Why You Should (and Shouldn't) Be Bullish on the Economy

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Luke Sharrett/Bloomberg via Getty ImagesSteady job growth is just one sign of an improving economy.
By Simon Constable

NEW YORK -- The state of the U.S. economy is almost Dickensian: It's the best of times and the worst of times. There are reasons to be bullish as well as reasons to be bearish.

First, the good news:

1. The housing market continues to recover, albeit at a moderate pace. Of particular note is the positive trend in home-construction permits. The number issued has grown year-over-year each month since May 2011, with the exception of a slight pullback in March of 2015, according to government data. Housing starts followed a similar pattern.

Permits are a particularly useful metric because they point to likely future economic activity, since houses require lots of materials such as copper wire, lumber, concrete and glass, as well as appliances. Plus, you need labor to build everything. So when you see a permit issued, it tends to be good news for the economy. In general, the more permits the better.

If the upward trend keeps going, it would be a boon to companies that supply such products, like those held in the SPDR Materials Select Sector (XLB) exchange-traded fund. Home-builder stocks, like those in the SPDR S&P Homebuilders (XHB) ETF, would do well also.

2. For big business, getting a loan is easier. "Banks reported having eased some loan terms, such as spreads and covenants, especially for larger firms," according to the Federal Reserve's Senior Loan Officer survey during the summer. There was also stronger demand for such loans from some banks.

Why does this matter? Loans taken out by businesses are typically used to invest in capital and equipment. They only purchase such equipment when the managers feel optimistic about future economic activity. If they are taking out more loans, they are likely optimistic, and that's good news for the economy.

3. The labor market continues to improve, and the outlook is good. "The number of private companies intending to hire over the next 12 months is at a post-recession high, which bodes well for the nation's payroll increases overall," according to the Trendsetter Barometer Survey from PwC, a report that measures the outlook by top managers of private companies.

The data has historically tracked well with what happens in the real economy. In this case, consistent hiring would push the economy into a so-called virtuous circle: New employees spend more, thus boosting the economy further so that more people get hired.

Still, there are some signs that all isn't well.

1. The Aruoba-Diebold-Scotti Business Conditions Index, reported by the Philadelphia Federal Reserve, shows a slowing economy for most of 2015. The index is a real-time gauge of the economy, more timely than some other measures, like GDP growth, which can take weeks to produce.

Its read on the economy is corroborated by The Economic Cycle Research Institute, which notes that the U.S. Coincident Index has been declining all year. Slow growth isn't negative growth, but if you slow down enough, you can fall below zero, so it's worth watching closely.

2. The risk appetite of investors has declined dramatically. The amount that bond investors need to be paid to lend money to reasonably creditworthy corporate borrowers, versus what they'd be paid by the government, has increased a lot lately. It's known as the credit spread. For those investment-grade bonds rated BBB, the spread has steadily marched higher since mid-May this year, according to the BofA (BAC) Merrill Lynch US Corporate BBB Option-Adjusted Spread data at the St. Louis Federal Reserve. It was 1.8 percentage points in the spring, and now it's 2.2. Historically, wider spreads augur slower growth, but to be fair, this process can take a while.

3. The manufacturing sector isn't doing well. The Philadelphia Federal Reserve's Business Outlook Survey, which examines the manufacturing sector near Philadelphia, dropped into negative territory this month. The latest reading for the New York Fed's Empire State survey spent a second month below zero as well, indicating contraction.

While manufacturing is typically much more cyclical than the services sector, there are two issues to be concerned about here: First, is that supply chains for factories are often intertwined across the globe, so the slowdown in China may crimp manufacturing in the U.S. Second, a stronger dollar may crush sales for some manufacturers as it makes their products more expensive to foreign buyers.

The net worry is that the manufacturing sector pulls the rest of the economy into recession. What happens over the next few months will determine exactly whether the U.S. tilts to faster growth or falls back to a more anemic pace.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.
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