U.S. stocks were able to shake off some market weakness overseas and China’s continued pull-back of stimulus measures, as they tighten lending standards, to end two-sessions of decline on Monday.  The three major indices gained back most of Friday’s losses. 

Certainly a bang-up manufacturing report helped to ease some concerns but the Commerce Department showed the income/spending ratio deteriorated again, which means spending is being stolen from the future.  These reports pretty much offset each other, if one is thinking beyond the here and now.  More on this data below the jump.

A reader expressed surprise that I didn’t touch on the attempted car bombing in Times Square in Monday’s letter, particularly since I’ve spent several years talking about the importance of geopolitical risks/domestic security with regard to economic growth.  The markets found it unnecessary to put in any additional terrorist premium as futures trading was not affected in the least, so I decided not to use space on the topic.  However, while we’re on it now, even though it didn’t seem like a serious explosive device, one would think it to be a large enough act to raise concern of the larger issue of terrorism, but no worries for this market…yet.  When risks lurk around many corners, it’s only a matter of time before some form jumps out and scares the complacency out of everyone.

Industrials, consumer discretionary (spend it like you got it), and financials led the market higher.  The S&P 500 index that tracks basic material shares was the only group down for the session.

Market Activity for May 3, 2010

Offshore’s Three-Mile Island?  Let’s Really Hope Not

The price of oil held steady yesterday, actually dipping a bit this morning, even though the leaking well has ramifications far beyond the immediate damage.  The damage to the coast, if not able to be contained and then capped in time, can be cleaned up and fixed.  What is entirely another issue is the first media photo of dead wildlife, drenched in crude.  That will pull at the emotional harp strings and curtail domestic production to an even greater degree than is already the case.

I’ve delayed talking about this incident, hoping it would be resolved – I haven’t wanted to add even more negative commentary, but it is clear now that this issue isn’t going to end well from a policy standpoint. 

The damaged wellhead has reportedly spewed two million gallons of oil, the equivalent of what would fill 3.3 Olympic-sized swimming pools.  Many seem to expect this situation to deteriorate to the size of the Exxon Valdez accident, which spilled the equivalent of 18.3 Olympic-sized pools.  The Exxon Valdez ranked 40^th in terms of the worst offshore oil accidents over the past 40 years.  Did you know that?  One would think it to have been 1,2 or 3 in rank by the way it’s been portrayed to everyone over the past 20 years.  This is why Three-Mile Island is the correct analogy. 

Even if the wellhead is capped with reasonable quickness, the Exxon Valdez storyline will follow this incident.  As a result, offshore drilling will be further burdened and blocked by restrictions.  Thus, we will not go full-bore in terms of our domestic energy production until our backs are fully against the wall in terms of dependency, cost and the need for high-paying manufacturing jobs.  Accidents happen, but the energy industry has an amazing track record of safety.  Think about when Katrina and Rita stormed into the Gulf, all the wells were properly capped.  We must also remember that if we don’t drill for our own resources, the world isn’t going to stop.  China and Russia are on our hemispheric door step, buying up fields and gaining energy resources.  For those who are serious about the way the world works, sorry to say, we’ve got to think beyond wildlife. 

Personal Income and Spending

Personal income rose 0.3% in March following a 0.1% increase in February.  The March data was helped by the largest private-sector components (compensation and wage/salary) but also received quite a boost from government transfer payments, again.  Personal income excluding transfer payments was flat in March, for the third-straight month.

The compensation and wage & salary components are beginning to look much better.  Compensation was up 0.2% for the month and is now 1.3% higher over the past year.  Wages & salaries collectively rose 0.2% also, and are up 1.1% over the past year.  These y/o/y increases may not sound like much, but they’re no longer falling.  Still total compensation as a oercentage of total income remains grounded at 64%, the 30-year average is 68%.

Transfer payments jumped 1.1% in March, and the unemployment insurance segment of this component rose 8.7%.  Transfer payments are offsetting the decline in personal income from assets, which have been falling as dividend income continues to get hit – div. income fell another 1.7% in March and is down 6.1% y/o/y.  Government transfer payments currently make up more than 18% of total income, the 30-year average is 13%.

Real personal income excluding transfer payments is down 6.7% from the peak (hit in September 2007), which is more than double the decline that occurred during the prior three recessions/downturns and the worst result since at least 1959 – which is when this data set began.

On the consumption side, spending rose 0.6% in March, propelled by a massive 3.6% increase in durable goods.  This is the tax-credit refund money getting spent as those first-time home borrowers buy appliances. 

As spending outpaced income, the cash savings rate fell again.  The savings rate made it all the way up to 6.4% roughly a year ago when consumers went into hiding.  But the consumption-to-disposable income ratio has sprung back to 97.3%, thus the cash savings rate hit 2.7% in March.  It is one thing for the cash savings rate to fall below 3% when the stock market is hitting new highs and housing is flying (household net worth hits record levels), but neither of these are quite the case right now.  Over the next couple of years, out of necessity, I believe this rate will make it back to 5-6%, and that will crimp spending.

So, the most important private-sector components (compensation and wage & salary) are beginning to show some improvement, that’s the good news.  But transfer payments are creating an environment that sets up for disappointment several quarters out.  If the private-sector improvement fails to improve markedly, the reduction from the temporary governmental support to income will weigh on total income and thus spending as we head into 2011.    When this temporary boost to income fades we’re going to have some trouble, especially if the stock market fails to hold up and the wealth effect moves in reverse again. 

ISM Manufacturing

The Institute for Supply Management reported that its survey of manufacturing-sector conditions accelerated for a second-straight month, rising to a reading of 60.4 in April from 59.6.  This is highest level since June 2004 and as the regional surveys have alluded to shows the factory sector is humming. 

Export orders have really been driving the improvement in factory activity, this gauge remained above 60 in April – a level that outside of the past two months hasn’t been hit since 1989.  This is due to China’s massive stimulus measures, which has fueled the entire Asian/Australian basin; it will be interesting to see how the factory gauges react as the Chinese government continues to rein in this stimulus, particularly on the lending side. 

From there, we’ll need strong final demand in the U.S. to keep this sector rolling a couple of months out, especially as Eurozone growth has shown weakness and will get weaker as they need to restrain government spending. 

As we’ve been talking about, I’ve been keeping a close watch on the backlog of orders and supplier deliveries components of this ISM survey.  They are both posting strong readings, which has been the case for four months now.   This illustrates that factories are beginning to become overwhelmed by orders, based upon current employee levels.  We’ll need strong job growth to propel that final demand, and these readings are indicating something good is about to occur on this front.  But I’ve also warned that indicators that have proven so accurate in the past may flash false signals this around, so I do have some doubt here.  We’ll know over the next few months; everything hinges on job growth. 

The prices paid component increased another 3 points to a reading of 78.0 – factories are certainly getting hit with higher costs; this could keep them hesitant with regard to job creation as factories need to squeeze evermore from current workers to absorb these costs.  Normally, it would take several years into an expansion for the ISM prices paid index to hit this level – but things are far from normal.

Construction Spending

Construction spending rose 0.2% in March following a large 2.1% decline in February.  The March increase ended a four-month slide but only because of public-sector spending. 

Public spending on residential construction rose 2.5% after a 7.4 increase in February – up 14% y/o/y.  Public-sector spending on commercial projects rose 2.3% after a 1.8% decline in February – down 6.8% y/o/y.  Private-sector residential spending fell 1.1% in March after a 3.4% decline in February – up 1.2% y/o/y.  Private-sector spending on commercial projects dipped 0.7% after a 1.5% decline in February – down 25.5% y/o/y.

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900

www.acrinv.com