September Durable Goods Orders, Existing Home Sales, August Home Prices and Investment Tax Cut Commentary

KEY DATA: Durables: +2.2%; Excluding Aircraft: +0.9%; Capital Spending: +0.7%/ New Home Sales: +18.9%/ Home Prices: +0.7%; Over-Year: 6.6%

IN A NUTSHELL: “The expected September hurricane driven slowdown doesn’t appear to have occurred.”

WHAT IT MEANS: Normally, after a major catastrophe such as hurricanes, the economy slows. But soon afterward, as rebuilding begins, activity accelerates. Well, we may not have gotten that much of a softening in growth from the disasters. First of all, durable goods orders were up sharply in September. That was not a major surprise as demand had been solid and the impacts from the hurricanes were localized. While we did get a huge bump from aircraft orders, even excluding that sector, orders were still robust. There were increases in demand for communications equipment, fabricated metals and a modest rise in motor vehicles. But most importantly, the best measure of business capital spending, nondefense, nonaircraft orders, rose sharply. Over the year, business investment orders are up a very solid 3.8%. Backlogs increased again, another sign that economic conditions are improving.

If the strong durable goods numbers were not enough, we also saw today that the housing market is coming back with a vengeance. New home sales skyrocketed in September and it wasn’t just a huge rebound in the hurricane-battered South. Sales were up in every region and the percentage rise in the Northeast (33%) was even greater than in the South (26%). Before we get too bulled up about the housing market, we need to recognize that outsized gains are usually signs of special factors. So don’t be surprised if there is a pull back in October.

Housing prices continued their inexorable trek upwards in August. The Federal Housing Finance Agency’s index surged over the month and is up quite strongly over the year. Regionally, the increases range from a low of 5% in the MidAtlantic area to 9.5% in the Pacific region. The rise in home prices has been slowly but steadily accelerating for three years now. While we aren’t near the double-digit pace posted in 2005, we are betting closer to nosebleed levels that raise concerns about affordability.

MARKETS AND FED POLICY IMPLICATIONS: Today’s data point to a solid third quarter GDP growth pace. It may not match the 3.1% posted in the second quarter, but it should be pretty good. But the real eye-opener was the private sector capital spending. It has been picking up rapidly and the increase over the year is accelerating. It looks like business investment on durable goods will be up this year by between 4% and as much as 5%, if the gains continue.

Commentary: The rising pace of private capital spending raises a major question: Do we really need tax cuts targeted to increase investment? If companies are already investing more without any certainty they will get a tax cut, why would one be needed? Economic activity, not tax policy, is driving capital spending and that is the way it should, especially since tax incentives for capital spending are incredibly inefficient and massively expensive. They reward businesses for doing what they would have done anyway given all firms that invest get the break, not just those incented to spend more.

Consider this example. Nonresidential investment will likely total about $2.5 trillion this year, in nominal dollars. Let’s assume there was going to be no increase next year but the tax changes cause investment to rise by a huge 10%, to $2.75 trillion. That’s great, so what’s the problem? The first $2.5 trillion in investment would have occurred anyway, yet those firms still receive a tax cut. That is, 91% of the tax break goes to firms that have done nothing different than they would have without the tax change! And I used a pretty large impact from the tax cuts. If it is smaller, which is likely to be the case, the percentage is even higher. A five percent increase would put the percentage at 95%. Depending on the size of the tax break, the government might actually be paying for most if not the entire rise in capital spending. To me, that makes absolutely no economic or fiscal sense. It is just a tax giveaway. With businesses already indicating by their actions that they are willing to spend more on capital goods, do we really need an investment tax cut? Comments welcomed.