Volume 57, Number 7 | November 19, 2010
It was a pretty good week for economic data in the US, with evidence of strong sales and production, an improving employment picture, and no inflation. However international concerns dominated the markets as China once again mashed the brakes as it tried to slow runaway inflation and Ireland was dragged kicking and screaming to a bank bailout. The threat of slower global growth and renewed problems in Europe put the risk-off trade back in the lead for now. We are particularly vigilant of the contagion problems in Europe, as bond spreads in Portugal, Greece, Spain and Italy continue to widen despite a solution for Ireland. Greece has its day with destiny (or at least the IMF) in less than two weeks.
It is increasingly clear that the big savers in Europe will impose not just austerity on the free spenders in the periphery, but will also require more homogeneous fiscal and tax policies as a price for any bailout. We have argued for some time that it is unlikely that the Euro will break up. Rather, political forces will force the various states toward a more centrally determined fiscal policy, with limited wiggle room for each nation — as in states in the US or provinces in China. The UK long ago decided that it would never give up its sovereign control over domestic policies and never opted into the Euro. The small nations of Europe are learning that they simply are not large enough to set their own rules if they still want to trade with the big boys. Now they must decide if the price of leaving the Euro – and remaining burdened with massive Euro denominated debt – if worth remaining in control of their policies on taxes and spending. Politicians are short sighted, and businesses will not want to give up access to the markets they have now in Europe. There will be great gnashing of teeth, but we suspect the Euro stands intact, to the determent of the independence of the PIIGS.
Loosening the Purse Strings
Retail sales rose a robust 1.2% in October, after a 0.7% rise in September, a 0.9% gain in August and a 0.5% rise in July. In the past four months, total retail sales have soared at a 10.2% annual rate – driven by outsized gains in motor vehicles, building materials and gas station sales. This surge reflects the rising confidence of the luxury class as the equities market has rallied. We see and hear more and more stories of the high end of the economy doing well, while the low end continues to suffer. However, the top 20% of spenders account for 40% of consumer spending, so the wealth effect has a pronounced effect of interest sensitive, big ticket items, like housing and cars. Over the past four months, retail sales of motor vehicles have risen at a 27% annual rate as the volume of vehicles sold has jumped at a 31% annual rate. The 12.2 million unit annual rate for sales in October is below the consensus estimates for 2011, suggesting that autos will continue to be a wind in the sails of the economy – primarily because consumers are trading down in size and price and freeing up monthly income for other purchases. Building material sales have also posted three strong monthly gains, up 1.9% in October after back to back 1.3% increases in August and September. The 14% annualized gain comes after a year with muted 3.2% growth, and may represent investors and homeowners fixing up the wave of short sales and foreclosures purchased in the spring with the $8,000 rebate. Given that additions, alterations and repairs now account for 20% more economic activity than new construction (single and multi-family) the retail sales figure is becoming the most important indicator for the construction employment and production.
Core retail sales rose a modest 0.2% in October, but maintained a 4.7% annual growth rate over the past four months. These past four months are a slight improvement over the 4.2% growth rate in the year ended June 2010 – the first twelve months of the official economic recovery. During the recovery, core retail sales have mirrored the growth in wage and salary income – which our income proxy estimates continued to grow at a 4.5% annual rate in October. Now, the initial claims report suggests that employers may finally be moving from adding hours to existing workers to adding more bodies to their workforce. Claims posted their third week out of four below the psychologically important 450,000 level, and continuing claims continue to fall at a rate consistent with hiring near 150,000 per month. It may be too optimistic to translate more hiring into more income, as it may simply be replacing a rise in hours per employee – but it is a positive sign of business confidence that they will take on new employees.
Prices Not a Crisis
Consumer prices rose 0.2% in October and are up at a 2.7% annual rate over the past four months due to food and gasoline inflation. However, core CPI was unchanged for the second straight month, and the one year rise in core CPI was just 0.6% — the lowest rate since data was first collected in 1948. The rise in gasoline prices is largely a dollar issue, as crude oil in Euros has moved in a sideways band since April. Moreover, as most crude oil is imported, energy is not a big factor in the GDP deflator, but rather reflects a relative price shift that consumers have to deal with. With core retail sales rising north of 4% and core CPI south of 1%, the core retail sector — which contributes over one-third of GDP — is very supportive of near 4% real growth.
Inflation in the services sector continues to signal a dramatically different backdrop for price pressures than at any time in history. Core service inflation rose just 0.8% (three month average compared to year ago three month average) during the past year, well below the 3% average it maintained for the previous two decades. Indeed, since the Lehman crash, it has been service inflation that has consistently held down the core rate. Commodities inflation experienced a brief spurt during the inventory restocking phase, but has now fallen back to near zero. Clearly, owners’ equivalent rent is a big part of this shift, as rents are now falling year on year – a situation not experienced in the post war period. As long as small businesses and home prices remain under pressure – an experience which is highly correlated with access to credit – it seem likely that core service inflation will remain quite low, underpinning a core PCE deflator that remains below the Federal Reserve’s 2% target. Bottom line, home prices remain the key indicator of US inflation, banking problems, and Fed policy – and nothing in recent data suggest any improvement in home appreciation.