Markets are always looking for turning points. We are likely at or near a turning point on both U.S. economic growth and headline inflation. The second quarter has ended up turning out quite well in terms of economic growth but was a nightmare on inflation. While there are monthly signs of improved economic growth, this is not likely to last into the second half. Meanwhile, we should get some help on headline inflation in coming months.

Recap of US Markets

OIL PRICES

Oil prices fell significantly this past week and played key roles in the equity and bond markets. Spot prices for crude oil fell over $2 per barrel net despite a dip in inventories and the Russian and Georgia hostilities with a key pipeline nearby. One would have thought that the conflict in the ex-Soviet republic would have caused prices to spike since about 1 percent of the world’s crude supply flows through a pipeline in southern Georgia. But the pipeline had already been shut down for repairs and traders believe the conflict will not spread that far south and that a diplomatic resolution is likely.

Other events far outweighed the perceived minor impact of Russia’s military intervention. These included a run up in the value of the dollar on reports that the 15-nation euro zone economy had declined by 0.2 percent in the second quarter. All three of the largest economies in the euro zone contracted – those of Germany, France, and Italy. 

Demand for oil is seen as falling as Japan’s economy also contracted in the second quarter and China reported a 7 percent drop in oil imports for July.  Also, Iran called for further nuclear talks, further soothing the oil market.

However, there was a $3 per barrel rebound in oil prices at midweek on an unexpected drawdown in inventories in the U.S. But weak economic data ended up dominating the U.S. picture with sluggish retail sales, a decline in nonoil imports, and high unemployment claims.

Net for the week, spot prices for West Texas Intermediate fell $2.38 per barrel to settle at $113.77 – and coming in $31.52 below the record settle of $145.29 per barrel set on July 3. Over the past two weeks, the spot price of oil has fallen $11.33 per barrel and is down 21.7 percent from the record high.

Without a doubt, the recent drop in oil prices is favorable to headline inflation in coming months and is helping the markets look past currently atrocious official statistics on inflation.

STOCKS

Equities were mixed this past week with blue chips weak while the techs and small caps posted moderate gains. The big factor behind blue chip weakness was further negative revelations about financials. A number of banks and financial institutions were forced – by threat of law suits and even potential incarceration of key figures – to agree to buy back auction-rate securities. Separately, JP Morgan Chase announced another $1.5 billion in credit market losses. Goldman Sachs pulled down on financials after downgrades by several banks.  On a positive note for financials, Fannie Mae and Freddie Mac moved higher after the Securities and Financial Markets Association allowed the mortgage companies to finance larger loans.

But throughout the week, a rise in the dollar and a fall in oil prices provided lift to U.S. equities as the stronger dollar made U.S. investments more attractive overseas and lower oil prices were seen as boosting the consumer discretionary sector. Small caps in particular were helped by these factors. Transports were particularly boosted by lower oil prices as were auto manufacturers.

Techs got some specific help from Apple announcing a jump in revenues related to software downloads for iPhones and from billionaire investor Carl Icahn boosting his stake in Biogen Idec, Inc., a biotech company.

While there is considerable uncertainty about whether underlying economic fundamentals support continued equity gains later this year, investors currently are focusing on the positive aspects of relatively lower oil prices and a favorable dollar that is attracting foreign investors.

Equities were mixed this past week with the blue chips down or flat. The Dow was down 0.6 percent; the S&P 500, up 0.1 percent; the Nasdaq, up 1.6 percent; and the Russell 2000, up 2.6 percent.

For the year-to-date, major indexes are down as follows: the Dow, down 12.1 percent; the S&P 500, down 11.6 percent; the Nasdaq, down 7.5 percent; and the Russell 2000, down only 1.7 percent.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

BONDS

Treasury yields eased this past week except on the near end.  Several factors played a role. The biggest factor was a rise in the value of the dollar caused by weakening growth in Europe and Japan. Second, a continued sharp drop in oil prices for the second week in row eased inflation concerns. Third, the rise in the dollar and an apparently relatively strong U.S. economic outlook (compared to Europe) led to a pickup in foreign demand for U.S. bonds. Finally, sluggish economic data for the U.S. pointed toward a slowing in growth in the second half. Key reports included a sluggish retail sales report and elevated unemployment claims. The bond market did have to get past a scary consumer price report on Wednesday (headline inflation at 0.8 percent in July and double market expectations) but falling oil prices and a rising dollar helped the markets look beyond the old numbers. The easing in Treasury yields is consistent with fed fund futures that have pushed out expectations for when the Fed will start raising rates – with more taking the view that increases will be the end of this year at the earliest.

For this past week Treasury rates were down except on the near end as follows: 3-month T-bill, up 14 basis points, the 2-year note, down 10 basis points; the 5-year note, down 9 basis points; the 10-year bond, down 8 basis points; and the 30-year bond, down 8 basis points.

Lower oil prices, a stronger dollar, and downgraded forecasts for economic growth in the U.S. and overseas have led longer rates down in recent weeks.

The Economy

While the manufacturing sector actual looks a little improved over the last two months, forward looking factors suggest that not only will manufacturing soften in the second half but also the overall economy. The good news is that we are likely to get some reversal of the extremely high headline inflation numbers in coming months but there is still some question as to how much core inflation might ease.

Retail sales lose their luster but don’t fade completely

The consumer was somewhat exuberant during spring and into June as income tax rebate checks temporarily fattened their wallets. But that appears to be a faded memory as July retail sales softened. But the news is mixed -- consumer spending is holding up reasonably well despite the ending of income tax rebates.

Overall retail sales slipped 0.1 percent in July, following a 0.3 percent rise the month before. Excluding motor vehicles, retail sales posted a moderate 0.4 percent gain in July, after a 0.9 surge in June. Higher gasoline sales were one of the stronger components, but other components were still positive overall. When excluding both motor vehicles and gasoline, sales rose 0.3 percent, after increasing 0.4 percent the month before. The July retail sales report shows consumers still spending but a key issue is that after inflation, sales are probably flat.

Weakness in July was led by a 2.4 percent drop in motor vehicle sales.  But strength was seen in a number of components -- nonstore retailers, furniture & home furnishings, electronics & appliances, and gasoline stations.

Overall retail sales on a year-on-year basis in July were up 2.6 percent while excluding motor vehicles, the year-on-year gain came in at up 6.0 percent. Excluding motor vehicles and gasoline, the year-ago pace was 3.4 percent.

The July sales report looks soft at the headline level but weakness was concentrated in motor vehicles — a component still reeling from high gasoline prices and consumer uncertainty about the economy. Outside of autos and gasoline, the 0.3 percent gain looks decent. But after discounting inflation, spending is close to flat. This is pointing to slowing in GDP growth in the third quarter. But all considered, the bright side is that it could have been worse.

Consumer price inflation remains strong

Although consumer price inflation moderated in July at the headline level, the pace remains very strong. Furthermore, core inflation remains elevated as higher production costs appear to be feeding through. The headline CPI posted a 0.8 percent gain, following a 1.1 percent spike the month before. The core rate was steady at a 0.3 percent boost, remaining above the Fed’s comfort zone.

As in recent months, energy led the boost in overall inflation with a monthly 4.0 percent rise, following a 6.6 percent increase in June. The energy spike actually was led by a 7.4 percent jump in natural gas. Gasoline was up 4.1 percent; electricity, up 2.5 percent; and heating oil, up 1.3 percent. Food inflation continued to accelerate, rising 0.9 percent in July after a 0.8 percent jump in June. 

Even though the headline number was disconcerting as being way above the Fed’s implicit target zone of 1-1/2 to 2 percent annualized growth, the markets shrugged off the number as being vastly out of date given the recent sharp drop in crude oil prices. What the markets appear to have ignored is that while headline inflation likely is headed down in the near future, that may not be the case for core inflation. Firms have held off on price increases from higher costs as long as possible but there are signs that firms are desperately pushing up prices now. Upward price pressure was seen in the majority of components. But the rise in the core rate was led by airfares, apparel, tobacco, and educational books & supplies. On the soft side within the core was a small dip in medical care commodities, a decline in used cars & trucks, and a modest rise in owners’ equivalent rent. The troubling trend in the core number is that there were few signs of prices being weakened by soft demand outside of used trucks. The decline in medical commodities may have been related to quality adjustments instead of demand. A higher cost structure for businesses seems to be offsetting slowing consumer demand.

Year-on-year, the overall CPI jumped to 5.5 percent (seasonally adjusted) in July from 5.0 percent in June. The core rate firmed to 2.5 percent from 2.4 percent the month before.

The latest inflation news is not good and it takes a good dose of hope to get beyond July’s numbers. Headline inflation is still being pumped up by earlier increases in oil prices and the Fed is certainly hoping that recent declines in oil prices will ease headline inflation in coming months. But core inflation now appears to have been bumped up a notch and that certainly will be causing concern at the Fed as oil prices still remain relatively high, boosting costs for the economy as earlier oil price gains continue to be slowly passed along in pricing.

Real earnings slide

The same day as the CPI, the Labor Department also releases a related report that typically does not get much attention – real earnings. But those numbers are becoming increasingly important. Over most of the past year, the run up in inflation has had a dramatic effect on employee purchasing power, which goes a long way toward explaining the slowing in consumer spending.

In current dollars, average hourly earnings in July were up 3.4 percent —a growth rate that on average is reasonable. But with headline inflation boosted sharply by food and energy costs, real earnings have dropped significantly. Real monthly earnings fell 0.6 percent in July, following a 0.8 percent fall the month before. Real average hourly earnings have fallen in eight of the last 10 months — and one of the non-negative months was unchanged. On a year-ago basis, real average hourly earnings have sunk 2.5 percent.

The numbers are even worse on a weekly basis since the average workweek has been slipping. Real weekly earnings were down 3.1 percent in July of this year, compared to up 1.4 percent for July 2007.

The bottom line is that inflation has undermined consumers’ ability to make purchases and this fact will be damping economic growth in coming quarters — especially in conjunction with sharply tighter credit conditions.

Import prices continue to surge

The lagged effects of a lower dollar and higher oil prices continue to boost import prices. Import prices extended their run of increases in July though at a slightly less severe monthly rate of 1.7 percent, down from four prior months of increases near or above 3 percent. The year-on-year rate however continued to extend into record territory, up 21.6 percent vs. 21.1 percent in June. The easing month-on-month rate reflects less severe increases for petroleum imports, up 4.0 percent vs. four straight months of high single digit readings. Excluding petroleum, import prices rose 0.9 percent for a second straight month -- a troubling reading pointing to pass through of petroleum costs.

Unusually high prices for capital goods, up 0.3 percent in the month for a 2.1 percent year-on-year gain, also offer evidence of cost pass through, especially as actual imports of capital goods have been soft. Prices of food imports are also quite high, up 1.5 percent in the month and adding to a four-month string of similar gains. Year-on-year, food import prices are up 15.7 percent.

Three recent factors, however, suggest improvement in import prices hopefully not too far down the road – a drop in oil prices, a recent rise in the dollar which lowers the effective price of imports, and a flattening of economic growth in Europe – which is softening demand for commodities. The inflation news is very bad for now but recent events have put in motion a slowing of inflation pressures – the key question remaining is whether the easing will be enough.

Trade deficient shrinks on weaker U.S. demand and jump in exports

In the battle between previously spiking oil prices and slowing consumer and business demand for goods, weaker growth won out and led to an unexpected drop in the U.S. trade deficit in June. A boost in exports also played a big role. The overall U.S. trade gap fell to $56.8 billion from a revised $59.2 billion deficit in May. In June, exports jumped 4.0 percent while imports rose 1.8 percent.

Overall improvement in trade went against oil-price headwinds as the oil gap jumped to $36.4 billion in June from $32.8 billion in May. The big improvement was in the nonoil goods deficit which fell to $32.2 billion from $38.0 billion in May. The nonoil deficit improvement was due to a drop in both capital goods and consumer goods imports, indicating that both sectors are expecting a slowing in demand. Imports excluding petroleum fell 1.4 percent in the latest month. Strength in exports was widespread but led by capital goods.

Once again, the average price of imported oil set another record high, reaching $117.13 per barrel in June, up from $106.21 per barrel in May. But the high prices are cutting into demand for oil. June's number of barrels nudged back up a monthly 1.2 percent but was down 7.5 percent from year-ago levels.

The latest report shows exports continuing to support U.S. economic growth while consumers and businesses are adjusting to weaker economic growth in part by easing back on import growth. These trends are likely to continue although export growth is likely to slow somewhat as economic growth has flattened recently in Europe and softened in Asia. On a final note, the drop in the June trade deficit points toward an upward revision to second quarter GDP as does moderately strong June numbers for business inventories.

Industrial production continues rebound — for now

The manufacturing sector appears to have actually improved moderately over the last couple of months – but the good news may not last. Industrial production in July posted a modest gain, led largely by a sizable boost in motor vehicles. Manufacturing outside of autos was slightly positive on net. Overall industrial production advanced 0.2 percent in July, following a 0.4 percent gain in June. The manufacturing component jumped 0.4 percent, after edging up 0.1 percent in June. Utilities output fell 1.9 percent in July while mining output rose 0.9 percent.

Within manufacturing, gains were widespread but notable strength was in motor vehicles which increased 3.6 percent. Outside of auto, increases were more modest as manufacturing excluding motor vehicles rebounded 0.2 percent after a 0.2 percent dip in June. Market group data indicated that housing is still depressing certain industries with declines seen in appliances, furniture, and carpeting, among others. Consumer goods were up 0.3 percent in the latest month while business equipment posted a 0.8 percent boost. Business equipment was lifted by motor vehicles and aircraft.

Overall capacity utilization in July nudged up to 79.9 percent from 79.8 percent in June and compared to the market forecast for 79.8 percent for July.

Looking forward, there are signs that factory demand may slow. Consumer fundamentals are weak in the U.S. with unemployment rising, real earnings declining, credit remaining tight, and consumer confidence near record lows. The lift that U.S. manufacturers have been getting from exports is likely to ease due to recent gains in the dollar and due to weakening growth overseas. But these export factors have moderately long lags and the softening in export growth will likely be gradual.

Empire State manufacturing edges back into positive territory

For now, manufacturing appears to have stabilized in the New York State area. The Empire State index edged back into positive territory in August, rising to 2.8 from minus 4.9 in July. Key readings were mostly near the breakeven point of zero and showed little month-to-month change. However, unfilled orders were soft at minus 9.0 versus minus 8.4 in July. 

Price data remain elevated but did not worsen. The input prices index came in at 65.2 in August compared to 77.9 in July while the output prices index was unchanged at 32.6.

Inventory overhang starts to weigh on production and imports

Slowing consumer and business demand is starting to show up in a modest inventory bulge. Business inventories jumped 0.7 percent in June for the largest monthly rise since November, building on gains in April and May of 0.5 percent and 0.4 percent, respectively.

Curiously, the numbers will add to economic growth in the second quarter but likely detract from third quarter production. Though June inventories will raise GDP growth for the second quarter, much of the gain appears to be unwanted (unsold goods and supplies due to weaker demand). Manufacturers are likely to cut back on production somewhat until inventory falls back in line with demand. Importantly, not all of the inventory adjustment will fall on U.S. producers. A good chunk of the inventories were imported. Hence, U.S. retailers also will be cutting back on imports to help bring domestic inventories back in line.  Essentially, there is a mild inventory problem – but the moderate adjustment by manufacturers will be shared overseas to a notable degree.

The bottom line

There are clear signs that the economy is slowing. Consumer spending is sluggish now that income tax rebate checks have been spent, credit is still tight, and jobs are less secure. There is also the prospect that export growth will slow due to a weakening in growth abroad and due to a rebound in the dollar. The good news is that headline inflation will be coming down some due to a recent drop in oil prices. Still, energy costs – including for gasoline – remain elevated and companies are still trying to pass along costs. Core inflation may not ease as quickly as headline inflation. But overall, the economy is at a turning point  for slowing growth and somewhat easing inflation.

Looking Ahead: Week of August 18 through August 22 

This coming week, we only get two market moving indicators but the first is very important – housing starts on Tuesday. Fed officials and many economists say the economy will not strengthen until housing picks up so markets are giving starts extra prominence. But technicalities in the data mean markets must carefully pick apart this week’s report. The other market mover is the producer price index. Some see recent declines in oil prices as making the July PPI as outdated. But the core numbers will still be important. Also, leading indicators come out and the release could boost chatter about recession.

Tuesday

Housing starts in June posted an unexpected rebound, jumping 9.1 percent to an annualized 1.066 million unit pace and following a 2.7 percent decline in May. However, strength was lopsided – mainly in New York City and based on a one-time change in regulations. The June rebound was led by a 42.5 percent monthly surge in multifamily starts as single-family starts fell 5.3 percent. The surge in multifamily starts reflected the enactment of more restrictive building codes in New York City effective July 1, 2008 which created a rush to get permits before that date which in turn boosted starts. For July, there will almost certainly be a sizeable drop in multifamily and overall starts as starts in New York City fall back to probably even lower than pre-June levels (starts there probably were accelerated by more than one month). Markets should focus on the single-family component for now.

Housing starts Consensus Forecast for July 08: 0.950 million-unit rate

Range: 0.890 million to 1.065 million-unit rate

The producer price index accelerated dramatically in June at the headline level but remained moderate at the core level. The overall PPI inflation rate remained red hot in June with a 1.8 percent jump, following a 1.4 percent spike the month before. The core PPI rate, however, held steady at a 0.2 percent rise and fell short of market expectations for a 0.3 percent gain. The headline number was led by a monthly 6.0 percent surge in energy costs and a 1.5 percent gain in food prices. Within energy, gasoline spiked 9.0 percent for the month and is up 39.7 percent for the year. More recently, deceleration in the overall import price index (1.7 percent from 2.9 percent in June) suggests that the headline PPI will ease in July but still remain relatively strong. Also, the July CPI came out earlier than the PPI and this index was much stronger than expected with a headline 0.8 percent boost.

PPI Consensus Forecast for July 08, m/m: +0.5 percent

Range: +0.1 to +1.6 percent

PPI Consensus Forecast for July 08, y/y: +9.1 percent

Range: +8.8 to +9.6 percent

PPI ex food & energy Consensus Forecast for July 08, m/m: +0.2 percent

Range: +0.1 to +0.3 percent

PPI ex food & energy Consensus Forecast for July 08, y/y: +3.2 percent

Range: +3.1 to +3.3 percent

Thursday

Initial jobless claims are remaining very levels – due to a weakening job market and to a recent extension of unemployment benefits. Initial jobless claims fell back 10,000 in the week ending August 9, but to a still much higher-than-expected level of 450,000. Initial claims over the past two weeks have been at the highest levels since the beginning of the expansion.

Jobless Claims Consensus Forecast for 8/16/08: 448,000

Range: 430,000 to 458,000

The general business conditions component of the Philadelphia Fed's business outlook survey posted its eighth consecutive negative reading in July, coming in at minus 16.3 versus minus 17.1 in June. The new orders index pointed to further weakness overall for August as new orders remained notably negative at minus 12.1, compared to minus 12.4 in June. Prices in July were quite elevated with prices paid at 75.6 and prices received at 28.8.

Philadelphia Fed survey Consensus Forecast for August 08: -15.0

Range: -17.6 to -11.0

The Conference Board's index of leading indicators has been hovering near zero in recent months, pointing toward a flat economy.  The leading index slipped 0.1 percent in June, following a 0.2 percent decline in May and a 0.1 percent rise in April. Money supply, which is an iffy indicator clouded by measurement difficulties, was the biggest negative for June followed by two substantial categories – stock prices and unemployment claims. The big plus for the report was a jump in building permits that however was tied to a one-time change in the New York City building code. A third consecutive decline in July might be cause for increased recession worries although many economists have upwardly revised their estimates for second quarter GDP to 3 percent. Softness in the economy now appears to be more the concern for the third and fourth quarters.

Leading indicators Consensus Forecast for July 08: -0.2 percent

Range: -0.9 to +0.1 percent

Econoday Senior Writer Mark Pender contributed to this article.