Spring Weather


“April is the cruellest month…mixing memory and desire.” – T.S. Eliot, The Wasteland

by M. Kevin Flynn, CFA

In the end, all the talk about the economy reaching “escape velocity” has turned out to be just another case of Wall Street hype, fortified by a low-volume, four-month moonshine rally in the stock market. But there is a silver lining to all of this, namely that the milder rate of acceleration in the first quarter of 2012 means that there is a good chance there will be a milder slowdown in the second and third quarters.

Last year saw an inventory accumulation episode come to a more abrupt end than it might have otherwise experienced when the Japanese tsunami hit and severely disrupted the global supply chain, not to mention life and death in Japan. A slowdown was due anyway as inventory levels refilled, but the supply chain shock made the data dip below trend and incited fears of a double-dip recession.

This year, we are due for another slowdown from the fourth- and first-quarter inventory accumulation, but we aren’t dealing with the tsunami this time. The European problems are still there, and China is slowing, so there is as yet risk to the global economy and from the attendant headlines, but while a slowing China will probably prove to be of more import to the economy than the tsunami, it should hopefully unfold more slowly and give us more time to adjust.

A period of overreaction to the let-down from last quarter’s hype is likely in store, but the flip side is that the downturn will probably be milder. We are being set up a little too pat for a repeat of the last two years, in particular 2011, so there is a chance that we could escape with less damage to the markets.

We have to emphasize that the chance is very much based upon the “other things being equal” escape clause of every economic outlook, and things could very well not turn out to be equal. It’s difficult to predict what will happen in Europe, as so much depends on policy decisions being made during one of the most sensitive times in Europe in decades. The German bloc is pretty set on its Austrian-economics approach of simply waiting out the bad times, and the view has borrowed additional impetus from the lack of enthusiasm in the stronger countries for using taxpayer money on the weaker ones.

The IMF has a more Keynesian pro-growth approach, especially with Christiane Lagarde at the head, but it can only use the carrot-and-stick approach with its money, as it has no direct political authority. That leaves the European Central Bank, or ECB, and Mario Draghi in the pivot seat. Longer term, Mr. Draghi is quite correct in saying that the ECB can’t solve all of the Union’s problems, but markets being what they are, they are much more focused on what the bank might try in the short term.

There is still a lot of bad debt that needs to be written down in Europe. The housing boom-and-bust that nearly ruined Ireland had its counterpart in Spain, with the difference being that many of the bad loans are still held at fictitious values, either because they are in private banks, or because foreign banks are not anxious to disclose the extent of the weakness. The latest nudges at Deutsche Bank (DB) to raise capital are part of the main European approach to the problem, namely to hope that everyone look the other way long enough that they can get rid of the bad stuff in small enough pieces that it won’t scare anyone, and maybe some of the real estate markets will even start to recover a little bit.

One can’t be sure about such matters, but it doesn’t look as if the markets are going to give that kind of time. Not without more ECB intervention, and therein lies the rub. The level of quarreling seems to have gone up overseas, and it isn’t clear how big of a bat Mr. Draghi can or will swing.

We wrote last year that the real Lehman moment for Europe would be Spain, and that still looks like a good possibility. The parallel is worth considering. Bad debts and nervous lenders are obvious enough, yet Spain is a sovereign nation, an important difference. The similarity worth thinking about is the policy one. The Bear Stearns rescue was followed by months of grumbling about bailing out rich bankers and government intervention in the marketplace. As a result, when Lehman couldn’t borrow in the overnight markets anymore, the government decided to look the other way and send a message.

The Greek bailout wasn’t really all that large, but it engendered a great deal of grumbling and Union tension. The stock market rally in Europe that followed has not only added a good deal of complacency to the mix at the policy level, it has probably cost the financial markets additional credibility in the eyes of voters.

With Portugal in line, Spain might not get help because Greece did and the problem didn’t go away. Now austerity programs are under attack in France, the Czech republic and perhaps most importantly, the Netherlands, which have been a stalwart ally of the German approach. The fault lines are spreading, and while bankruptcy isn’t really in the cards for Spain, nobody can really say whether or not the EU will be able to hold everything together under the pressure.

Europe has the resources. Its recent passing of the hat for global capital sums up the problem, however: nobody wants to pay for anyone else, and there is no federal government to impose a solution across all actors. Political chances for the best solution, writing down the debts with an all-hands-together recapitalization, were never favored and seem to be fading.

Yet the timing and nature of the eventual policy decisions remain uncertain. So does the eventual clearing of the Chinese property bubble. One thing stock markets like to do is rally on the deferral of crises, even if it’s given back later; today’s worries can easily turn into next week’s rally. If Europe simply stumbles along a bit longer, or the ECB takes another dramatic stab at stealth recapitalization with another LTRO variant, then equities will probably benefit, at least for a time. The focus should swing back to the U.S. in the coming week.

A likely timeline might be a bit of seasonal rally followed by a moderate correction, and then another rally leg up when fears of an exaggerated slowdown don’t materialize. We can’t see, however, the U.S. economy forever sidestepping both a deepening recession to the East and an increasing growth slowdown to the West. It’s just too much to ask.

The Economic Beat

We present the following evidence about the industrial side of the economy:

Industrial Production manufacturing
        Jan   Feb   Mar
2011 0.4% 0.2% 0.6%
2012 1.1% 0.8% -0.2%

ISM Manufacturing Survey
2011 59.9 59.8 59.7
2012 54.1 52.4 53.4
ISM Non-manufacturing Survey
2011 58.3 59.0 56.3
2012 56.8 57.3 56.0
Philadelphia Business Outlook
2011 29.8 39.2 15.1
2012 10.2 12.5 8.5

We used the manufacturing indices rather than the total number from the national industrial production report in order to exclude the effects of utility and mining production, which are lumpy and weather-influenced.

What the data show is a more tempered rate of improvement than the first quarter of 2011, as well as some softening from the early part of the year. All three industrial reports last week – industrial production, the NY Fed survey and the Philadelphia survey – fell well short of consensus.

The most important reason, we would say, is that the mild lift from the warm weather has passed and we are returning to the underlying rhythm. This is not quite the same as saying the rate of recovery has leveled off – that probably happened in 2011. It hasn’t been the most robust of rebounds, in good measure due to its credit-constrained nature. We also have a much smaller manufacturing sector than we once had: goods production is highly cyclical and bounces harder. However, S&P 500 companies are hiring outside the US at three times the rate they are hiring domestically.

The housing data last week missed on all three reports. The homebuilder sentiment index took a pretty sizable dip, housing starts fell instead of rising, and so did existing home sales. They are both still up year-on-year, but it wouldn’t be unreasonable to attribute those modest increases to the weather as well. Guesses and chatter about a bottom in housing are seemingly endless, but the market is slowly clearing and appears to be healing. Even so, a shock – from Europe, for example – could still set it back. Even without one, given the onerous credit conditions, shadow inventory and reluctance of sellers to accept depressed prices, it’s difficult to make a case for more than an agonizingly slow recovery.

Weekly claims moved up again, along with another good-sized revision to the week before. For us, it’s further evidence not of a slowdown, but that the warm weather wiggled the underlying trend into appearing better than it really was. The employment market looks like housing to us: the recovery will go on, but at a maddeningly slow rate.

Retail sales for March looked nice with an overall monthly gain of +0.8%, but that will probably come down as vehicle sales are recalculated. Sales excluding gas, autos and building materials – the so-called core rate – rose 0.5%, and that is about average for an Easter month. April sales are set to look slower, going by the weekly data.

Next week has three big events. There are other reports, including Case-Shiller home price data, new home sales and consumer confidence on Tuesday, durable goods on Wednesday and pending home sales on Thursday. But the markets will be focused on Apple (AAPL) earnings on Tuesday, the FOMC statement on Wednesday, and the initial estimate of first-quarter GDP on Friday. They matter much more than the others.

The Fed isn’t expected to do anything different on Wednesday, but the statement wording will be scoured for clues about the prospects for more quantitative easing. As for GDP, the consensus we are looking at today – 2.5% annualized for the first quarter – looks much too high for us. People are being lazy about the 3.0% fourth-quarter print and factoring in a slowdown of half of a percent, but it’s a bogus print. Annual inflation is running between 2.5% and 3.0% by every measure but the fourth-quarter GDP report, which had it running at 0.8% annually. If growth slowed by a half-percent and the deflator returns to a more normalized rate (it averaged 2.6% in the prior three quarters), say 2.2%, markets are likely to get a nasty surprise.

The earnings parade continues next week. Notables include United Technology (UTX) on Tuesday, Caterpillar (CAT) and Boeing (BA) on Wednesday, Amazon (AMZN) on Thursday, and Chevron (CVX), Ford (F), and Proctor & Gamble (PG) on Friday.

The stock of the last year, Apple, has seen considerable selling pressure in the last ten trading days. Since making a high of 644 on the morning of April 10th, which translated into a doubling off its 52-week low last June, the price has fallen by over ten percent, dragging most of its suppliers and even the Nasdaq composite down with it. That is unusual behavior for the stock, which typically rises into earnings and then sells off afterward. However, nor has it had a habit of doubling in only ten months.

In recent years, when the stock has gone into an earnings report under pressure – which hasn’t happened often – it’s had a rebound afterwards. Should that form hold next week, it would make the April rally for the stock market. If it doesn’t, a flight to defensive big-cap stocks seems likely.

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