Economy Stronger Than Headlines Suggest

Robert Johnson Morningstar April 25, 2011

Outside of some relatively unimportant housing data and continued downward adjustments to first-quarter real GDP growth forecasts, the market's main focus this week was on corporate earnings, which were generally positive and well received by the markets.

Housing Starts Improve, Prices Under PressureHousing starts showed some improvement, and the prior month's numbers were restated upward, but there is nothing to get too excited about just yet. Eric Landry, our housing analyst, summed up the news on housing starts and permits as follows:

Existing Home Sales Improve--Don't Expect Much More ImprovementThe market cheered this week as existing home sales managed a 3.7% increase to 5.1 million units. To put that number in some context, the average monthly number since 1998 has been about 5.6 million units. During the best of boom times (2005), the annualized rate of existing home sales got as high as 7.4 million units. Outside the couple of odd months near the expiration of the two housing credits, the lowest sales rate was about 4.5 million units. I don't think that we will ever get back to the 7.4 million unit level; the 5.6 million level might represent the "new normal." Shrinking household sizes and a flood of new homes certainly helped inflate these statistics in the mid-2000s (people had to sell existing homes to move into new homes).

Sometimes lost in all the monthly data grazing is that existing home sales were up 14% in the December quarter (compared to the September quarter) and 8.3% in the March quarter. That could explain some of the better furniture sales numbers that we have seen lately.

Also, even at today's slow sales rate, inventories of houses on the market have shrunk from more than 12 months of supply to a more manageable 8.4 months of supply. This compares to a 50-year average of about 6.4 months of supply. While foreclosures or owners in severe delinquency could add to that supply, people who currently live in those homes will still have to live somewhere. They will either be converted from an owner to a renter or physically move to a different housing or rental unit. Unless all those people move in with relatives, they shouldn't add greatly to new supply in my opinion.

As a reminder, existing home sales don't enter directly into the calculation of GDP any more than the sale of an individual stock or bond does. None of these items represents new production, just the transfer of an already produced asset. However, real estate commissions and indirect purchases like furniture do add to GDP calculation.

Home Prices Continue to Torture Investors with Small but Persistent DeclinesIn other housing news, home prices continued their slow grind downward based on a federal government report that showed home prices down 1.6% from January to February. Because the numbers came on a slow day before a holiday and because most investors prefer the Case-Shiller prices indexes, the decline didn't seem to have much impact on the market. Small declines that clear markets and reflect the reality of higher mortgage rates are tolerable--large declines that destroy consumer confidence and bank balance sheets, not so much. I believe we could hit that pain threshold if home prices decline much more than another 5%-10% from here.

Earnings and First-Quarter GDP Reports Drive the News Flow Next WeekNext week I expect investors to continue focusing on earnings, but next week's GDP report is likely to draw attention, too. Forecasts have dropped from as much as 4.0% growth to a range of 1%-2%. One source I read this week even indicated that we might see a down GDP report for the first quarter. This compares to a more robust 3.1% growth rate in the December quarter.

Mathematically, based on data for just the first two months of 2011, it is really hard to argue for growth of much more than 1.5%. Consumer spending, which was up at an annual rate of 2.5% for the first two months of the year, is likely to slow further in the March quarter based on moderate nominal retail sales growth that was almost entirely eroded away by inflation in March. Low inflation-adjusted consumer spending growth for the month could bring consumer spending down below the 2% level for the first quarter. Given that consumption is 70% of GDP, it would be hard for the economy to do much better than that. That full-quarter GDP growth rate is likely to be brought down by net exports that declined during the first two months of the quarter as well as residential building that slipped a bit in the first quarter. Business investment spending could be a small plus for the quarter, while inventory adjustment remains a huge unknown. I will say the trend has been that poor net exports generally lead to an additive adjustment for inventory. I wouldn't count on government to save the day, as state and local governments continue to make cuts.

The Economy Is Stronger Than the Headline Forecast SuggestsAll of that said, I am not any more worried about the economy than I was a month or two ago. While there are many things to be concerned about--especially inflation--I don't really think the first quarter was weak compared with the fourth, as the GDP forecasts suggest. I suspect, however, that next week's GDP headlines won't be nearly as conciliatory. I have picked out some key statistics that suggest to me the economy is not nearly as weak as the 1.5% potential growth rate would suggest.

A combination of a strong start to the fourth quarter and a weak start to the first quarter may explain part of the issue. A quarter that starts off on a down note, as it did in January, makes it hard to have a decent quarterly number even if the remaining two months of the quarter were "normal." Certainly accelerating inflation also wrecked havoc on the numerical calculations. Higher employment, production, and manufacturing statistics (that are generally based on units not dollars) cited above seem to indicate a strong if not accelerating economy. However, the normal GDP calculation that subtracts inflation from the growth in nominal dollars might not have captured all the real growth in the economy during the first quarter. How could the economy show almost no real growth if stingy U.S. employers added 478,000 jobs in the quarter? Just as the economy was probably weaker than portrayed by the official government statistics mills in early 2009, I suspect the "real" economy is doing better than what will be captured in next week's GDP report. A relatively strong quarterly earnings season would also seem to support my view that the economy is doing better than current first-quarter forecasts suggest.

The tech sector was particularly strong, as both Apple and Intel displayPTip('INTC', 'INTC','YTD', '', '', '', '', '', '','msg','P'); reported shockingly good results. The Intel results were particularly meaningful (and embarrassing), as many analysts and data services had sharply cut their PC shipment forecasts drastically just last week. Strength in emerging markets (that can't be easily estimated) and inventory restocking (from levels that were unsustainably low after a brisk holiday shopping season) help explain the disconnect between Intel's surprisingly strong results and analysts' much more dour forecasts. Intel is standing by its forecast of double-digit PC shipments for all of 2011.

Non-U.S. Operations Aiding Corporate Earnings Reports in a Big WayIn fact, Intel is the poster child for companies reporting surprisingly strong earnings results, even in the wake of a U.S. economy that "appears" to be weakening. In this week's video, I discuss why corporate earnings are doing better than the U.S. economy. Strong developing-market economies are part of the answer to that question. Unfortunately, some of those goods sold in emerging markets by U.S. companies are also produced overseas. That means that developing-markets sales don't necessarily translate into strong U.S. export statistics or boost U.S. employment. This week, the Wall Street Journal ran articles (click here and here) that suggested U.S. corporations have been ramping up both their employment and capital investments outside the U.S. for some time.

Industrial Results Continue to SoarBesides robust tech earnings, results at manufacturers were also surprisingly strong. Organic growth (versus acquisition-driven growth), strong auto-related data, and capital goods used in other factories looked particularly strong. Strong emerging-markets sales certainly helped manufacturers as well. Another surprise was that companies that have units servicing the commercial construction industry also began showing signs of life (think United Technologies' displayPTip('UTX', 'UTX','YTD', '', '', '', '', '', '','msg','P'); Otis Elevator and Carrier Air Conditioning units).

The strong earnings results seem to be indicating that the various purchasing manager surveys including the national one from the ISM (which have been uniformly strong since this fall) were better indicators of the industrial activity than the government's new orders reports (which have been lackluster at best). Last week's Empire State report pointed to continued manufacturing improvement, while this week's Philly Fed report showed some early signs of softening. Typically, Empire State has proved to be a more effective predictor than the Philly Fed, but the Philly Fed report is one of the few caution signs I have seen from the purchasing managers' series of reports since last fall.

Banks Lower Bad Debt Reserves, Drive Earnings Even as Loan Growth StagnatesThe other big industry reporting early was the banking sector. The news there was less than exciting, and investors generally reacted by taking stock prices down. Earnings overall did improve, in some cases substantially. However, almost all of that improvement came from reduction in both real loan losses and loan-loss reserves. New loan growth at many firms, including J.P. Morgan Chase displayPTip('JPM', 'JPM','YTD', '', '', '', '', '', '','msg','P');, was almost nonexistent. Overall, Chase revenue declined 9% even as profits rose a stunning 67%.

Health-Care Earnings Exceed Modest ExpectationsMarket participants weren't excited about health care going into earnings season with exceptionally limited expectations of growth. While growth reports were still in the low single digits, those results were better than forecasts. Some of the stocks, especially industry mammoth Johnson & Johnson displayPTip('JNJ', 'JNJ','YTD', '', '', '', '', '', '','msg','P');, reacted positively to the slightly better than expected news. Outlook commentaries sounded just a bit more optimistic as well. Health care is one of those sectors that could show better results as employment (and therefore insurance coverage) continues to show improvement.

Commodity Price Inflation at McDonald's Bodes Poorly for Other Consumer StocksThough we haven't heard much from consumer-oriented firms, the news out of McDonald's displayPTip('MCD', 'MCD','YTD', '', '', '', '', '', '','msg','P'); Thursday was mixed. While revenue increases were decent across a wide range of geographies, the stock fell 1.9% as margin expansion was lower than expected. Rising commodity prices were apparently the culprit here. Exceptionally modest margin improvement in the face of better revenue growth doesn't bode well for other, less well-positioned consumer companies during the remainder of this earnings season. Given that tech and manufacturing companies are doing exceptionally well and tend to be early reporters in the quarterly earnings cycle, the news from here on out might not be quite as robust.

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