By James Picerno        Jun 16, 2010

The markets told us that there were problems in May, and as the economic data rolls in there’s no reason to think otherwise. Today’s numbers on housing starts and new building permits certainly suggest that the economic recovery struggled last month. The question is whether the change is temporary, or the sign of more trouble ahead?

At the very least, it’s clear that the housing market hit a speed bump in May. New housing starts dropped 10% in May on a seasonally adjusted annualized basis, the government reported this morning. Building permits also fell last month by nearly 6%. The year-over-year trend is still positive, but the pace of expansion has slowed considerably in both cases. Another month or two of setbacks and housing starts and permits could be posting declines vs. the year-earlier figures. If that happens (and it’s not obvious that it will), the dip into negative territory on an annual basis would be a disturbing sign for the forces of expansion.

Adding to the anxiety in the numbers du jour is today’s update on wholesale prices, which dropped in May—the second straight monthly decline and the third so far this year. Deflationary winds generally appear to be blowing harder these days, if only marginally, as we’ve been discussing (see here and here, for instance). Today’s producer price report won’t soothe those concerns.

“We’re still in disinflationary territory and probably will be for a while,” Julia Coronado, a senior economist at BNP Paribas in New York, told Bloomberg News ahead of today’s reports. “If anything, the Fed is going to be erring on the side of more easing rather than tightening.”

To be fair, the weakness in housing last month was to some extent expected, considering that the federal subsidy for new home buyers recently expired. And if we look at core wholesale prices (excluding food and energy), producer prices actually rose 0.2% last month. In addition, wholesale prices overall on a 12-month basis remain firmly higher, advancing more than 5% for the year through May. In addition, the Federal Reserve reported this morning that industrial production rose by 1.2% last month–the strongest monthly gain since last August. Even better, the cyclically sensitive durable goods sector was a key reason for the growth. May had its problems, but it was far from a complete wash-out.

And if we focus on the longer-term trend, it’s still clear that upside momentum has the upper hand. The broader year-over-year trends, in fact, are superior gauges of economic activity. Monthly numbers, by contrast, are subject to any number of one-time events and statistical noise. Looking at the annual pace minimizes such distractions. On that basis, housing and wholesale prices are still in recovery mode. Ditto for industrial production, which rose by nearly 8% for the year through May.

Even so, the warning signs last month are unmistakable, particulary for housing. There’s no doubt that the economic recovery had a rough time in May. We should prepared for additional confirmation as the remaining economic reports for last month arrive. This news is already factored into market prices, as suggested by last month’s sharp drop in the broad indices for the major asset classes. The greater challenge is deciding if May was a blip, or the start of something more ominous.

No one should discount the possibility that the economic recovery faces stronger headwinds. But based on a broad review of the economic reports, including our broad economic index published and analyzed in The Beta Investment Report, we still think economic growth will prevail. Expansionary momentum is slowing, but that’s not surprising. The powerful rebound of last year was destined to slow.

The bigger problem is that the growth looks set to remain subpar for an extended period. The low-grade pace of expansion ultimately threatens another round of economic contraction, although that risk looks minimal for the rest of this year.

Nonetheless, the great hazard that we’ve been talking about since last year is upon us. The post-snapback period in the economy is history, replaced by the harder work of keeping the rebound in positive territory. The numbers in May remind that the task ahead isn’t going to be easy. Indeed, there’s chatter bubbling that the Fed will soon pare its economic growth forecast for the U.S.

http://wallstreetpit.com/31986-sharp-drop-in-housing-starts-and-building-permits