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Reading Indicators

April 25, 2015

Is It Up, Up, and Away for the Housing Industry?

With manufacturing under pressure, the housing recovery should be a tailwind
for GDP growth rates.
By Robert Johnson, CFA and Roland Czerniawski
+1 (312) 696-6103 and +1 (312) 384-4828

It was a great week for equity markets and commodity markets around the world. Most of
the activity this week was driven by first-quarter earnings reports that were particularly
strong. Most equity markets were up between 1% and 3%, with the S&P 500 pulling up
the rear at 0.85% weekly growth while the Nasdaq composite was up over 3% (thank you,
Amazon AMZN and Microsoft MSFT). Europe and the EAFE indexes performed in the middle
of the range for world equity markets with gains of around 2%. Increases in emerging
markets in general and China in particular remained out of control with another growth rate
near 3%, even as the economic news out of China continued to disappoint economists. Rabid
Chinese investors, not so much. Emerging markets are up almost 10% over the last month.
Commodities, as usual, were one of the worst performers but still managed a gain of 0.8%.
Much of the strength was related to strong earnings reports that dominated the news flow
this week, with little economic or government-related news to move markets. Earnings
reports were generally better than expected, by relatively typical margins. However, sales
reported by S&P 500 companies were clearly disappointing, with more than half of all
companies missing revenue forecasts, a relatively high miss ratio. A strong dollar is probably
the key reason for that disappointment. Overall, earnings for the quarter are now expected
to decline just 2.8% versus expectations of a 4.0% decline just a week ago. The difference
comes from a large number of high profile "earnings beats" this week including Microsoft,
Caterpillar CAT, and Amazon. A shrinkage of 2.8% year over year in S&P earnings growth
sounds terrible. It sounds especially bad in light of full-year growth in S&P 500 earnings that
has been running at 6% to 8% per year for the past four years. However, the combination
of a collapsing energy sector and a falling dollar masks some pretty good strength. Without
the energy sector (which was down 65.0%), earnings would be up a more palatable and
typical 5.6%. Exclude the companies deriving more than 50% of their revenues from overseas
plus those pesky oil companies, and earnings were up 9%. The IT sector and health-care
companies are leading the earnings way. Overall six of 10 sectors are expected to see
earnings growth in the first quarter, while energy, utilities, materials, and telecom are all
expected to show declines for the quarter. First-quarter earnings estimates data includes
actual results for the 40% of companies that have already reported results.
The economic news from around the world was relatively light. Durable-goods orders
for the U.S. and Markit purchasing manager data from around the world indicated that
manufacturing remains under considerable pressure everywhere, not just in the U.S. The
fact that all markets, including those with weak currencies and more temperate climates, are
soft, indicates that the manufacturing problems extend way beyond currencies and weather.

Overall, slow world growth rates, a still-staggering energy complex, and a soft market for
anything vaguely related to commodities are weighing heavily on manufacturing growth
rates. While soft, and certainly softer than they were, the manufacturing growth rates are
not free falling, either, with growth rates hovering near zero in many locales.
The other big news this week was that U.S. housing data, though not fantastic, appears to
indicate that the U.S. housing industry has established a bottom. Early spring shoots are
clearly beginning to turn into new blossoms, especially in the new home sector. Dont be
fooled by some flaky month-to-month data points; the pattern in the yearly statistics appears
to be moving up, up, and away for now.
Manufacturing Going From Bad to Worse
We have been among the more bearish on the manufacturing sector and even we were
disappointed by the durable-goods orders report. The headline number actually seemed quite
bullish, with new orders increasing a surprisingly strong 4%. However, that good news was
almost entirely from the transportation sector, including autos as well as civilian and defense
aircraft, with orders for these goods up a stunning 13%. Excluding the transportation sector,
durable-goods orders were down 0.2% between February and March, marking the sixth
month-to-month decline in a row. Even the single-month year-over-year data is down 0.2%,
and the three-month average is down almost to zero. Five of the seven individual categories
were down, with only the aforementioned transportation sector and computers showing
gains in March. Even our year-over-year, three-month average isnt painting a pretty picture.

Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

News for the longer-lasting capital goods sector didnt offer any more hope than the entire
nontransportation book of business did. Its not just small business or some trimming of
short-term business supplies that is hurting the numbers. Big businesses, too, appear to be
afraid of the future.

Nondefense capital goods orders have been going down for a month longer than regular
orders and are even closer to falling below zero on a year-over-year average basis.
Recall that durable-goods orders of all kinds are important because those orders eventually
turn into real-world manufacturing on a production line with workers and robots and
eventually are shipped, perhaps months later. Currently shipments of nontransportation are
running 5% higher than the order rate, suggesting more bad news for industrial production
and manufacturers in the months ahead. Obviously with the West Coast port issues being
settled in February and weather improving sharply in March, this weeks poor numbers are
not a one-off. Weather and special factors were not the driving cause of the manufacturing
weakness in January and February.
Not in any particular order, a poor commodities market, a weak housing construction market
(at least in the prior six months), less need for oil- and gas-related equipment and supplies,
and a strong dollar have taken the wind out of manufacturings sails. Unfortunately, energy
and the dollar are not issues that are likely to be fixed soon. The good news is that the
decline in the commodity sector may be slowing, and housing may take the baton from the
energy sector as the engine of manufacturing. And civilian aircraft manufacturers have so
Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

many years of backlog in front of them that it will be hard for this sector not to grow 5%-10%
every year for the next five or 10 years, offsetting some of the weakness in nontransportation
World Manufacturing Looks Even Worse Than the U.S. Data
Markit Flash Purchasing Data was disappointing for not only the U.S., but the rest of the
world as well. The data wasnt awful, but all three major manufacturing regions listed in the
following table, plus Japan, registered down readings between March and April despite all
the supposed tailwinds including better U.S. weather, the port strike settlement, and weaker
currencies for many regions (though not the U.S.).

Though the readings did decline sequentially in all markets, the U.S. and Europe both stayed
well above the 50 reading that generally separates growth from declines. However, China
has been at or below that 50 level for five of the past six months. A strong currency has
not helped matters for China, as is the case with a softening real estate market. Prices and
orders in the Chinese housing market have been slumping for over a year, and it appears that
weakness is finally affecting the manufactured goods that go into building and furnishing
a house. The overall China reading was the worst in a year, and most individual categories
looked as bad as the headline number. Japan dipped back below 50 for the first time in nine
months, capping a string of nice improvements. Europe held up the best and declined the
least in April, as quantitative easing probably helped that economy improve. If Europe can
hold the April month PMI levels for two more months, an increase in the second-quarter
GDP growth rate for the eurozone should be stronger than the 1.2% annualized rate of the
first quarter. Some concerns about Europe are that the data out of France still looks terrible
and that while Germany remains strong, it saw a decline in the April Flash reading. Outside
Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

of France and Germany, admittedly the largest countries, 16 of the 18 other eurozone
countries saw improvement in their PMI readings, a pretty amazing feat. The PMI readings
outside of France and Germany are at a recovery high and are now at higher levels than at
any time since 2008. Our guess is that Germany, the U.S., Japan, and China are still hurting
from the commodity bust that is now well into its fourth year. The relative lethargy of the
manufacturing sector around the world clearly shows that there are problems beyond
currencies and the U.S. energy sector.
Housing to the Rescue of the Manufacturing Sector?
Residential housing still accounts for an anemic 3.1% of the U.S. economy, well below its
long-term average of just under 5% as shown in the following chart. This includes remodels,
commissions on existing homes, and both single-family and apartment buildings. While
the mix of these various categories is likely to be significantly different in this recovery, we
still believe that housing-related investment will approach 5% of GDP over the next five to
10 years, providing a long and sustainable tailwind to the otherwise poor, demographically
challenged GDP growth rates. Thats why housing is so important to this recovery.

Thus far the housing recovery has been slow, and 2014 was particularly slow and very
disappointing. At the moment everybody seems to have kind of forgotten about or given up
Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

on housing as an engine of growth. While there are a number of tactical short-term reasons
that housing has been weak (affordability, student loans, tough loan standards), these
arent the whole story. The entire housing industry was totally trashed. People who built the
homes, bankers that lent to the industry, readily available tracts of desirable land to build
on--all are gone or diminished. This supply side of the issue has kept on the conservative but
still-too-optimistic side of the housing industry. Most economists have believed that it was
just a matter of time until we got back to needing 1.5 million units of housing per year (versus
disappointing housing starts of just over 1 million recently). The demographics seemed
irrefutable based on births, deaths, normal destruction trends, and household formation
rates. In the long run, I still believe that they are. But getting back to those 1.5 million units
(which is just two thirds of the previous high of 2.2 million units) is not fast or simple, nor is it
likely to be. More likely is a slow improvement with occasional speed bumps like in 2014. And
hopefully we will get a potential bump in activity when rates begin moving up and the panic
factor sets in.
Existing Home Sales Bounce Back
So far, there is no panic-buying in the existing home market, just slow improvement. In
March, existing home sales hit 5.19 million, which represents the third-best level of the
recovery. Sales were terrible in February at 4.88 million, and the small increase represented
in the consensus estimate of just 5.03 million units proved to be way too low. Rolling three
months together, the sequential pattern doesnt look all that great, but at least this metric
has stopped going and should almost automatically bounce back as the poor winter months
drop out of the averages. Always remember that this is not the best way to look at the data.
But it is among the more popular ways of looking at housing data in the financial press.

One very bad consequence of the sequential numbers shown in the previous table is that
if one looks at total house value sold, the three months ending in March will be down from
the three months in December. That means the housing component of GDP is likely to be
down between the fourth quarter and the first quarter. This will put even more pressure on
the already worrisome potential for a sub 1% GDP growth rate for the first quarter when it is
released next Wednesday.

Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

Year-Over-Year Existing Home Sales Data Shows a Steady Run of Improvements

As I have said many times, year-over-year data is my preferred way of looking at housing
data. Year-over-year data has improved for an impressive six months in a row and is now
in what we believe to be a long-term sustainable growth rate of 5% to 10% in units and
perhaps slightly higher when including price increases.
New Home Sales Surprisingly Strong, Up 20% Year Over Year
New home sales growth has strongly outpaced existing home sales recently, after a period
of looking similar to or even worse than existing home sales. We like to see new home
sales coming in better than existing homes because they make a much bigger contribution
to employment and GDP growth rates. In fact, there is even a small chance that new
home sales, which have improved sequentially, might be able to bring the residential fixed
investment category out of the red in the first quarter despite the poor showing for existing
homes noted above.

Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

We couldnt help but peek at the numbers not seasonally adjusted, and to our surprise both
February and March showed one-month sales of 45,000 units, both records for the recovery.
And while we have seen an occasionally good month, it has been highly unusual to see two
of these in a row, which is why we believe the recent housing market increases are the real
Demographics Working Toward First-Time Buyer
One little-recognized factor in the housing market collapse beginning around 2006 was the
demographics. Most first-time home purchases have been made at age 31, a number that
remained incredibly stable over time and even economic conditions. The number of people
turning 31 reached a peak in 1992 at 4.2 million people and began a slow slide to 3.1 million
people by 2006. While we improved back to over 3.6 million people in 2015, we are only
halfway back to peak levels (3.67 million in a range of 3.1 million to 4.2 million). This should
mean better news for those serving the first-time buyer in the years ahead.

Home Price Growth Begins to Heat Up by Roland Czerniawski

According to the Federal Housing Finance Agency, U.S. home prices increased 0.7% in
February, and the year-over-year growth stood at 5.1%. Thats a sizable increase from the
much lower 4.5% pace recorded in September and October 2014. After a brief period of
Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

stabilization, the pace of home price increases has begun accelerating again. The year-overyear three-month average, which is typically a powerful trend-telling tool, stood at an
elevated 5.3% level for the second consecutive month. We estimated home price growth in
2015 at 4%-6%, and given the relatively high demand coupled with unusually low inventory
levels and lethargic housing starts, the high end of this range is now likely. The price growth
dynamic is largely dependent on the magnitude of the typical inventory rebound that comes
with the spring season. If builders get to work more aggressively than usual, it could put
a lid on future price increases. On the other hand, low land availability in regions such as
New England and Middle Atlantic will be difficult to overcome. States in those regions might
experience more persistent price increases going forward.

Next Week GDP, Autos, and Purchasing Managers Data and Pending Home Sales
Psychologically, next weeks GDP report will be the most important but the most
unpredictable. Sequentially GDP was up a stunning 5% in September, which drove a lot of
activity, particularly hiring in the fourth quarter. Then growth shrunk back to a more normal
and sustainable 2.2% GDP growth rate in the fourth quarter as exports and government
became big detractors to the GDP calculation. Hopes were high at the beginning of the
year for a quick rebound to 3% growth in the first quarter led by the consumer. However,
the weather, West Coast port issues, export issues due to the strong dollar, and a stubborn
consumer are widely expected to limit growth to 1.5% or less on a sequential, annualized
basis. The consensus is lower at 1.2% growth, and we think GDP growth will be lucky to
breach the 1% mark. The consumer is likely to grow less than 2% in the first quarter after
growing over 4% in the fourth quarter, which is the primary reason for our short-term

Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015

pessimism. And unless the government makes a heroic assumption about March net exports,
they are likely to be a meaningful detractor from GDP in the first quarter (though slightly
smaller than in the fourth quarter). Government and business investment arent likely to
be too influential in either direction. Inventory and exactly how inflation flows through the
calculations are potentially large and important numbers within the GDP forecasts. These
factors are really impossible to project and include government estimates instead of hard
data. So we could theoretically have no growth or 2% growth, but check the inventory and
export data before panicking or breaking out the champagne. I am sticking with my forecast
of 0.5% growth for the first quarter.
Autos are always important to the economy, and with much of the manufacturing sector
beginning to fall apart, we could really use some good news out of the auto sector. March
was exceptionally good, with 17.2 million annualized, seasonally adjusted units (though aided
by a day count issue). Consensus is for minor slippage to 17.1 million units, which would put
the second quarter off to a good start. Because the day count factor wont be present this
month, I am thinking auto sales could drop back to 16.8 million. As long as we stay above
16.4 million units, I would not be too worried.
Pending home sales will also be important, as we have laid out the significance of a good
housing number earlier in this piece. Housing could act as an offset to energy-related issues
for the rest of the year. Though new home sales are important, the pending home sales index
should at least give us some hints as to the customers state of mind. Given a large bounce
in pending home sales for February (up over 3% sequentially), economists are very wary that
the March number could be horrible, with expectations for a 1% decline in pending home
sales. I think these concerns are overblown, and with all the activity in new homes, I suspect
that the original homesteads (which are almost always sold near the time a new house is
purchased) will go on the market soon, creating more supply. Lack of good-quality homes
for sale has been one of the factors holding back existing home data. If that is true, I would
suspect that we should see some improvement even as early as the March pending home
sales data, not the month-to-month decline pending home sales that the market is looking
In terms of the ISM manufacturing purchasing manager data, the March report was down
after an already lengthy list of monthly declines. The current reading of 51.4 is still in growth
territory, but that growth rate has been declining since October. With the consumer still
in the early stages of coming out of winter hibernation, the terrible durable-goods orders
report, and oil and export issues, I am wary of forecasting any improvement for April. I am
still hoping for a reading above 50, but if it doesnt happen, I wont be surprised at all. And I
wont panic until this metric drops to 45 or below.

Robert Johnson, CFA, is the director of economic analysis with Morningstar.

Roland Czerniawski is a markets research analyst with Morningstar.

Is It Up, Up, and Away for the Housing Industry? | Reading Indicators | Robert Johnson, CFA and Roland Czerniawski | April 25, 2015