The Word is Resilience

Even with the disappointing US June retail sales report, the take away point from recent developments is the all-round resilience of everything, but the US dollar.

Retail sales fell 0.9% in June. The market had expected a 0.1% decline after the outsized 1.5% rise in May. Excluding auto sales, which were the weakest since Oct 05, retail sales still fell by 0.4%. The market had expected a 0.2% increase. Some of the sting was offset by the upward revision to the May series from 1.3% to 1.6%.

If there is a silver lining, it is that excluding autos, gasoline and building materials, which is the measure that is used for GDP calculations was flat after a 0.9% increase in May. The other mitigating factor is that that it is well understood that after a couple of quarters of near 4% growth, personal consumption was set to slow. And slow it has. The GDP-measure of retail sales rose about 0.8% in Q2 after a 1.3% rise in Q1 and a 1.4% rise in Q4 06.

Yet the more impressive thing is that the US consumer is not even weaker. The consumer is being battered by a number of head winds. Even though unemployment remains near multi-year lows, there is a great deal of job insecurity; perhaps in part because of globalization; perhaps in part because of ongoing technological changes. Gasoline prices have risen well beyond what experts previously was the consumer breaking point. In both May and June, gasoline averaged more than $3 a gallon for the first time.

The other significant headwind against consumption is the concern about the price of the largest asset that more than two-thirds of American households own, their homes. Equity withdrawals have ceased to be the cash-register that they appeared to be previously. The market has tended to be more pessimistic toward the US consumer than has actually been the case. The University of Michigan’s preliminary July consumer confidence reading was well above expectations and at 92.4 is the highest since January.

Being too pessimistic on the US consumer also led to a surprise from the chain stores reporting same store sales. According to the International Council of Shopping Centers, same store sales rose 2.4%, compared with expectations for 2% gain. The reports of a couple of larger retailers were particularly impressive. Analysts, for example, expected Wal-Mart sales to rise by 0.8% and instead, same store sales at the world’s largest retailer rose 2.4%. Abercombie & Fitch were expected to have seen same store sales fell by almost 3% and instead they rose by 2%. And even when there was bad news, like J.C. Penny’s 1.5% decline, the market had expected that its same store sales fell by twice as much.

It is not just the US consumer that is proving to be fairly resilient, but the economy as a whole. The economy slowed to almost a stop in Q1 at a 0.7% annualized pace, but this was not the prelude to an economic contraction that many economists have warned about. By all reckoning, even by those who had been forecasting a number of Fed rate cuts this year, the economy has snapped back in Q2.

Composition of growth has shifted. In the first quarter, residential construction, inventories and trade each took around one percentage point off Q1 GDP. In Q2, inventories and trade appear to have contributed to GDP by nearly as much as they subtracted from it in Q1. Residential construction is still a drag, but that drag appears to have lessened somewhat. A pick-up in capital spending and government spending, which were unusually soft in Q1, look to pick up part of the slack created by the softer consumption.

The sub-prime woes remain a potential threat to overall credit conditions and to the overall health of the economy. However, on balance most of the evidence seems to suggest, as at least two Fed officials and one Treasury official indicated, the problems seem largely contained and do not appear to be posing systemic risk or preventing an overall economic recovery. For sure, things can get worse, but that potential, while needing to be respected, does not mean that it is the most likely scenario.

This is also not an argument for US exceptionalism, as the world economy seems impressively resilient as well. In the past, a marked slow down in the US economy might threaten world growth, but is hasn’t this time. Perhaps this is at least partly because the softness of the US economy were concentrated on domestic variables, like the housing market. The world economy has also shown itself to be resilient in the face of oil prices in excess of $70 a barrel. For nearly every $10 a barrel advance in the price in the price of oil since $40 a barrel, there was some pundit saying that it would be the proverbial straw that broke the camel’s back. Yet here we are and if anything official as well as private growth forecasts have been revised up.

The world economy has also proven itself resilient to global imbalances, which from time to time some official(s) cite as the major risk to the world economy. The deterioration of the US current account deficit has slowed, largely we’d argue as a result of narrowing of growth differentials (not the dollar’s decline), but has not reversed. China’s trade surplus continues to grow. And the world economy has not strung together such a period of strong growth in a generation.

It is true that some credit quality spreads have widened, like the J.P.Morgan’s Emerging Market Bond Index (vs US Treasuries) or the spread between high yielding (junk) bonds and US Treasuries, but the spreads remain relatively tight by any metric but the most immediate past. This is also true of the major emerging market currencies. The US is trading well below 2 Brazilian reals, and below 7 South African rand, and below 1.28 Turkish lira. Many East Asian currencies, with the notable exception of the yen, are trading at their best levels since the Asian financial crisis as decade ago.

The US dollar itself is the single biggest exception to the general resiliency that the global economy is demonstrating, which tends to be under-appreciated by most observers. The most compelling diagnosis of the dollar attributes its ailment to the fact that most market participants, including a strong majority of primary dealers, cannot see the Federal Reserve raising interest rates. Instead, as has been the case more of less since the Fed stopped raising rates last June they expect the next move to be a cut. While the forecast for when the cuts will begin keep being pushed back, the bias remains clearly evident in the Fed funds and Eurodollar futures strip and in surveys.

Since the news stream from the housing market remains poor, obviously it will take more than strong Q2 growth to put a floor under the greenback. Until the market is convinced that the growth will be sustained in H2, the dollar may not find a solid floor. Many analysts are looking for a near-term test on the $1.40 level for the euro. In 1995, the old Deutschmark made a record high which today would convert to about a little more than $1.45. During runs on the dollar, few short-term traders care to be short the yen, even though their interest rates remain low, but once the greenback stabilizes, the yen-carry trades draw interest again.