data was the mining sector, which slumped 2.5% and accounts
for almost 18% of the production index. Some pundits are attributing the poor showing to oil
and gas production slippage. That would be wrong. Oil and gas extraction in February was
up 0.3% from January. We suspect that number will eventually begin to fall, but not yet.
The real shortfall came in coal mining, which was down 7%, and scattered declines in other
non-energy-related categories. The supports services for both regular mining and oil and gas
production were both very weak, too. That will eventually turn up in the production numbers.
The manufacturing sector, which is the most important part of the report, was also soft,
declining by 0.2%. This marked the third monthly decline in a row for this important metric.
However, I caution that this series is prone to big bumps and plateaus instead of nice, steady
straight-line growth that confounds a lot of econometric models. The year-over-year data has
been considerably less volatile. It shows a flattening growth pattern that is likely to turn into
a declining growth rate pattern in the months ahead. For the full year, industrial production
is likely to slow to 3%4% in 2015 from 4.4% for all of 2014. Continued slowness in the
housing industry, slowing growth rates for exports and autos sales, as well as a slower oil
and gas business will all hold back manufacturing in 2015.

Losing Patience With Market's Fed Obsession | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | March 21, 2015

Month-to-Month Sector Data Shows Broad-Based Weakness

The weakness in manufacturing output was broadly based with more than half of all
industries showing a decline between January and February. Aerospace, computers, textiles,
and petroleum products were the only categories to show gains. Autos, primary metals, and
apparel were all particularly soft for the month. While helping utilities, poor weather likely
played a role in the broad-based declines. Supply disruptions related to issues at the West
Coast ports probably didn't help matters, either.
On Tap Next Week: Homes Data, CPI, Manufacturing Data, and Final GDP Reading
Existing-home sales are expected to show a little improvement from 4.8 million units in
January to 4.9 million in February. These are still well below recovery highs of around 5.4
million units and are likely being affected by harsh weather conditions. Given some of the
other housing data we have seen, the 4.9 million units might be a bit of a stretch. However,
the worse the February numbers are, the better the numbers are likely to be later this spring.
We are finally expecting a little inflation in February. After a couple of months of deflation in
gasoline prices, the primary driver of the deflation managed a healthy increase in February
due to refinery issues and temporarily higher crude oil prices.
Durable goods orders and Markit purchasing manager data could give us a little hint about
the health of the manufacturing sector. These numbers have been flat to trending down
lately. I am a little afraid that a slowing energy sector is likely to keep a lid on both of these
reports. The expectation for the durable goods order report is a gain of 0.6%, but that does
include those volatile airline orders. Poor weather and port strike issues may be factors in
February. Those factors are likely to reverse themselves in March and April as ports get back
to normal and the weather breaks.
The final report on GDP for the fourth quarter is also due next week. Due to higher healthand insurance-related issues, seen in a separate U.S. Census Bureau report, those figures
will need to be raised in the GDP report. However, it is hard to guess if there will be any
offsets to those gains. Without any offsets, the GDP estimate is likely to be raised from 2.2%
in last month's estimate to around 2.4%.
Robert Johnson, CFA, is the director of economic analysis with Morningstar.
Roland Czerniawski is a markets research analyst with Morningstar.

Losing Patience With Market's Fed Obsession | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | March 21, 2015