July 24, 2013

The Dow set another new all-time high yesterday although the S&P 500 gave up a bit of ground in a mixed session dominated by earnings reports.

Over 25% of the S&P 500 companies are reporting earnings this week.  Let me just gloss over a few of the reports to give you some flavor of what’s going on.   This morning Ford announced better than expected sales and earnings for the quarter.  The auto industry has been a bright spot during this entire economic recovery and clearly a beneficiary of low interest rates.  Volumes are getting back toward old annual highs. There even seems to be a bit of a turnaround brewing in Europe.  In time, one would expect auto sales to flatten out at healthy levels but, for now, they keep growing.  Boeing is another company reporting very good numbers this morning.  We all know of the battery problems with its 787 Dreamliner but with those aside, the company is accelerating Dreamliner deliveries and delivering a record number of planes as airlines seek to improve fleet fuel economy in this era of very high jet fuel costs.  Speaking of fuel, Schlumberger and Halliburton also reported nice numbers reflecting a spike in energy production, particularly in the U.S. where fracking technology is having a major positive impact.   The easy low cost oil and gas has been largely found and extracted years ago.  Now oil and gas companies have to go deeper, both onshore and offshore, and need to use very sophisticated and expensive techniques to get the energy resources out of the ground.  Oil service firms like Schlumberger and Halliburton are key beneficiaries.   Pepsi is another winner.  Not too many consumer companies have reported so far and the returns have been spotty.  Coke, for instance, had a mixed report.  But Pepsi is doing very well as its snack foods (those wonderfully healthy Doritos and potato chips) find new customers worldwide.   Pepsi has been prodded by a series of activist investors to do more but so far it seems to be doing just fine without outside interference.

But all the news isn’t good.  There have been notable misses within the technology sector as PC demand is in a big slump and demand growth for consumer appliances appears to be waning.  Intel was expected to do poorly and it did.  Microsoft had a big miss, mostly tied to PCs sold to consumers.  Apple last night had an OK report but lowered guidance.  Phone sales beat expectations but iPad and computer sales were down year-over-year.  As I noted previously, this was not a very important quarter for Apple investors.  Apple’s future is almost completely dependent on the success of new products that will be rolled out later this year and in 2014.   Consumer response to these products, both upgrades to existing lines and new concepts altogether, will shape the company’s future.  The number of iPhone5s or iPads sold this quarter simply isn’t that important.  But with that said, the waning demand for iPads should serve as a strong reminder that product freshness and innovation need to be constant.  As they fade, so does demand.  So far, tablets are information retrieval devices and not much more.   Unless their functionality broadens, the total market for tablets will be limited.

Indeed, if you look more broadly at tech demand, what you see is that maturing product cycles, from PCs to phones to tablets, are weighing on the industry.  While IT departments and consumers don’t necessarily wait for computers and phones to break before replacing them, they will willingly upgrade for new features, better functionality and meaningful speed improvements.  However, as you move from the sixth iteration of a device to the seventh, the perceived increment in performance gets less and consumers are willing to hold on and wait to upgrade longer.   There was a time when a new PC every three years was the norm.   Now it may be five or even six years in some cases.   Apple phone fanatics used to upgrade as soon as their carrier would allow, maybe once every 18-24 months.  But there are still a lot 3-4 year phones out there and it is likely that customers will wait even longer going forward.  What I am saying is that PCs and smartphones aren’t any different from TV sets or washing machines.  At some point, new products no longer motivate the purchase.  Appliances get replaced when they break.  That’s already true for PCs and will soon be true for phones and tablets.

Let me now step away from earnings and talk a bit about the economy worldwide.  It is quite possible that when we get our first look at second quarter GDP growth in the U.S. it will be a number below 1%.  Although consumer spending has been OK, it probably decelerated from the first quarter as tax increases take their toll.   Government spending may have been down in the quarter, part due to the sequester, part due to less war related expenses, and part due to ongoing weakness in state and local government spending.  Investment spending was probably up a tad but still rather anemic.   If there was one good sign that we can decipher from Q2 earnings it was that industrial demand in the U.S. appears to be improving a bit and that trend continues into Q3.   On the other hand, export demand is poor, except for planes, and rising gasoline prices are only beginning to act as a tax on spending.  The conventional wisdom is that demand will pick up in the back half of the year as the impact of sequestration dissipates by the end of the third quarter and both consumer and investment spending improve.  But that supposition requires Washington to resolve budget and debt ceiling manners in a non-disruptive fashion and that is looking increasingly unlikely.  For one, Republicans can’t decide among themselves what they want to do and Speaker Boehner has said repeatedly that nothing will move forward in the House without a majority vote among Republicans. 

Overseas, the picture is mixed.  Europe appears to be coming to an end of its recession but that doesn’t mean growth will follow.  In fact, I expect Europe to mirror the U.S. post the 2007-2009 recession with very low growth for a very extended period of time.   Japan appears to be one bright spot, at least for now.  But the BRIC nations have big problems.  Brazil may be in the worst shape with high inflation and real growth near zero as it tries to deal with a bifurcated economy, weak commodity prices, and political discord in front of the 2014 World Cup and 2016 Olympics.   India, always a bureaucratic mess even in good times, is trying to stabilize its economy as its currency weakens dramatically.  In China, they report good growth but no one should believe the government figures are even close to reality.  Wage growth has slowed in response to government efforts to curb inflation and consumer spending as a percent of GDP is declining.  China has long been dependent on exports and infrastructure spending.  But how many roads and apartment buildings can you build? While China’s balance sheet appears in good shape, its banks are a mess. China has allowed its shadow banking world to get out of control as ours did before the Great Recession. Now it has to take action to regain control.  China remains a work in progress that may take a few more years to resolve.  China will grow again but nowhere near the 7-8% rate it projects. 

Add all this together and you get an economy still moving forward but at a very disappointing speed.  It is like driving on the turnpike in third gear.  It beats walking but it isn’t a very satisfying journey.  The Federal Reserve and other central banks have tried to boost the forward speed by forcing down interest rates and making money plentiful.  But while the Fed can increase the supply of money, it can’t increase the demand for loans or for employees.   It will take a few more years for capacity utilization to rise high enough and the unemployment rate to fall low enough for the environment to feel right.  That is true no matter what the Fed does. 

The Fed talks of tapering and, publicly, bases that choice on the notion that accelerating economic growth will allow it to begin the process in the second half of this year.  But the reality is that the Fed is running out of time.  It now owns about a third of all 5-10 year Treasuries outstanding and a greater percentage of longer dated bonds.  As the present pace it will soon pass 40%.  Do we want to see what happens when the Fed owns a majority?   I’m not sure anyone wants to see how the Fed intends to exit from that situation.   So tapering is likely to begin slowly this fall.  We can all speculate how the markets might react but no one really knows.  Indeed, there are now a number of unanswered questions that face us.  Is the economy going to accelerate in the face of higher energy prices and Congressional dysfunction?   Will we have another disruptive debt ceiling war in the late fall?   Has the bond market found a new level or will Fed tapering send rates higher once again?

Soon earnings season will end and these questions will grab front page attention.  When they do, markets may become more volatile for a time.   I don’t think any of these issues threaten the end of the bull market nor do they threaten the overall economy enough to raise the specter of recession.   But they can be disruptive until they are resolved, most likely later this year.  Thus, while it is nice to see new all-time highs hit daily, I suspect we might be in for 2-3 months of seesaw volatile behavior before the next leg up.

Futures point higher this morning on generally good earnings.  The notable exception is Caterpillar which had weak numbers related to low demand for mining equipment and excess inventory that will take a few more quarters to work down.

Today Jennifer Lopez is 44.  Wonder Woman Lynda Carter turns 62.  Speaking of Wonder Woman, Ruth Buzzi (remember Rowan and Martin’s Laugh-In?) turns 77.

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