Last week corporate earnings news overwhelmed the few economic indicators that were released in the US. I was relieved that markets largely ignored the big weekly jump in initial unemployment claims that were the result of an artificially depressed number the previous week week. Housing data last week, while down, looked better than I feared and failed to have much impact on the market.
After the previous week's disappointing earnings reports, last week's strong results from the manufacturing sector powered the market ahead dramatically on Thursday. While manufacturing results were generally robust across all geographies, heavy-duty results in developing markets were clearly an important driver of strong news out of the manufacturing sector. Outstanding earnings, combined with powerful forward-looking statements from many manufacturers, helped allay market concerns over other manufacturing indicators--including the ISM manufacturing indicators--that had begun to show some softness.
Apple's earnings report also showed the powerful force of consumer electronics in moving the economy forward during this recovery. I think earnings will continue to drive the market this week, along with continued reactions to the European bank stress tests. At the end of the week, the first reading on US second-quarter GDP has some potential to move the market. A lot of the forecasts for the quarter are in the 2% range, but I believe the results will show closer to 3% growth driven by business spending and less negative effects from the residential housing market.
Believe the Companies or the Indicators?
Whether to rely on company comments and data or the more objective economic indicators has always been one of the real tricks of economic forecasting. Though a lot of the indicators, especially in manufacturing, have slowed some, comments from manufacturers sounded very positive. Caterpillar's results were particularly impressive, with sales up 31% and earnings per share up 82% for the June quarter. Far more remarkable than the results were the forward-looking comments from corporate executives. "While there are significant economic concerns around the world that we are watching closely, orders have continued to outpace our shipments, and we expect to increase production in the second half of the year," remarked Caterpillar CEO Doug Oberhelman.
Results out of 3M and transportation specialist UPS are also indicative of the potential for an improving manufacturing environment in the second half. I've always believed that a stronger manufacturing environment will eventually seep into other sectors and drive the economy forward.
Earnings Growth Stronger than Revenue Growth Again; Forward-Looking Statements Look up in Manufacturing
While it is always difficult to make sweeping statements about earnings season, especially this early, I think a few trends are evident. As has been the case for many quarters, revenue growth outside of a few sectors remains relatively anemic while earnings continue to power ahead at a robust rate. Revenue growth at many large companies is centering in the 5%-10% range, while earnings growth is often exceeding 20%. Normal operating leverage explains some of this divergence, but corporate efficiency and parsimony are also playing a role.
Higher spending on high-tech equipment this quarter and statements from some CEOs that they plan to step up employment in the second half indicate that maybe some corporations are beginning to let loose. It seems to me that while all eyes have been on the consumer this year, it may be corporate spending that ultimately pulls us out of our morass.
Strong Dollar and Divestitures Depress Revenues
Upside revenue surprises this quarter are running numerically ahead of normal. Unfortunately, some of the negative surprises have come from fairly high-profile companies like IBM and many of the banks. In the case of nonfinancial corporations, a stronger dollar means that each overseas sale translates into fewer sales in US dollars. This is the first quarter where the dollar has begun to hurt more than it has helped. Another key trend is that a lot of businesses have disposed of some of their weaker performers. While this is good for a corporation over the long term, it hurts short-term revenue. IBM disposed of one of its software businesses that hurt its revenue comparison. In the case of banks, strong trading operations and fewer write-downs masked anaemic loan growth in previous quarters. This quarter, trading profits slowed dramatically, even at Goldman Sachs, exposing poor lending growth for all to see. Ultimately, loan growth has to resume, or else bank earnings won't make much forward progress.
Consumer Electronics, the Surprising Bright Spot, Bumps Up Imports
The other big trend out of the quarterly results is that consumer electronics of all sorts continue to be the one item consumers are willing to splurge on. Apple's results last week were stunning, driven not only by remarkable sales of the iPhone and the iPad, but also pricey Mac computers. From an economic standpoint, the one issue with electronic sales driving consumer spending is that more of those dollars have to be shared with overseas vendors. That sharing detracts from GDP growth (and is one of the reasons that GDP growth estimates for the second quarter have been marked down). In a more typical housing- or auto-driven recovery, more of the revenues are generally retained in the US.
Overseas Strength Drives Earnings, but US Picks Up the Pace
Overseas sales are also a continuing contributor to growth in corporate revenue and earnings. Caterpillar in particular pointed to strong sales in developing markets, although US sales also improved. Even Coca-Cola, who has continually whined about poor North American beverage sales (as overseas sales trudged upward), indicated some improvement in the North American situation this quarter.
Initial Unemployment Claims Jump as Expected; No Cause for Alarm
As expected, initial unemployment claims soared by 37,000 to 464,000 last week because holiday-related delays and changes in the automakers' summer shutdowns artificially depressed initial claims numbers in the previous week. The more meaningful four-week moving average remained mired in the mid-400s as it has for most of the year. Continued mergers and acquisitions, continued tightening in the financial sector, and a cost-conscious drug industry could continue to weigh on the layoff figures for some time. In the near term, improving overall employment will most likely have to come from more hiring, with limited help from falling layoffs.
Mixed Housing Data Having Little Effect on the Market
Housing starts data and existing home sales didn't shed a lot of light on the state of the housing market. Housing starts, at 549,000 seasonally adjusted annual units, were below the consensus forecast of 575,000 for this notoriously hard to forecast metric. I had feared that the number would come in substantially worse. The silver lining was that building permits, which generally lead starts, managed to eke out a small gain that might show up in future months.
Existing home sales came in better than expected at 5.4 million homes (seasonally adjusted annual rate) versus expectations of 5.2 million units and 5.7 million units the prior month. Given the expiration of the housing credit in April (many closings resulting from that credit-induced surge occurred in May and June and even later), I suspect this number will trend down for another month or two before stabilising in the 5 million unit range that was more typical of the pre-credit era. It is pretty clear from the data that the housing sector has gotten so small that it can't inflict much more damage on the broader economy. However, it's equally apparent that it isn't going to lead us out of the recession in the short run.
I Forecast Second-Quarter GDP Growth in the 2%-3% Range
The GDP report this week is the most important economic indicator. There is some controversy as to whether the real growth number for the quarter will be as low as 2% or as high as 3% (following 5.7% growth in the fourth quarter 2009 and 2.7% growth in the first quarter of 2010). While a lot of the currently available data that go into the report indicate the lower end of the range, harder-to-forecast business spending, inventories, and exports could help surprise on the upside. Either way, it doesn't look like we're going to get that sharper V-shaped recovery I was hoping for. However, I think a slower recovery may actually prove to be more durable. Slower growth means more controlled inflation and a more efficient allocation of resources. Given that I believe long-term demand, especially in the housing and auto sectors, remains unchanged, slower growth now just means more growth is left for future quarters.
