Introduction

The week's data run was led by a retail sales report that showed unexpectedly strong headline growth but nevertheless was not entirely positive. Clearly not positive is a dip underway in the housing sector, one likely tied to capacity shortages, while a drop in a key advance indicator may be raising new questions for the manufacturing sector. But these are only limited negatives with the week's numbers on productivity, employment, and inventories all very positive.

The economy

Wednesday's retail sales report was the biggest positive in the week, posting a strong monthly gain that easily topped high-end expectations. But it's not the monthly gain that we'll look at now but the year-on-year rate. At 6.4 percent, July matches May as the strongest showing since early 2012 and compares well with the very highest rates of the 2001-2007 expansion. It's ultimately the enormous strength of the labor market that deserves the credit for this achievement. The month-to-month gain, at 0.5 percent, was skewed higher by a sharp downward revision to June which set up an unexpectedly easy comparison for July. Month-to-month offers a close-up barometer of change and is largely what the financial markets watch for in U.S. economic data. But stepping back and looking at year-on-year change allows the eye to more easily grasp the long-term trend. And when it comes to retail sales, this trend right now couldn't be stronger; if it were, the debate over economic overheating would be on the front burner.

Restaurants are the leading force right now in the retail sector. The red bars of the graph track month-to-month sales change, at prodigious gains of 1.3 percent, 1.6 percent, and 2.8 percent over the last three months. Gains for restaurants speak to consumer confidence and the spending is largely discretionary, again underscoring the strength of the jobs market. This category (techincally defined as food services & drinking places) makes up 12 percent of all retail sales and came out to $62 billion in July. Though the nation's restaurants may be busy, there appears to be less traffic not more at dealer showrooms. Auto sales, another discretionary category and tracked in pink on the graph, have been sputtering in recent months, posting gains of only 0.2 and 0.1 percent in July and June. At $103 billion in July, autos make up the most of any category, 21 percent of total retail sales.

This graph really tells the story. It tracks year-on-year change on a 3-month average and restaurant sales are literally shooting higher, at 8.2 percent in July for a 3-year best and among the very highest readings of the last 15 years. This rising strength supports a positive outlook not only for third-quarter consumer spending but also third-quarter restaurant profits. But the trend for autos, unfortunately, is not going in the same direction. The 3-month average for this yearly rate is respectable enough at 3.7 percent but is down from June and May and down from most readings in 2017. Offering a strong hint of why sales are slowing is this month's preliminary consumer sentiment report where consumers describe auto prices as the most unfavorable since 1984. For the overall consumer picture, slowing growth in auto sales is a significant offset to accelerating growth at restaurants.

Retail sales represent about one third of total consumer spending, the bulk of which is spending on services. But advance data on service spending (in what is a glaring shortcoming in the U.S. economic data scene) is virtually impossible to come by which makes the retail sales report the leading barometer for consumer spending as a whole. The blue columns of the graph track month-to-month change in total retail sales against the green columns of consumer spending, the July report for which will be posted in a couple of weeks. And the strength in retail sales during July points to a fifth straight solid gain for total consumer spending -- and also a fast start for third-quarter GDP.

But auto sales are not the only crack in the economic picture. So is housing. The housing market index, compiled by the nation's home builders, is at its weakest point since September last year while housing starts and permits, tracked in the accompanying graph, have clearly shifted lower. A big downward revision to starts in June punctuates the sector's weakness with starts in July doing little better, coming in far below low-end expectations at a 1.168 million annualized rate. Weakness is tied to both shortages of available construction labor and also high costs for materials including tariff effects on lumber, negatives that home builders have been warning about for months. Other symptoms of capacity stress are an extending slowdown in housing completions and an extending rise in homes not started, both bad news for a housing market starved of supply. But permits are less affected by capacity issues and here the step lower is less pronounced, at a 1.311 million rate and moving higher following a sharp dip earlier in the year. The year-on-year rates show the separation and highlight the lack of boots on the ground in the construction sector: starts down 1.4 percent and permits up 4.2 percent.

One area where third-quarter GDP isn't likely to show much strength, given the weakness in starts, is in residential investment. The graph tracks the blue columns of starts against the green line of residential construction spending, last at a $575 billion annualized rate in data for June. Home sales have been unexpectedly flat this year, both for new homes and especially for resales. And where sales go is probably where construction spending will go. Why the slowdown this year? Less favorable mortgage rates can't be a plus nor high prices. Home price appreciation has slowed but following a peak over 7 percent through last year and into early this year, a high rate of return for such a general and essential investment. Growth is now in the 6 percent range but still may be too high for many home shoppers especially those at the low end of the nation's income distribution. That's another finding of August's consumer sentiment report where housing prices are judged to be the least favorable in 12 years.

Though nothing to compare with the actual slowing in housing, a widely followed advance indicator for the manufacturing sector is showing cracks of its own. The Philly Fed general conditions index, which tracks manufacturing conditions in the Mid-Atlantic region, is down sharply this month, to 11.9 for the lowest reading in nearly two years and far below Econoday's low estimate. It also follows June's reading of 19.9 which first marked a turn lower for this index. Growth in new orders is at a 2-year low for this sample while backlogs are slowing and employment easing slightly. And inflation pressures, though still highly elevated, are easing both for inputs and selling prices. But a little slowing may very well be what's needed, allowing this sample to have some breathing room to increase capital investment and expand production capacity. The Philly Fed is one of the first manufacturing reports out each month with the August edition pointing to slowing for the coming week's manufacturing PMI from Markit Economics.

One of the strongest highlights of the week, and one fundamentally driven by capital investment, was productivity, posting a 2.9 percent annualized growth rate which is a very solid result for the ongoing expansion. The gain reflects a sharp jump in output to a 4.8 percent rate and a slowing in hours worked to a 1.9 percent rate. Higher output with easing hours is a mix everyone wants and is tied, as tracked in the graph, to rising investment in new equipment. The blue columns of the graph are year-on-year change in the real nonresidential fixed investment component of the GDP report, at a very strong 6.7 percent in the first and second quarters this year. The red line is year-on-year change in real output per hour, at a modest but improving 1.3 percent in the second quarter. One factor pointing to extending growth in business investment is this year's corporate tax cut which is giving companies more cash to spend. A second factor is that labor is hard to find which will encourage businesses, in order to expand their output and keep up with demand, to invest in new machines.

Nowhere in the economic data is demand for labor more consistently evident than in weekly jobless claims. All readings in this report have been making historic lows this year including initial claims which may soon approach 200,000, a level if and when breached that would make good economic headlines. The August 11 week came in at 212,000 with the 4-week average, as tracked in the blue line of the graph, edging higher to a 215,500 level that is nevertheless trending 5,000 to 10,000 lower than mid-July levels. This comparison offers an initial indication of strength for the August employment report. Continuing claims, where data lag by a week, had been edging higher but not in the August 4 week with this 4-week average down 8,000 to 1.739 million. The unemployment rate for insured workers, like all readings in this report, is very low, steady at 1.2 percent. Employers are holding onto their employees with apparent urgency, a factor that hints at wage inflation to come and points to the business necessity for increasing capital investment.

We close out the week's data run with what may be the third-quarter's biggest hidden positive. Final data on second-quarter business inventories showed only a marginal 0.1 percent build in June. All three components, those from wholesalers, retailers and manufacturers, rose 0.1 percent in the month though retail inventories (dark blue area of graph) are clearly behind. Year-on-year inventories in retail are up only 1.7 percent and are way below the 6 percent growth rate for retail sales. Given the strength in retail spending, retailers will have to begin restocking at a faster rate. And as retail inventories build, wholesale activity and manufacturing production (not to mention related demand for labor) are certain to get a lift. Builds are positives for the GDP calculation which in the second quarter was held back by the lack of inventory strength. This graph is actually what shows off the deceptive strength of second-quarter GDP. Despite the quarter's big drag from inventories, GDP still managed a robust 4.1 percent growth rate. Without inventories in the equation, second-quarter GDP would have been 5.1 percent. The need to stock inventories looks to be a major positive for third-quarter GDP.

Markets: Foreigners selling U.S. equities, and Treasuries too?

It was another volatile week for stocks which were up and down on weakness and recovery in the Turkish lira before the market rallied strongly Thursday on news that China is sending another round of trade negotiators to Washington. On the week the Dow rose 1.4 percent for a year-on-year gain of 3.8 percent. The Nasdaq is up 13.2 percent on the year though it slipped 0.3 percent in the week. A trade accord would be a major positive and could attract foreign demand back into the stock market, reversing what has been heavy ouflow in recent months.

Foreign accounts sold $27.1 billion of U.S. equities in June which came on top of a $26.6 billion outflow in May. These numbers are part of the Treasury International Capital report which comes out late in the afternoon on the 11th business day of the month. Foreign accounts were also very heavy sellers of Treasuries in June, at $48.6 billion with Japan cutting its holdings by $18.4 billion to $1.030 trillion and China trimming back by $4.4 billion to $1.179 trillion. And if trade talks eventually fall through, Chinese holdings of Treasuries, amid the risk of retailatory selling, could become the most closely watched detail of any economic report.

The bottom line

Conditions are very strong right now but capacity constraints have been evident in manufacturing all year and are now pulling down the construction sector. And early hints of cost constraints for autos and housing is also of note. But business investment is strong which will help expand capacity and the outlook for productivity is improving, and as long as the labor market keeps growing, and there's no evidence right now that it won't, consumer spending will remain the nation's central strength.

Week of August 20 to August 24

The Federal Reserve's annual Jackson Hole conference will highlight the week with a speech on Friday from Jerome Powell, who reports say will offer analysis why inflation, despite a strong labor market, has been subdued. FOMC minutes from the meeting earlier this month will be posted on Wednesday in a meeting that upgraded the economy and household spending and made no recognition of President Trump's call for the Fed to keep rates low. Housing will be a highlight of the week with improvement the call for existing home sales on Wednesday as well as new home sales on Thursday and a moderate rise for the FHFA house price index also on Thursday. Factory news is also slated in the week including the Kansas City manufacturing index on Thursday and durable goods orders on Friday where a strong gain for capital goods is the forecast.

Wednesday

Existing Home Sales for July

Consensus Forecast, Annualized Rate: 5.425 million

Consensus Range: 5.400 to 5.509 million

Existing home sales have been flat and at the low end of expectations this year. But based on a rise in pending sales, forecasters see improvement for July, to a 5.425 million rate from 5.380 million in June.

FOMC Minutes

Covering the July 31 & August 31 Meeting

The FOMC statement on August 31 didn't include too many surprises as rates, after a hike in June, were held unchanged and members were mum on President Trump's call for the Federal Reserve to keep rates low. But the assessment of the economy was upgraded to strong from solid as was the assessment of household spending. Upgrades for these are consistent with what most expect for the remainder of the year: two more 25-basis-point rate hikes.

Thursday

Initial Jobless Claims for August 18 week

Consensus Forecast: 215,000

Consensus Range: 210,000 to 220,000

Initial claims are expected to come in at 215,000 in the August 4 week vs 212,000 in the prior week. All readings in this report are at or near historic lows and consistent with strong demand for labor.

FHFA House Price Index for June

Consensus Forecast, Month-to-Month Change: 0.3%

Consensus Range: 0.2% to 0.6%

Though still too high for many buyers, home prices have been cooling along with sales and are part of the cracks appearing in the housing sector. The FHFA house price index has managed only very small gains the past three reports with a bit better gain, at 0.3 percent, the consensus for June.

PMI Composite for August Flash

Consensus Forecast: 55.6

Consensus Range: 54.0 to 56.3

PMI Manufacturing

Consensus Forecast: 55.2

Consensus Range: 54.8 to 55.9

PMI Services

Consensus Forecast: 56.0

Consensus Range: 54.0 to 57.0

Moderate-to-strong has been the signal from the PMIs with capacity constraints cited as a factor that is limiting growth. The consensus for August's flash PMI composite is 55.6 with PMI services at 56.0 and PMI manufacturing seen at 55.2.

New Home Sales for July

Consensus Forecast, Annualized Rate: 648,000

Consensus Range:  630,000 to 660,000

New home sales have been struggling to move higher but forecasters do see strength for July, at a consensus annualized rate of 648,000 vs 631,000 in June. Prices were down in the June report while supply moved into the market, both positive indications for the July report.

Kansas City Manufacturing Index for August

Consensus Forecast: 23

Consensus Range: 22 to 25 

Steady strength at a high level is the forecast for the August edition of the Kansas City manufacturing index, at a consensus 23 in August in what would be unchanged from July. The July report saw a little less acceleration in orders and production but even more stress in deliveries and prices.

Friday

Durable Goods Orders for July

Consensus Forecast, Month-to-Month Change: -0.2%

Consensus Range: -1.7% to 4.0%

Durable Goods Orders, Ex-Transportation

Consensus Forecast: 0.4%

Consensus Range: -0.3% to 1.0%

Durable Goods Orders, Core Capital Goods (Nondefense Ex-Aircraft)

Consensus Forecast: 0.6%

Consensus Range: 0.4% to 1.2%

A step back for aircraft is expected to pull down durable goods orders by 0.2 percent in July with ex-transportation, however, seen at a respectable 0.4 percent gain. Core capital goods orders (nondefense ex-aircraft), which slowed in June, are seen up a very strong 0.5 percent. Unfilled orders in this report have been rising which is a tangible confirmation of strength in the factory  sector.