Economic Cracks Solidify the Bullish View

Many observers equate the U.S. economy to a battleship at sea. One spin of the ship's wheel is not enough to move it in the opposite direction. If the analogy holds, the U.S. economy will naturally show some evidence that 17 straight interest rate hikes have taken a toll, but it will be a long time before all the data line up to show the economy is clearly moving at a slower rate.

Monday's data showed a crack or two, helping spur a rally in a holiday-shortened session. Trading in U.S. stock markets ended at 1 p.m. EDT Monday, and markets will be closed Tuesday for Independence Day.

Both the Institute for Supply Management's manufacturing index and U.S construction spending came in weaker than expected, reinforcing the view that the Federal Reserve's tightening campaign may end soon. But the components of the ISM index reflect the Fed's bigger challenge: stamping out inflation without killing the economy.

The headline reading of factory growth slipped to 53.8 in June, down from 54.4 in May and 57.3 in April, and vs. the consensus expectations of 55. The data show the rate of manufacturing growth in the U.S. is slowing, but any reading over 50 is still considered growth. The June report is the ISM index's 39th consecutive month above 50, suggesting the "USS America" grew larger than normal amid years of historically accommodative monetary policy.

Meanwhile, construction spending declined 0.4% in May, defying consensus expectations for a 0.2% increase.

The data support the market's hopes, fueled by last Thursday's dovish FOMC statement, that the Fed will soon pause.

The stock market reacted accordingly, rallying in the shortened trading session and sending investors into the holiday with something to celebrate. The Dow Jones Industrial Average gained 0.7% Monday to close at 11,228.02. The S&P 500 gained 0.8% to 1280.19, and the Nasdaq Composite gained 0.8% to 2190.43.

The 10-year Treasury fell 5/32 in price to yield 5.16%, while the two-year Treasury fell 1/32 to yield 5.17%.

Leading the Dow, shares of Alcoa ( AA) rose 2.6% on the heels of a JPMorgan report suggesting the aluminum giant could be a takeover target.

Elsewhere in the metals and mining space, Newmont Mining ( NEM) gained 4.48% following an upbeat article in Barron's, and Freeport-McMoRan Copper & Gold ( FCX) climbed 5.7%.

Shares of General Motors ( GM) fell 1.21% on profit-taking after its 8.6% gain Friday on news of shareholder Kirk Kerkorian's proposal that GM partner with Nissan and Renault. GM bondholders were more optimistic. Its long-duration 8.375% bonds due 2033 were quoted up 0.5 points to close at 81 cents on the dollar.

GM's shares rose early in the day, but fell later in sympathy with Ford's ( F) and DaimlerChrysler's ( DCX). Ford reported a 7% decline in sales from the same month a year ago, while DaimlerChrysler reported a 13% decline in sales. Ford's shares fell 3.03%, while Daimler's gained 0.59%. (After the 1 p.m. close of trading, GM reported a 25.9% drop in June sales from a year ago, close to the numbers in its recent forecast.)

Devilish Details

Investors should be careful about gleaning too much hope from the ISM headline number. May's reading also came in below expectations, but was buried amid other data that pointed to a stronger-than-expected economy and additional rate hikes. ISM probably isn't enough to turn the battleship, in other words.

Downside risks to the economy, such as the May ISM report, a weak nonfarm payrolls report for May, and a weak University of Michigan consumer sentiment index, were mitigated by "a flurry of stronger second-and third-tier indicators that have pointed to stabilization or improvement," Jan Hatzius, a Goldman Sachs economist, wrote last month. He noted that a decline in jobless claims, improved industrial activity as indicated by the New York Fed and Philly Fed surveys, and renewed consumer confidence readings reveal an economy chugging along at a rapid clip.

The headline ISM also tells only part of the story. Hopes for a Fed pause Monday focused also on the employment component of the ISM report, which showed that manufacturers cut back on their hiring in June. The employment index fell to 48.7 in June, from 52.9 in May and 55.8 in April. Indeed, the employment index's slip below 50 represents contraction, not growth.

While ISM may be a nod to some employment weakness, Friday's employment report will be more telling. May's nonfarm payrolls report showed an increase of 75,000 jobs, missing expectations by 105,000 jobs. The consensus estimate for June's payrolls report is 160,000 new jobs. In addition, economists expect unemployment to remain at 4.6% -- matching the lowest level since July 2001.

Beyond slowing growth and employment, the ISM manufacturing report revealed the thorn in the Fed's side: rising prices. The report's prices-paid index read 76.5 for June, down slightly from 77 in May, but still up from 71.5 in April. It may be wishful thinking to hope the weak headline and employment elements of ISM foretell an economic slowdown strong enough to make Ben Bernanke and the Fed rethink another rate hike.

Why wouldn't a high inflation reading similarly suggest more rate hikes and a more hawkish Fed? Inflation data have been the most consistent, after all. There is no denying that three straight higher-than-expected core CPI readings mean inflation is going up. And, despite the dovish words about future rate hikes in the FOMC statement Thursday, the Fed has expressed surprise about the resilience of the economy after the very strong first quarter.

"Whether economic growth would moderate to a sustainable pace was not yet clear," read the minutes from the May 10 FOMC meeting, released May 31. At the same meeting, the committee debated a 50-basis-point rate hike after only one higher-than-expected core inflation report had come in.

"It is much too early to declare victory over inflation," writes Ethan Harris, chief economist at Lehman Brothers.

The Fed's inconsistent messages leave an investor to rely on the data, which is also inconsistent. Friday brings June's nonfarm payrolls report. July 19 brings the next CPI report and Bernanke's semiannual congressional testimony, while July 20 brings the minutes from June's FOMC meeting.

In the meantime, the battleship is drifting somewhere between north and south on the economic compass.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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