US Corporations Feeling Their Oats

Other than some very positive news on the inflation front, last week's economic data were sparse. Initial unemployment claims were the only other major indicator last week, and the news there was mildly disappointing, though not terribly surprising, as I explain below.

On the corporate earnings front, soaring tech sector revenues, including earnings from Hewlett-Packard and Dell were indicative of a strong economy. Retail reports were more mixed, with Wal-Mart disappointing in the US (customers moving upscale?) and Target light on revenues overall. Home improvement stores Lowe's and Home Depot also reported nicely improving quarterly results, perhaps a precursor to an improving housing market. Morningstar's industrials team also came back from a major manufacturing conference with an array of bullish tales.

Market Now Under Morningstar's Fair Value Estimate
As I warned several weeks ago, the economy and the stock market can and often do move in opposite directions. In the article, I also indicated the market was 7% overvalued at the beginning of May. As of Thursday's close, the market had moved to 6% undervalued according to Morningstar's proprietary price-to-fair value calculation. Lower stock prices and higher analyst-generated fair values were responsible for the change.

Markets Worry That Greece Is the Next Subprime Issue; I Beg to Differ
News out of Europe and Greece continued to weigh on the market last week, though I still believe that this is not another cascading subprime mortgage debacle. Sure, individual countries and companies will get hurt, but I don't think this is going to blow up the entire financial system.

Debt in the problem European countries is not held in a myriad of different places, nor are there layers and layers of leveraged bets on that debt held by major institutions. I think the backdrop of a sharply improving world economy versus an economy that was just beginning to sink could also serve to limit some of the damage.

While US export sales may be a little slower due to Europe's problems, US interest rates are likely to stay low for longer and import prices could begin to decline. A stronger dollar and weaker commodity prices may also help the consumer. Major declines in the price of oil from the mid $80s to the low $70s per barrel should eventually surface, as lower prices at the pump mean more dollars in the pockets of US consumers.

Last week, our tech team indicated they had checked in with several major semiconductor producers, and thus far orders to Europe had been holding up quite well. That said, it would only take a few poor and ham-handed decisions (or even statements) by European policymakers to potentially upset the whole economic apple cart. For alternative views on this issue, see the recent video by my colleague, Pat Dorsey.

My other worry is that US consumers could panic from all the negative headlines, as they did in the autumn of 2008. Thus far, consumers have hung in there, though some of the weekly retail sales data points were down a touch last week after a few very strong months for the weekly metrics. I will continue to watch the weekly sales data closely, but ignore the consumer sentiment surveys that are probably about to turn ugly.

For now, most of the problems appear foreign and faraway from consumers, perhaps explaining the calm spending reaction thus far. Continuing weakness in the stock market could change that devil-may-care-attitude. At a minimum, the continued negative headlines from Europe combined with a weaker stock market are bound to move the consumer sentiment surveys negative in the weeks ahead. Just ignore those surveys and watch what the consumer actually does.

Inflation Tame for Now, Pockets of Price Increases Creeping into View
The inflation numbers (as reflected in both the consumer price index and the producer price index) were benign, at least for now, with consumer prices down 0.1% in April compared to March, and up only 2.2% from 12 months ago (and only up 0.9% when excluding food and energy--the smallest increase in 44 years).

Falling oil prices and stable houses were the key reasons behind the decline, though furniture and apparel also registered declines. Falling prices have the effect of giving consumers their own special payraise. With hourly wages more stagnant than I would like to see, the respite in monthly price increases, especially for gasoline, was music to my ears. With falling energy prices, the likely short-term collateral damage of the European crisis, and continued stability in rents and housing prices, the short-run outlook (next three to four months) for inflation appears very stable.

However, not everything is rosy here. Many categories showed significant increases, including consumer leisure related activities, health care, and many services provided by government entities. In an apparent attempt to recoup revenue losses, prices for many government-dominated services spiked in April. Public transportation prices were up 1.7%. Education, trash collection, and water fees were all up as well. Given the bind that local and state governments are in, this is a trend I expect to continue.

The leisure category increase, including airline ticket prices and hotel rooms, could indicate problems down the road for the rest of the economy. These are sectors that drastically altered their capacity during the downturn. Now, with demand modestly on the rise, airlines are finding themselves in the catbird seat relative to pricing. It is not unusual to find price increases of 20%-25% for airline seats this summer, compared to last year. When other industries that drastically cut capacity begin to experience demand increases, prices could easily shoot up faster than most economists are expecting.

News Out of a Major Manufacturing Conference Looks Strong
Our industrial team, including Eric Landry, Daniel Holland, and Anil Daka, attended the Electronic Products Group Conference last week and the news was uniformly bullish, as you can see by their summary:

"We attended the EPG conference down in Longboat Key this week and were not surprised to see virtually all of the senior-level leadership at the world's largest electrical product manufacturers swelling with confidence regarding current business conditions.

"Simply put these business leaders like what they're seeing so far in 2010. What's more, virtually all of the 22 presenting companies are probably now in their best shape, both from balance sheet and cost structure perspectives, than at any time in recent memory. This, of course, isn't news, but the conference was helpful in confirming that our thesis about a relatively strong worldwide industrial recovery is shared by the senior officers of many industrial companies.

"We heard many comments that business conditions have remained strong or even accelerated since March 2010, and none to the contrary. As one might expect, however, most of the positive attributes being discussed are largely baked in at this point (though getting less so as the market declines on fears over European sovereign credits).

"Last year much of the commentary and questions revolved around restructuring and plummeting end-market demand. This year, several puffy-chested presenters showcased the drivers behind recent impressive margin performance, high levels of cash generation, balance sheet strength, and plans for allocating the mountains of cash most now sit on. In most cases order books continue to expand as business conditions in the US and, more importantly, in the developing regions remains strong. Very few companies are counting on any growth out of Europe."

Initial Unemployment Claims Disappoint, But the Trend Is Not Unusual
The other bit of distressing news last week was that initial unemployment claims jumped by 25,000. At this stage of the game, most economists continue to look for strong improvement in this category. However, history tells a different story.

Once the percentage of unemployment claimants has fallen meaningfully, and six months to a year have passed since the peak in claims, this figure tends to stall out. In the recoveries following the recessions of 1990 and 2001, the initial claims figures stalled out for nearly two years before resuming their decline, with no meaningful negative effect on the overall economy.

Note the other periods of stabilisation in this graph, as indicated by the relatively wide blue vertical bars. Only in the recovery from the 1980 recession did the initial claims percentage figure move down in a straight line from peak to the old low.

Housing Data Dominates Next Week's Results, Homebuyer Credits Winding Down
This week brings data on existing home sales, Case Shiller home pricing data, and new home sales. The consensus for existing home sales is for 5.6 million units in April versus 5.35 million units in March, again up 5%. Given that pending sales (recognised at contract signing and usually leading actual sales by a month or two) were up 8.3% and 5.3% in February and March, respectively, I believe that the 5% existing home sales estimate might prove to be too low.

All of these months benefited from the homebuyers' credit. To get the credit, the final closing must occur by June 30, so we will see another few months of positive effects on existing home sales, though either April or May will probably represent the peak benefit.

Many economists are fearful about the expiration of the credit, but it really didn't seem to do that much good this time, compared to the first credit that was supposed to expire in November. During the time period of the first credit, sales peaked at 6.5 million units (annual run rate basis); this time 5.6 million units is the peak expectation.

Longer term, I suspect that existing home sales will stabilise in the 4.75 million to 5.5 million range. An improved jobs outlook combined with even lower mortgage rates may very well offset the effect of the expiring credit. At the worst of the recession, existing home sales bottomed at a 4.5 million annual rate in January 2009, after peaking at a 7 million rate for 2005, the peak year. Clearly, the credits didn't force existing home sales to a stratospheric unsustainable number, so the withdrawal effect should be minimal, except maybe for a month or two immediately following the expiration.

New home sales (where closing dates and sign dates are synonymous, as far as the statistic mills are concerned) will be an earlier indicator of the effect of an expiring credit. However, the new home sales data to be announced next week is for April, a month when the credit was still applicable, so the expectation is for new home sales to creep up from 411,000 units to 420,000 units. Given that the peak of new home sales in 2005 was 1.4 million units, and the bottom in 2009 was 329,000 units, the homebuyer credits were even less stimulating for new home sales than existing home sales.

On the pricing front, I surmise that the Case Shiller Home Price Index will show a small decrease in prices. However, the index is calculated as a three-month moving average of home prices for the period ending in March, making this a lagging indicator of reality. According to our housing analyst, Eric Landry, real-time listing price indicators have again turned positive, which should be reflected in the widely reported Case Shiller numbers in another two to four months. Still, I am not expecting a big move in housing prices, either way, this year.

Expectations High for Durable Goods Orders
On the manufacturing front, I am expecting a strong durable goods number this week, though the 1% consensus might be just a little optimistic. The ISM numbers indicate a good number, though some of the regional numbers have looked a little softer recently, tempering my optimism a bit.

Consumers Saving Again?
Personal income and spending numbers are also due at the end of the week. Unlike past months, I suspect that consumer spending is likely to come in at 0.2% but income is likely to show more robust growth of 0.4%. This conclusion is based on slower growth in retail sales reports and declining auto sales (after a big incentives-driven March) on the spending side.

Incomes should look higher with a higher hours-worked figure, higher wage rates, and more employment all moving in the right direction. My guess is that dividend income may also start moving in the right direction again in the near future. Combined, the numbers suggest to me that the savings rate will move up for the first time in several months.

The first revision of the GDP forecast for the first quarter is also due. I am pencilling in a new GDP estimate of 3.4%, versus the 3.2% initial estimate. Higher retail sales and exports should help, though construction spending shortfalls will suppress some of the improvement.