Daily Insight

• U.S. stocks ended a three-day winning streak on Friday as the Commerce Department showed personal spending was weak during July and incomes declined for the first time in three years. More than anything though, Friday’s down market was more a function of traders’ unwillingness to take on additional long positions considering the increased uncertainty that Hurricane Gustav wrought.
  
  That personal income figure was really more a function of the government’s rebate check program coming to an end as this caused government transfer payments to fall substantially. The fundamental components of the data continue to look pretty good, as we’ll touch on below. (Real income growth remains a chief concern, but the income data looked much better in July than the headline number would lead one to believe.) Further, it’s tough to blame economic data for Friday’s stock-market decline considering the most important regional manufacturing survey showed activity was just shy of robust last month.
  
  Market Activity for August 29, 2008
  

All 10 major industry groups ended the week on a down note, with information technology, utility and industrial shares leading the declines. Financials were the best-performing sector on a relative basis, falling just 0.59%.

Crude-oil prices have plunged this morning, falling 6.30%, or $7.27 per barrel, as Hurricane Gustav failed to strengthen to the level many had feared and thus oil and gasoline production should resume in pretty quick order. We won’t know the extent of the damage until tomorrow – firms will get out and assess rigs today – but there’s a strong possibility we escaped major damage. That said, the Louisiana Offshore Oil Port (LOOP) has been closed for a few days and likely won’t be able to begin taking shipments again until Thursday, so this will have a meaningful effect on stockpiles in the very short term.

As the chart below illustrates, we’ve enjoyed a welcome 25% decline in oil prices over the past six weeks, yet remain 43% higher from the this time last year and 24% higher from date the Fed began to aggressively ease with their January 22 inter-meeting cut. (The annualized figures are meaningless for the purposes of this graph, so pay not attention to those readings, if you can even read them.)

It’s been amazing to watch how emotion-driven trading has turned. Just six weeks ago the slightest disturbance would lead to large moves higher as crude hit $145 per barrel in mid July. Now, even when a large production disturbance occurs, so long as it doesn’t reach the worst-case assumption, traders push crude down 4-7%. This is a huge development for the consumer and profit margins.

Helping this trend out is some encouraging signs from Congress regarding the removal of energy production restrictions; let’s hope the recent decline in prices doesn’t cause a reversal. Further, the pro-drill candidate continues to make progress in the polls, which likely has an effect on traders’ mentality as well.

I’ll caution though, OPEC meets next week and you know what that means with crude 25% off its high. Yep, they’re likely to push through a production cut, especially since Russia will put pressure on them to do so. (Russia is not a member of OPEC, but they do have strong, and concerning, ties to Iran and Venezuela – regimes that very much depend on the high price of oil to remain relevant.)

On the economic front, the Commerce Department reported personal income fell 0.7% in July. This decline was due to the rebate-check effect. Recall back in June how we explained the big jump in May income growth was due – largely – to government payments and that there would be some blowback effect as the numbers were adjusted to this one-time situation. Well, here it is.

The large 17.6% decline in the “other” component of government transfer payments moved the overall figure lower. However, the components that really matter – compensation, wage and salary, proprietor’s income, rental income and dividend income all posted decent-to-strong results.

Compensation was up 0.3% in July and 4.0% year-over-year (YOY)

• Compensation was up 0.3% in July and 4.0% year-over-year (YOY)
• Wage and salaries gained 0.3%, up 4.1% over the past 12 months
• Proprietor’s income rose 0.4% -- nonfarm proprietor’s income up 3.2% YOY, accelerating to 8.9% at an annual rate last three months
• Rental income jumped 7.2% in July and has soared 50.6% YOY
• Dividend income was up 0.6% in July and up 8.2% YOY
• Disposable (after-tax) income is up a very healthy 5.8% YOY

So the income components that matter show pretty nice trends, although for the labor-income related segments the growth has not been enough to keep up with elevated inflation rates. Broadly speaking, disposable income does continue to outpace inflation, which is good.

On the spending side, personal consumption rose 0.2% last month and is up 5.1% YOY and just a bit more six-month annualized. One should expect the pace of spending to ease as inflation eats into the growth of income. Lower commodity prices of late will help, but as we’ve touched on in past letters there is a risk that inflation has become embedded. We’ll just have to see how the data turn out over the next two months.

And speaking of inflation, the gauge tied to this personal spending data showed the PCE deflator (one of the big-three inflation gauges) has increased 4.5% over the past 12 months – a large acceleration from the June year-over-year figure of 4.0%.

The core rate also edged up, coming in at 2.4% YOY – well-above Bernanke’s stated comfort zone of 1%-2%. We’ll admit, as this letter has stated before, a comfort zone of below 1.50% is rather ridiculous as some pricing power is important, but I believe it is worth mentioning that the actual readings continue to blow past his comfort level even if the lower end of the range is silly.


Lastly, the Chicago Purchasing Manager’s survey (tracks Chicago-area manufacturing) came in much stronger than expected, jumping to 57.9 in August from 50.8 in July – a reading above 50 marks expansion and a reading approaching 60 borders on robust.


The sub-indices within the survey were extremely encouraging. The production index jumped to 63.4 from 49.2 in July. New orders rose to 60.2 from 53.5 last month. The order backlog reading rocketed to 63.0 from 45.7.

While these are all very good readings, we’ll need the national reading to confirm this strong rebound before getting too excited – and we’ll get that with the ISM report this morning. Stronger auto production of late likely helped to push this figure higher and since auto sales are relatively weak…well, that’s where the caution comes in. Overall, though the manufacturing sector has remained largely upbeat despite housing’s woes -- and the heretofore drag from the auto sector -- and this reading does offer optimism that the sector will remain in expansion mode. That order backlog reading is also very encouraging.

The prices paid index pulled back, falling to 80.6 from 90.7 in July, but remains very elevated.

Have a great day!


Brent Vondera, Senior Analyst