Reading Indicators December 22, 2012

Fiscal Cliff Worries Disguise Strong Economic Data

Given the increasing and undeniable strength in the economy, we need not worry if some tax increases and spending cuts are implemented.
By Robert Johnson, CFA +1 (312) 696-6103

The economic data this week was surprisingly strong across a very broad swath of categories. Real estate data, consumption, income, and even durable goods all performed better than expectations. Nevertheless, a bounceback effect from Hurricane Sandy was evident and may have inflated some of the statistics. Year-over-year data, averaged, suggest the economy is still stumbling along at a rate of about 2%, with no real signs of breaking out in either direction. That said, both businesses and consumers didnt seem terribly worried about the fiscal cliff, with both groups showing renewed vigor in the first months of the fourth quarter of 2012. The fiscal cliff/budget talks hit another stalemate as the discussion seemed to move from just tax rates to a discussion about what spending cuts might be made in return for tax increases. As I have said many times, both taxes and expenditures are out of line with relatively stable longterm averages, so some adjustment on both counts seems to be necessary. It now appears increasingly likely that we may go over the cliff at least for a week or two. However, the number of concrete actions that kick in on Jan. 1 are slimmer than many pundits would have you believe. Given the increasing and undeniable strength in the economy as I detail below, I am not worried if some tax increases and spending cuts are implemented. In fact, I am pretty sure that the economy could endure $200 billion-$300 billion in spending cuts and tax increases in 2013. I would sure hate to see us try for more. At the end of this report, I provide a little more color on my view of the cliff. Personal Income and Expenditures Dramatically Better than Expectations Economists had a very dire view of the fourth quarter, believing that consumption and incomes were likely to be very disappointing given the poor consumption data for October that was strongly affected by Hurricane Sandy. While economists expected some bounce in both incomes and consumption for November, no one imagined that inflation-adjusted incomes and expenditures would move up a stunning 0.8% and 0.6% in a single month (those amount to 9.6% and 7.2% annualized). Better yet, data from September and October were also revised sharply upward. The news, indeed, looks almost a little too good to be true. If we roll up the various data points into a three-month average and compare it with a year ago, we get more sober but still relatively positive results, as shown on Page 2:

The December growth figures assume that there is no improvement in December. Given the weekly retail sales that I examine and what is likely to be another month of deflation, an assumption of no growth seems to be very conservative. These types of growth rates, especially in consumption, make fourth-quarter GDP estimates of a mere 1% appear just a little bit silly. That is especially true as consumption represents more than 70% of the GDP calculation. More on that later. This Week's Durable Goods Report, Along with the Employment Report, Show Businesses Are Less Fearful Business investment spending accounts for less than 15% of GDP, making it much less important than consumption when analyzing the economy. However, the swings in this number can still can hurt the GDP calculation. Economists were very worried about investment growth in the fourth quarter. In fact, spending had slipped a little bit in the third quarter and with the fiscal cliff approaching, many had feared that businesses might make a more substantial cut in spending during the fourth quarter. However, the durable goods orders report shows that orders have now been up three months in a row. Excluding the transportation sector, orders have been up more than 1.5% in each of the last three months. Looking at just the big-dollar capital spending accounts, excluding defense and aerospace, orders were up 3.2% and 2.7%, respectively, for the last two months, indicating that businesses have been investing despite the threat of the fiscal cliff. The world got some inkling of that fact earlier when Oracle (ORCL) reported surprisingly strong sales of software. Durable goods shipments were also up in October and November, which now means that business investment is likely to be an adder to fourth-quarter GDP and not a subtractor as previously expected.

Fiscal Cliff Worries Disguise Strong Economic Data| Reading Indicators | Robert Johnson, CFA | December 22, 2012

Third-Quarter GDP Revised to Up 3.1%, Upward Revisions for Fourth Quarter Yet to Come Speaking of GDP, the government revised its estimate of the inflation-adjusted GDP growth rate for the September quarter from 2.7% to 3.1%, making it the third-best quarter of the 13-quarter recovery. Consumption and import/export numbers were revised to the better, while inventories were less of a contributor than before. Although the government sector remained strong, and is most likely an unsustainable contributor (at a 0.7% contribution rate), the volatile soybean and auto markets were still detractors from GDP growth, offsetting at least half of the large jump in government spending. Upward Revisions for the Fourth Quarter Yet to Come Normally such a large GDP increase for one quarter would be a negative for the next quarter, because above trend line quarterly results are generally followed by poor ones that bring the average back to something closer to 2%. The already strong third-quarter GDP report, combined with poor October results (many of which were just revised upward) had caused many economists to predict a meager 1% growth rate in the fourth quarter. However, with the revised October data and some stunning (though not sustainable) growth rates in November, and assuming no growth in December results, it appears that the economy will grow at least 2% in the fourth quarter. Economists are already racing to revise up their forecasts. The Housing Market Continues to Sprint Ahead There was a lot of housing news this week and almost all of it was exceptionally positive. Existing home sales are up dramatically, inventories are exceptionally low, and prices are up. While housing starts looked weak compared with the prior months data, the November report came after a period of dramatic expansion. However, permits were up dramatically, which should bode well for starts in the months ahead. Builder sentiment moved up in November, which also points to more good housing news ahead. Continued growth in employment and increases in household formations (which is coming primarily from 20-somethings moving back out) bode well for the housing market for the next several years, not just a few lucky months. That doesn't mean that bad weather, statistical glitches, or a series of terrible headlines couldnt cause at least a pause in the strong upward trajectory in housing data. In complete honesty, I would have expected that we would have seen at least some signs of a pause by now. I suppose large positive seasonal adjustment factors are lending a bit of a helping hand to just about all the real estate statistics. With the holidays approaching and the kids in the middle of their school year, this is normally one of the slower times of the year. Therefore, even small improvements get amplified by large seasonal factors. The same factors could just as easily reverse themselves, especially with a couple of snowy months. The housing bears aren't quite ready to give up the ghost just yet, either. I got a real laugh out of one piece of analysis Friday morning that claimed that all the recent housing price moves were "artificial." The author noted that sellers were refraining from putting their houses on the market because they couldnt get a price that they felt was fair or that they were still under water. Higher demand combined with this "artificial withholding" has caused prices to levitate,
Fiscal Cliff Worries Disguise Strong Economic Data| Reading Indicators | Robert Johnson, CFA | December 22, 2012
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according to this analysis. Hmm, somehow this sounds like supply and demand from my Economics 101 class. FHFA Home Prices Jump 0.5% Sequentially and 5.4% Year Over Year The Case Shiller home price indexes are considered the gold standard for real estate prices. However, these indexes become available with a considerable time lag compared with reports from CoreLogic (CLGX) (which is available at the very beginning of the month) and the FHFA data (the Thursday before Case Shiller). And these other two indexes provide a single months worth of data instead of just a three-month moving average. Interestingly, the Federal Reserve Consumer Balance Sheet Report (the Z1) is based on the FHFA data points. This week's FHFA report was yet another good on. Even when scaled back by using a threemonth moving average, year-over-year growth from October to October was up 4.7%. On a year-over-year basis, eight of the nine regions in the country showed price improvement (the New England market was down a paltry 0.1%). Gains ranged between 0.2% in the Mid-Atlantic region to a stunning 13.1% in the mountain region. Increases from just September to October were nearly as widespread, with seven of nine regions showing improvement, and the two problematic regions may have felt belated effects from Hurricane Sandy.

At the beginning of 2012, it was impossible to find a real estate price forecast with an increase as high as 2%. Now, it is increasingly looking like full-year price increase will be in the 5%-6% range. Thats a massive sea change. A 6% change would add approximately $1.2 trillion to consumer balance sheets (consumers own $20 trillion of real estate). To scale that number for readers, U.S. GDP is $15 trillion or so. With my tongue planted firmly in my cheek, I note that the

Fiscal Cliff Worries Disguise Strong Economic Data| Reading Indicators | Robert Johnson, CFA | December 22, 2012

annualized highest fiscal cliff impact amount is a mere $720 billion. Existing Homes Sales Data the Break-Out Performer This Week Existing home sales data had become stuck in a bit of rut as inventory ran low and closings remained less than a sure thing because of poor appraisals and stringent lending requirements. However, Novembers report brought a real breakout as existing home sales jumped 8.5% sequentially to just over 5 million units, which is just the third time that mark has been crossed since July 2007. The large gap between pending home sales and closed sales (that is, existing home sales) is finally beginning to narrow. I surmise that the improved prices noted above are finally solving at least some of the appraisal problems that caused so many sales contracts to be broken at the beginning of the year.

Housing Inventories Getting Crushed Just a few short months ago, the Realtor's Association was complaining about a lack of inventory and wished out loud that the foreclosure process could move along a little faster to provide more potential supply. This was especially true on the West Coast. I will admit to at least a small smirk and a little cynical disbelief when I read these remarks, especially considering the source. Im not laughing anymore. Home inventories have now been cut almost in half from the peak reached in July 2007 and now stands at 2 million units. I have to go back to 2001, over 11 years ago, to find a lower level. At the most recent selling rate (which might be just a little artificially high) there is a mere 4.8 months of supply, down from a peak of 12.4 months of supply in 2010. Wow. Four to six months of supply is considered normal. With inventories this low, prices will have to go higher to draw in more supply. Or builders will need to start more homes. Either way, the economy wins.

Fiscal Cliff Worries Disguise Strong Economic Data| Reading Indicators | Robert Johnson, CFA | December 22, 2012

Don't Be Fooled by the Monthly Decline in Starts Speaking of housing starts, a lot of commentators worried about what appeared to be a meaningful drop in housing starts between October and November, from 888,0000 to 861,000. However, we just had two massive back-to-back gains that moved starts from 750,000 in August to 888,000 in October. A little breather was probably in order and most economists had expected at least a small drop. Strong permit growth, which usually precedes starts, took away some of the sting of declining starts data, growing between October and November and setting a new recovery high. The more meaningful three-month average of year-over-year growth in starts and permits both remained more than 30%. Holiday-Shortened Week Contains No Real Market Moving Data The only real new news for next week will be pending home sales and new home sales, and even these arent typically market movers. Pending home sales are for November and should be up a little after a small decline in Sandy-affected October data. However, inventory shortages could cause a negative surprise. New home sales are expected to move up very modestly from 368,000 to 379,000 in November given improving builder sentiment. This has never been one of favorite metrics because it includes only single-family homes, and it includes only homes where the builder originally owned the land and built the house. It also mashes together sales of homes already for sale on a lot and homes where building may not even have begun yet. Case Shiller home price indexes are also due, but these are pretty much a non-event these days because of the much earlier release of data by CoreLogic and the FHFA. Because the Case Shiller numbers are not seasonally adjusted and generally reported on a month-to-month basis, the
Fiscal Cliff Worries Disguise Strong Economic Data| Reading Indicators | Robert Johnson, CFA | December 22, 2012
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headline number is likely to show a small decline. However, on a year-over-year basis I suspect that prices will be up in the 3.5%-4% range, trailing some of the other indexes as it usually does. The Fiscal Cliff Probably Won't Kill Us I still believe that both political parties in Congress will agree to a relatively narrow set of tax increases and spending cuts that wont do wonders for the economy but are highly unlikely to kill it, either. Very few things will happen instantaneously, but those are things that the parties may agree upon. I consider the Obamacare taxes, the expiration of the 2% payroll tax cut, and the ending of 99 weeks of unemployment benefits will be darn hard to avoid at this point and will hit with the first payroll of 2012. This amounts to $170 billion in increased taxes or decreased spending on a full-year basis (compared with the full cliff of more than $700 billion). If these cuts/ taxes translated dollar for dollar into consumer spending cuts, this would amount to a 1.5% cut in consumer expenditures and a 1.1% hit to GDP. However, keep in mind that falling demand might lead to lower prices or that some consumers will finance their purchases out of savings. As a matter of fact, the deficit was reduced by $200 billion in 2012, yet the economy will still be able to eke out a 2%, inflation-adjusted gain in GDP. Also keep in mind that consumers endured violent swings in gasoline prices in 2012, which during brief periods, may have hurt consumer incomes by close to $100 billion on an annualized basis. Consumers are amazingly good at shifting and making do when they have to. Two Measures That Amount to Half of the Fiscal Cliff Will Never Happen I am relatively sure that the two really big pieces of the fiscal cliff will never happen: the alternative minimum tax changes ($130 billion) and the elimination of the Bush tax cuts for all ($210 billion). The lower exemptions for the alternative minimum tax for 2012, which is due in early 2013, would be a total disaster unless patched soon. It would extend the reach of this awful tax from single-digit millions to tens of millions of taxpayers overnight. And there would theoretically be penalties due if consumers did not realize the additional amount was due. And anyone with income of over $40,000 would be unable to safely file a return and claim a refund until this is settled. This is not about 2013 income; it is about what has already been earned in 2012. If the AMT patch is not implemented, it will cost taxpayers an estimated $130 billion. The government might still have a little more time to deal with the Bush tax cuts, which affect 2013 income. And there is broad-based agreement not to raise taxes on those with incomes below $200,000 (single return, joint $250,000). The dollar amount involved is $155 billion on low earners and $55 billion for high earners. The low earner can be saved for a while just by an executive order not to change withholding tables. Wealthy earners will see the biggest increases in capital gains and dividend taxes that are not immediately due and payable. Almost 30% of the Cliff Affects Corporations More Than Individuals Likewise sequestration ($110 billion of the $720 billion) and the changes in the corporate tax code ($85 billion) are not likely to have an immediate effect. Bureaucrats are likely to put off the negative effects of the sequestration until much later in the year. The corporate tax changes will only indirectly affect consumers. They will only be affected if corporations choose to or are able to pass on price increases. Robert Johnson, CFA, is director of economic analysis with Morningstar.

Fiscal Cliff Worries Disguise Strong Economic Data| Reading Indicators | Robert Johnson, CFA | December 22, 2012