Will The Economy Rebound In The Second Half Of the Year?

From the WSJ:

Nonfarm employers added 157,000 jobs to their payrolls in May, nearly double the 80,000 new jobs recorded in April, the Labor Department said Friday. Led by the service sector, the rebound brought the three-month average job gain to about 137,000, a pace strong enough to keep unemployment low and wages rising. The unemployment rate held steady at 4.5%

Let's break the economy down into it's subsections.

Consumer spending -- which accounts for 70% of overall growth. This section of the economy has showed resilience during the housing slowdown. The latest figures from the BEA showed personal consumption expenditures increasing .5%. So long as this area of the economy is increasing, the other areas will have to really slow down to get the US economy to a recession.

Business Spending/Investment -- while this was slow for the past two quarters, it may be picking up. As the WSJ noted:

The roots of the first-quarter slowdown trace back in part to late last year when businesses experienced a greater-than-expected drop in sales, especially of vehicles. "Sales simply weren't up to expectations," said David Resler, chief economist at Nomura Securities International Inc. "Rather than order new output...they liquidated existing stocks and didn't replenish them in the first quarter."

That created an air pocket in the economy during the quarter as inventories were drawn down. Inventories fell by an annualized $4.5 billion in the quarter, the Commerce Department said, a big shift from the government's previous estimate of a $14.8 billion gain for the period.

Some recent figures on industrial production and retail sales suggest that businesses may not want to liquidate inventories much further, Mr. Resler said.

Here's the chart of the year-over-year change in durable goods orders from Martin Capital. While it shows an improvement last month, we're still at low levels relative to a year ago. As such, we should be cautiously optimistic about this indicator.



In addition, new orders are looking fairly good right now:



The latest industrial production figures showed across the board gains:

All major market groups recorded increases in April. The output of consumer goods rebounded 0.9 percent after having fallen 0.8 percent in March. Production of consumer durables expanded 2.1 percent in April. Apart from the strength in automotive products, the output of home electronics climbed 4.8 percent because of gains in computers produced for households and in audio and video equipment. Also within consumer durables, the indexes for appliances, furniture, and carpeting and for miscellaneous goods increased. Within consumer nondurables, the output of non-energy goods edged up 0.2 percent, as a decline in foods and tobacco was more than offset by increases in clothing, in chemical products, and in paper products. Among consumer energy products, an increase in residential sales by utilities outweighed a decline in the output of fuels.

So -- the business investment indicators are looking good.

Housing is a mess. Calculated Risk concisely sums up the situation:

• Housing inventories are at record levels, in both absolute terms, and as a percent of owner occupied units.

• Households are already dedicating a record percentage of their income to mortgage obligations.

• Banks are tightening mortgage-lending standards.

What's interesting is this hasn't bled over into the economy -- yet. My theory is that stock valuations have replaced home valuations from the consumer's perspective. As long as stocks continue to move higher, the consumer will continue to spend. However, so long as we have the housing market in decline we will have to make sure it is not effecting consumer spending.

To sum up:

1.) The Consumer continues to spend.

2.) Several Indicators show business investment may be picking up.

3.) Housing is still a mess, but so far the damage has miraculously been contained.

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A Comparison to 1987?

From Barron's (subscription required):

Because we also turned negative in 1987 prematurely, about two or three months prematurely, and people thought we didn't recognize a new era of valuations. The two things Wall Street was talking about to support the market before the terrible October decline was the huge amount of liquidity and the big shrink in equities. Then liquidity was coming from Japan because Japanese brokers had started selling U.S. stocks. The big equity shrink was partly the result of LBOs, but mostly from companies buying back their own stock. There were other parallels. Breadth was deteriorating and investors were gravitating to big-cap stocks from small-cap stocks. There was an acceleration of inflation, which we are seeing now. There was an acceleration of interest rates, and the market kept going up in the face of higher rates, although, back then, the rise in rates was greater. There were a lot of similarities.

First, I am loathe to compare any economic or market period A to period B. There are simply too many economic and technical factors in an economy like the US to warrant this kind of comparison. The market and the economy are ever changing.

That being said, this is the first market observer who has said increasing liquidity and stock buy-backs are a net negative for the market. I have interpreted these developments as a net positive for the market for the simple reason more money floating around the world plus fewer outstanding shares means more money is chasing fewer things to buy which equals higher prices.

Let's look at his observations to see what is going on.

1.) I've written a fair amount about all of the M&A activity going on. I remember seeing an article in CBS Marketwatch that showed M&A activity for May was very high (sorry but I can't find the story). In short, there has been a ton of mergers over the last 6 months or so. It seems like every Monday we have a new round of mergers to consider. I have argued this is bullish so long as the mergers continue to make sense -- which most have. For example, the Wachovia/AG Edwards deal was a great idea because it allows Wachovia to sell financial products to AG Edwards customers and creates a retail firm with the size, resources and current customer base to compete with Merrill Lynch. This is just one example of some of the positive mergers that have occurred over the last 6-9 months.

2.) According to the Federal Reserve's Flow of Funds report (see page 45) there has been a net decrease in equities issued starting in 2005. The latest seasonally adjusted annual rate is -277.2 billion. So, the corporate buy-backs and deal making are acting to lower the amount of outstanding shares.

3.) Interest rates have started to creep up lately. Here is a chart of the 10-year Treasury.



I'm an old-fashioned 10-year guy. I think bond prices are determined by three forces: inflation expectations, equity performance and interest rate policy. I'm not a big fan of the 10-year minus TIPS spread analysis. I think the recent sell-off in Treasuries is simply explained: stocks are making more money and with the perception the economy will rebound in the second half of 2007 there is a concern about inflation heating up again.

4.) This analyst seems to be using a different breadth indicator (many analysts have their own proprietary indicators). However, these publicly available breadth charts from Stockcharts indicate NY new highs/new lows and overall market breadth is OK. The NASDAQ breadth has been an issue for some time, although the new high/new low numbers are good. However, the current rally is a basic materials rally, not a tech rally so a better breadth indicator from the NYSE makes sense.

5.) According to Barron's the S&P 500's PE is 18.42. While this isn't cheap, it's not expensive either.

So, this analyst has some interesting points to make. However, I think he is wrong in concluding these are bearish indicators. I think they are all slightly bullish with the exception of the 10-year situation. Even there, however, rates are still low by historical standards. The 10-year is still under 5% which is really low.

So -- I respectfully disagree.

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Back On Sunday

Taking a day off. See you tomorrow

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The World's Costliest Airline

Here's a little conundrum for you.

What's the difference between the following?

A business class return air ticket for two people (Gatwick to Barcelona), flight to be taken in July, purchased via Iberia.

A business class return air ticket for two people (Gatwick to Barcelona), flight to be taken in July, purchased via BA.

In terms of the departure times, airport terminals, lounge facilities and airline operating the aircraft...no difference whatsoever.

The flights are operated by BA.

However, here's the rub.

The price of the two return tickets, if purchased via Iberia will set you back £455.80.

The price of the two return tickets (for the identical flight), if purchased via BA will set you back a stonking £1165.80 (256% of the Iberia price).

Don't believe me?

Try it for yourselves:

-www.ba.com

-www.iberia.com

Could BA please explain this differential?

Oh, and by the way, BA own 10% of Iberia.

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More On The Jobs Data

Capital Spectator is an economic blog I read regularly. This is a chart from their website that has a 12-month moving average of employment gains.



The graph indicates the employment picture has been spotty for about a year now.

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Personal Income Down, Spending Up

From the BEA:

Personal income decreased $7.1 billion, or 0.1 percent, and disposable personal income (DPI) decreased $9.7 billion, or 0.1 percent, in April, according to the Bureau of Economic Analysis. Personal consumption expenditures (PCE) increased $52.0 billion, or 0.5 percent. In March, personal income increased $85.9 billion, or 0.8 percent, DPI increased $71.7 billion, or 0.7 percent, and PCE increased $42.4 billion, or 0.4 percent, based on revised estimates.

.....

Personal outlays -- PCE, personal interest payments, and personal current transfer payments increased $55.2 billion in April, compared with an increase of $44.2 billion in March. PCE increased $52.0 billion, compared with an increase of $42.4 billion.

However -- here's the really good news:

Core consumer price inflation increased just 0.1% in April, bringing the year-over-year increase down to 2%, just inside the Federal Reserve's target, the Commerce Department reported Friday.

It's the first time in 14 months that core prices have been inside the Fed's unofficial target zone of 1% to 2%. Core inflation peaked at 2.4% in February; it was 2.1% in March.

The deceleration in core inflation is welcome news at the Fed, but officials have stressed that they still believe inflation could accelerate again despite the recent improvements.

It's interesting that income dropped when employment showed a strong increase. That leads me to conclude we'll see a revision in one of today's two numbers.

The increase in spending will come as welcome news. Consumer spending has been solid for the last year and has helped to ameliorate the effects of a slowing housing market and drop in business investment.

About the PCE -- while it's only one month with the number inside the Fed's comfort zone, the markets should be very happy. In addition, Bernanke should enjoy this because he has been saying for the last year or so that inflation should come down. Right now he looks pretty damn good.

There are some mixed signals in this report that combined with the employment report raise some questions.

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Payrolls Increase 157,000

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Payrolls Increase 157,000

From the BLS:

Nonfarm payroll employment increased by 157,000 in May, and the unemployment rate was unchanged at 4.5 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Health care and food services added jobs,
while employment declined in manufacturing. Average hourly earnings rose by 6 cents, or 0.3 percent, over the month.

Let's look deeper into the numbers:

Goods producing industries lost 19,000, all in manufacturing. There were 0 losses in construction. I have been wondering for a few months if the increase in nonresidential construction is absorbing residential housing jobs. This may be confirmation of that idea.

Education and health care had an increase of 5,000. This area of job creation has been consistently solid for the last few years, so this increase comes as so surprise.

Leisure and hospitality has an increase of 46,000 jobs. Think bartenders and waitresses here.

Professional and service jobs increased 32,000 -- a pretty good increase.

This is a good report which the market should like.

However --

I will also add the BLS has continually revised these numbers as time progresses. As a result these numbers could change pretty drastically.

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Gasoline Prices Drop

From This Week in Petroleum:

After four consecutive weekly increases, the U.S. average retail price for regular gasoline declined 0.9 cent to 320.9 cents per gallon as of May 28, 2007, 34.2 cents per gallon higher than this time last year. However, prices were mixed across the regions. East Coast and Rocky Mountain prices increased, with East Coast prices up 0.1 cent to 309.8 cents per gallon and Rocky Mountain prices up 1.1 cents per gallon to reach 327.6 cents per gallon. In the Midwest, prices declined 0.6 cent to 332.0 cents per gallon, while prices for the Gulf Coast fell 2.5 cents to 306.7 cents per gallon. West Coast prices were down 2.3 cents to 334.9 cents per gallon. The average price for regular grade in California was down 2.9 cents to 340.7 cents per gallon, but remains 14.1 cents per gallon above last year's price.

Here's a chart of gas prices from the report.



While prices have dropped, notice they are higher than last year by a wide margin.

Production is finally kicking in and gasoline inventories appear to have turned the corner.



This is a very tight situation. While gas production has obviously increased, we don't know if it will be enough to supply the market throughout the busy summer driving season. The situation is very touchy and will require constant monitoring.

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Gordon's Legacy

As Gordon Brown limbers up to change jobs, after holding only one office of state over the last 10 years (Chancellor of the Exchequer), Grant Thornton have issued a timely reminder as to his tax legacy.

Brown, during his stint in office, increased the tax burden by an equivalent ten pence on the basic rate of income tax.

Additionally, the UK is now lumbered with more than double the number of pages in its tax code, increasing from 4,555 to just under 10,000 since 1997.

The number of higher rate taxpayers now stands at 3.5M, an increase of 58% since 1997 when Labour came to power.

Francesca Lagerberg, head of Grant Thornton's national tax office, said:

"Silently the tax take continues upwards with fiscal drag raking in yet more revenue year on year.

If income tax allowances had risen in line with earnings, then the average taxpayer would achieve tax freedom a lot earlier in the year.

Despite headline announcements in this year's Budget of dropping the basic rate of income tax, aligning national insurance contributions and reducing mainstream corporation tax, the reality is that other increases will lead to a maintenance of the status quo."

Aside from Brown's economic legacy calling into question his qualifications to be an effective, dynamic and forward thinking Prime Minister, there is also one other very obvious hole in his CV.

He has never held any office of state, other than that of Chancellor, he has been in exactly the same job for 10 years.

Where was his ambition?

Where is his experience of the other major offices, eg Foreign Secretary?

He may well not be up to the job of Prime Minister, nor will he let go of the Treasury so easily (as his successor will soon discover).

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