Hard Sell


“It was one of those March days when the sun shines hot and the wind blows cold.” – Charles Dickens, Great Expectations

by M. Kevin Flynn, CFA

Last week we listened to Safeway’s (SWY) CEO assure analysts, on a call, that promotional activity was “highly rational.” We’ll say this – it’s a cinch he wasn’t talking about Wall Street. The wind blows pretty hot there.

We saw some remarkable things on Thursday, the first day of March. No, not that stocks went up, it’s practically written into exchange by-laws that stocks go up the first day of the month. But there was a remarkable segment on a business news channel bragging about the improving manufacturing outlook in Europe and China. What? The European PMI announced that morning was a contracting 49.0. Germany, France and the UK, said the newsreaders, were improving. Germany has been 50.1 and 50.2 the last two months, which any survey maven could tell you means, “unchanged.” The UK measure fell from 52 to 51. The French data looked unchanged to us as well.

The European recession is deepening – unemployment fell to 10.7% in January. Spain revised their GDP outlook for 2012 just a tad – from +2.3% to (-1.7%). What were these TV folks trying to sell, and why?

The official Chinese PMI – which is not taken very seriously – is hanging in at about 51, but the private measures have been consistently around 49 (slight contraction). The services PMI was reported over the weekend to have dropped to 48.4 – and promptly blamed on the Chinese New Year. China announced it was cutting its GDP forecast to 7.5% (also the fault of the New Year, no doubt).

At the other end of the scale, U.S. chain-store sales were being reported as above expectations – even the Gap (GPS) reported an increase – but none of the retailers wanted to lift guidance. Clearly they’re worried that the weather has created an illusion. Strategists are proposing that the warm weather will lift the February jobs report, and that the Fed will have to start raising rates in the second half of this year. Now that’s a weather illusion.

As for the non-default Greek default announced Thursday, don’t even get us started. There’s a good chance it won’t survive.

We also read on the 1st that the January-February start for equities was the best since 1995, when stocks rose 38%. A promising omen, we were told. Well, let’s see. In 1995, interest rates fell, rather than rising as expected. Long-term bonds roared, rising by 30%. We’re going to go out on a limb here and guess that interest rates won’t fall this year. The unemployment rate in 1995 fell to around 5.5%. Yes, we’ll stay on the limb with that one too. Perhaps most importantly, corporate profit growth accelerated to a 19% rate in that halcyon year, while such growth is on course to shrink to a 7-8% rate this year.

However, there is one similarity for the rosy-eyed to dream upon: Europe and Japan were out of fashion in 1995, with the former struggling with austerity and the latter in semi-recessionary conditions. Ergo, the U.S. is the logical alternative again for investors. That may happen, and it’s certainly an opinion in wide circulation. But the European market is up even more so far, despite economic data pointing towards deepening recession.

What the latter suggests is that the rally in both places is due to two factors: momentum, and the non-exit of Greece from the Euro. How much longer can either sustain prices? Some Europeans are indeed arguing that the Union must do more to stimulate credit and investment, and therefore growth.

We fear that that stimulus is going to be an even tougher sell in Germany than keeping Greece from going under. It’s one thing to avert the Lehman-monster of the disorderly exit as being necessary to avoid another systemic meltdown. However, the Austrian school of economic thought that is still cherished in German circles is very much against government expansion of credit and investment, seeing it as a temporary fix that can lead to disastrous inflation. The only “safe” cure, the thinking goes, is prudence and time.

Rising markets are not only not a disincentive to such action, but breed the kind of complacency that can further imperil the European economy, not to mention the peripheral group that includes Greece. But that, at least, would give the markets something to rally against.

The Economic Beat

There was actually a report last week that was better than advertised – the ISM manufacturing survey. The other reports didn’t fare so well.

We could hardly believe our ears listening to National Public Radio gush over the pending home sales report on Monday. Billed as “yet another positive indicator” of a housing recovery (what was the other one?), the announcer joyfully announced that the index was up 8% increase over the same month last year. As we remarked in last week’s column, sales rates are flat with last year and prices are down. The latter was emphasized by yet another downbeat release from Case-Shiller on home prices: 2011 produce a 4% decline in existing home sale prices, punctuated by a steep December decline.

There has been no genuine improvement in housing at all from a year ago, except in the homebuilder sentiment survey. The latter group is feeling better because apartment construction is up, but there is nothing happening in single-family. Traffic is said to have improved, but the real key to unlocking single-family housing is credit, and the banks are still in their fallout shelters. Mortgage-purchase applications are down from a year-ago. Contracts may be up, but the closing rate has been minimal. Large increases in the pending home sales index in October and November did not carry over to actual sales.

Durable goods fell sharply and unexpectedly in January, down (-4.0%) overall and down (-4.5%) in the business investment category. The latter ended with a 6.5% increase on the year, which isn’t all that impressive given the accelerated depreciation bonus that expired in December. The Wall Street Journal immediately rushed an apology for the number into print, essentially telling us to pay no attention, as the decline was a normal reaction to the expiration of the bonus. We think that the number is likely to get revised upward, as the seasonal adjustments are large in January and the unadjusted number wasn’t bad by historical standards. But it isn’t a great way to start.

That said, the regional manufacturing surveys that appeared all posted good numbers: Chicago, Richmond, and Dallas. That’s good, but we have to point out that all the numbers were below the levels of a year ago. Some other things to ponder in the Chicago report include the home page of the group remarking what fine weather Chicago has been experiencing. We cannot ever remember somebody boasting about the great weather in a Chicago February. The other item of note is that the respondents’ remarks were, on balance surprisingly cautious. It’s clear from the monthly auto sales figures released on Thursday that that sector is doing well, and the Chicago region is a particular beneficiary of auto strength. Ex-autos appear less robust.

The ISM manufacturing survey, as noted, was better than it looked. Although the headline number of 52.4 was below the consensus of 54.6 (the whisper number was much higher, with some hoping for something in the 60 range), the ratio of growing-to-contracting industries was a reasonable 11-4. The subcomponents showed broad improvement in respondents indicating a better mix of activity, but the seasonal adjustment factors rubbed them out. Like most of the recent economic data, however, the ISM numbers in January and February are significantly lower than they were this time a year ago.

So if manufacturing is enjoying a lift from the calendar and inventory cycle similar to the one a year ago, but less pronounced, where is first-quarter GDP headed? Last year’s first quarter clocked a 0.4% annual rate that completely wrong-footed the markets. Looking at the first month of preliminary income and spending data doesn’t inspire. Real disposable income fell (-0.1%), and real spending (PCE) was unchanged for the third month in a row. The year-on-year PCE rate fell for the fifth month in a row. The income and spending numbers are preliminary, but the rate is so far below the rate for the first two months of 2011. Oil prices are higher, raising our import bill.

Yet fourth-quarter GDP was revised higher, contrary to our expectations, to 3.0%. We correctly anticipated that the price deflator would rise and the import subtraction would be larger. However, the extra inventory addition was more than enough to cancel them both out. This modifies our view towards the first quarter; the inventory rebuild appears likely to be smaller than we first thought, largely because sales were pulled forward into last quarter (also opined by the Journal’s pay-no-attention view on durable goods orders).

The pull-forward effect seems to have also been on the minds of apparel retailers. Most reporting companies came up with better-than-expected February sales, but none of them wanted to raise guidance for the rest of the quarter (which ends in April for most retailers). The warm weather gave a lift to spring apparel sales, said management, but one can’t blame them for being unsure if it’ll continue. It certainly didn’t benefit the national supermarket chains and their kin, who were left with a lot of unsold snow shovels and ice melt.

It’ll be interesting to see the week after next how February sales panned out. Autos and apparel clearly did better, but the two weekly sources of chain store data, Redbook and ICSC, were completely at odds over sales trends for the month. Keep in mind also that the same-store sales data that gets into the papers is heavily biased – when chains mature and start to struggle to generate comparable sales increases, they usually stop reporting monthly sales data. By the way, February is also a retailer’s least significant month.

Construction spending eased (-0.1%) in January, a big miss in that it was supposed to increase by 1.0%. We were advised to ignore this number too. Weekly claims were flat (after revisions), and the Fed’s Beige Book made its usual observation that growth seems to be moderate.

Next week brings a heavy schedule, starting with the ISM non-manufacturing survey on Monday. Factory orders come out at the same time, but a drop has already been telegraphed by the durable goods data; the main interest is the revision for the latter. The big one, the jobs report comes out on Friday (apologies for our mistake last week when we intended to write next Friday) and the consensus is for something over 200,000. We’re not sure what the impact of a robust number would be, but some of last week’s trade action indicates worry that further monetary easing may not happen.

Also due, besides the usual job teaser numbers (ADP et al) are data on productivity and costs (important for profit margins), consumer credit, the trade deficit and inventories.

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