Last week was more of the same: great news from the US economy but a flagging stock market as Europe continues to struggle and the euro erodes.
Views on the Dollar Change on a Dime
Just a few months ago the popular press was filled with articles about how to hedge one's exposure to the US dollar. I have long believed that higher productivity, more favourable demographics, and greater labour flexibility would make for a stronger dollar in the years ahead. However, I had no idea that the cracks in the European system would be exposed this quickly and that the dollar would rebound this strongly.
European Leaders Fail to Find a Common Voice
The euro has now fallen from a high of €1.6 per $1 to €1.24 per $1--which is where it was way back in 2008. Despite excitement over the European bailout plan earlier in the week, enthusiasm quickly faded as individual countries fretted about implementing austerity plans and politicians began to more openly worry about the euro's demise. There was even a rumour (later denied) that French president Sarkozy threatened to take France off the euro. It certainly didn't help that the chief executive of Deutsche Bank publicly questioned Greece's ability to repay its debts in a televised comment.
Eurozone politicians are in many ways sabotaging themselves with the lack of a common story line and a single voice--a benefit that was certainly instrumental in helping the Federal Reserve bring the US out of its mess.
The US' Biggest Problem with a Weak Europe: the US Banking System
An indirect risk to the US economy from the European debacle is related to the various European banks that hold a lot of government (sovereign) debt. These banks do business with US banks and are counterparties in many transactions. If banks start distrusting each other again, that could cause additional problems in the US banking system. This time around, however, the US banking system is better capitalised than before the subprime fiasco that kicked off in North America.
European Exports Represent Just 2%-3% of US GDP
The direct effects of a weaker Europe on the US are less clear. Total US exports account for only 12% of total US gross domestic products, making America one of the most self-contained countries among developed nations (in contrast, Germany derives almost 40% of its GDP from exports).
Breaking that down even further, the eurozone constituted just 20% or so of US exports in 2009. So even if US sales to the eurozone immediately and permanently dropped to zero, the effect on the US GDP would be just over 2%.
As bad as things may get, I don't think the US is going to reach zero sales to Europe anytime soon.
Europe Will Be More Competitive, US Companies With Large European Exposures Will Be Hurt
Unfortunately, a softening euro will create other problems for the US. A weaker euro will make some European products more competitive in other world markets, although sky-high productivity in the US will erode some of that advantage. Individual companies with large European exposures, such as consumer goods companies, could also see their profits cut short as sales in euros translate back to fewer dollars of US profits. The dollar tailwind of late 2009 is in the process of turning into a headwind.
For a bigger picture of the European crisis and the recent bailout, this article from the Wharton School of Business provides an interesting European perspective.
US Market Now at Morningstar's Fair Value
As volatile as the recent market has been, the S&P 500 Index is down just about 6% from its interim high near the end of April. Even after this adjustment, the market is still up 72% from the bottom of March 2009. Morningstar's price/fair value ratio for the market has fallen from a high of 1.09 (9% overvalued) to a still slightly overvalued 1.02 on May 14. The manic/depressive results of recent trading sessions have made some of the damage seem worse than it's actually been. Meanwhile, the economy continues to provide upside surprises.
Manufacturing Charges Ahead, and There's More to Come
The highlight of last week's economic releases in the US was again a very strong manufacturing sector. Industrial production for April was 0.8% sequentially from March and 5.2% ahead of year-ago levels.
The numbers are even better than they look on the surface, as yet another poor number from the utilities sector depressed the overall figure. Volatile and inconsistent weather plays havoc with the utility portion of the index. Excluding the utilities segment, the manufacturing sector showed growth of 1% and the mining sector grew 1.4%.
As good as all the production data were, there's still a lot more room for improvement in the months ahead. The industrial production index has recovered just 43% of the business lost during this recession. In contrast, consumer spending overall has now surpassed its previous high and recovered more than all of its losses.
Given that the consumer leads industrial production by four or five months, I believe it is just a matter of time until production, and the high-paying manufacturing jobs associated with it, gets much nearer to its old highs. Strong durable goods orders and purchasing manager data from the previous week, as well as extremely strong data out of the transportation sector (rails, trucking, and air), also bode well for the manufacturing sector in the months ahead. Eric Landry, head of our industrials team, notes that the pace of recovery in the industrial production index is ahead of three of the last five recessions, but a little slower than the recoveries from the disastrous recessions of 1975 and 1982.
US Retail Sales Surprise on the Upside, Though not Uniformly Bullish
The Census Bureau's retail sales report also provided a nice upward surprise, as retail sales increased 0.4% from the previous month (that is, 4.8% annualised) and 8.8% from a year ago. A surprising upward move in auto sales and higher gas prices contributed to the overall increase. The results were off a bit from the blistering (and just revised) pace of 2.1% sequential growth in March. A combination of an early Easter and great weather does indeed appear to have shifted sales from April into March.
Nevertheless, less-volatile quarterly data show sales overall increased 2.4% (7.2% annualised) in the three-month period from February through April, when compared with the prior three-month period of November through January. Revisions to earlier periods were also meaningful. Recent revisions to export sales, higher inventory levels, and the revised March retail sales report mean that the first-quarter GDP number (first estimate) of 3.2% is likely to be revised upward later this month.
But the retail sales report wasn't all bullish. Nine of the 19 categories I track were actually down, including electronics, furniture, and clothing. Gasoline prices were up, which tends to raise the overall sales numbers but tends to depress sales of non-gas-related retail items. The recent sharp decline in oil prices may show up at the pump this month, which could reduce the overall retail growth potential, but would be highly beneficial to the consumer over the intermediate term.
Building materials was another standout category in April with sales up a rather dramatic 6.2% sequentially. That number may also prove hard to sustain.
US Inventory/Sales Ratio Sets a New Record Low
As I have previously reported, a slower draining of inventories was a major contributor to growth in the second half of 2009. Recent data indicate that inventories are growing, according to this week's report from the Census Bureau.
Higher inventories at this stage of the recovery are generally a good thing, indicating that wholesalers and retailers are now more confident that they can move goods. Embedded in the inventory report was even better news. While inventories were up in March, sales of goods increased even faster. The result was that the all-important ratio of inventories to sales decreased to a new record low of 1.24 compared with a ratio of 1.46 at this time a year ago. This should mean that increasing inventories could continue to boost GDP results for another quarter or two.
Second-Tier Consumer Metrics Looking Better
In other news last week, initial unemployment claims were down again on both a weekly and on the less-volatile four-week-moving-average basis. Consumer confidence numbers also looked a little better, but I have written this indicator off as having very limited forecasting value. On the other hand, weekly chain store sales--a better metric for checking on the consumer--were up last week, representing five increases in the last six weeks.
Housing, Manufacturing, and Pricing Data on Deck
This week brings more manufacturing data from some of the US regions, and I expect to see continued improvement. Housing starts will also be interesting to watch, as will the relationship between permits (which have been quite strong) and starts (which have still been quite weak). The negative impacts of the expiration of the housing credit could potentially show as early as the April data. Given that a home generally takes three months or more to complete, and that a final closing on a house must be completed by June 30, a home begun in late April most likely won't qualify for the credit. However, the consensus is for 650,000 starts, which is better than March's 626,000 and looking just a bit rich to me.
Market Expecting Benign Inflation Data; I'm Not so Sure
A lot of pricing data will arrive this week, with both the producer price index and the consumer price index due. Consensus forecasts centre on growth of 0.1% on each metric for April. The forecast strikes me as a bit light given recently announced strong growth in import prices and a continued upward trend in oil products, at least until very recently. I'll be scouring the different data categories to detect building pressure on prices that may not be reflected in the headline numbers that are strongly influenced by the depressed housing component.
